Brocade Communications Systems F3Q07 (Qtr End 7/28/07) Earnings Call Transcript

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Brocade Communications Systems, Inc. (BRCD)
F3Q07 Earnings Call
August 23, 2007 4:30 pm ET

Executives

Michael Klayko - CEO
Richard Deranleau - CFO
Tom Buiocchi - VP of Marketing
Yin Cantor - Manager of IR

Analysts

Mark Moskowitz – JP Morgan
Aaron Rakers - A.G. Edwards
Paul Mansky - Citigroup
Brent Bracelin - Pacific Crest Securities
Min Park - Goldman Sachs
Analyst for Harry Blount - Lehman Brothers
Roy Kaushik - Pacific Growth
Tom Curlin - RBC Capital Markets

Presentation

Operator

Good day, ladies and gentlemen and welcome to the Brocade third quarter fiscal 2007 financial results conference call. (Operator Instructions). I would now like to turn the call over to your host, Ms. Yin Cantor. Please proceed, ma'am.

Yin Cantor

Thank you and good afternoon. I'm Yin Cantor, Manager of Investor Relations. Joining me today are Michael Klayko, Brocade's CEO; Richard Deranleau, Brocade's CFO; and Tom Buiocchi, Brocade's VP of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing its third quarter fiscal 2007 financial results via PR Newswire and First Call. The Q3 press release, along with the corresponding slide presentation, is available on our website at brocade.com. Know that the slides will automatically advance as part of the webcast presentation, and a PDF version will be posted just after the call concludes.

This conference call is being webcast, and will be archived on our website for approximately 12 months. In addition, a telephone replay will be available at approximately 3:30 pm Pacific time today through 12 pm Pacific time August 30th. To access the telephone replay, dial 888-286-8010 or 617-801-6888. The passcode is 44627068.

As a reminder, the information the presenters discuss today will include forward-looking statements including, without limitation, statements about Brocade's financial results, business outlooks and guidance. The forward-looking statements are only predictions, and involve risk and uncertainties such that the actual results may vary significantly. These and other risks are set forth in more detail in our Form 10-Q for the fiscal quarter ended April 28, 2007 and Form 10-K for the fiscal year ended October 28, 2006. These forward-looking statements reflect beliefs and estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements.

Certain financial information on today's conference call is presented on a non-GAAP basis. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures is provided in our 3Q07 press release, which has been furnished to the SEC on Form 8-K, and in the corresponding 3Q07 slide presentation on our website. In addition, the presenters will discuss sell-through information, which provides a measure of OEM and channel partner sales to end users. Brocade does not record revenue based upon OEM sell-through information, and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand but not a GAAP measurement of revenue, and therefore is subject to the same level of internal controls as reported GAAP revenue.

The third quarter of fiscal 2007 is the second combined quarter for Brocade and McDATA. In accordance with purchase accounting, we have not restated prior quarter financials to include McDATA, and therefore the comparisons we will refer to in this presentation, other than 2Q07 do not reflect McDATA's historical results.

With that, I will now turn over the call to Mike.

Michael Klayko

Good afternoon, everyone and thank you again for joining us. Today I will briefly discuss Q3 results and update you on our product lines, growth initiatives and on the business trends we are seeing. Following my remarks, Richard will review the Q3 financials in more detail, and provide information on our outlook. Overall, we are very please with both our results and execution in our third fiscal quarter. In just two quarters, we have met or exceeded the vast majority of our target business metrics related to our acquisition of McDATA, and have strengthened our combined profitability and business fundamentals. We believe we are well-positioned competitively and our leadership position is unchanged.

Revenues for the third fiscal quarter were $327.5 million, representing a growth of 73% over 3Q06. Non-GAAP diluted EPS was $0.12 per share, at the high end of our earlier guidance. Non-GAAP gross margin for the quarter was 55%, also at the high end of our guidance. As you all know by now, this is a little less than we expected on the top line and a little more than we expected on the bottom line, as we continue to further hone and improve our business model. I am very satisfied with the overall results, and will give you some more insight on both the top line and bottom line dynamics in just a moment.

But before I get into the quarter, I would like to step back for a moment and provide perspective on the market fundamentals and dynamics that drive our target markets and customer needs. We want to be very clear about both the immediate and long-term opportunities in this industry, as it appears its sentiment in the market is at least temporarily mixed. Our perspective is unwavering, that the market fundamentals and subsequent growth potential of the overall market remains very positive, indicating continued expansion of opportunities for Brocade.

First of all, to be clear, the markets in which we participate go beyond our traditional SAN business. These target markets include storage networking, the broader data center infrastructure and products and services that help customers better manage both their block and file-based data. Our total available market has more than tripled from our original SAN-only business. Industry storage growth continues to be an important indicator of our target market, but it is by no means the only or the dominant factor.

Server connectivity to shared storage, driven increasingly by the requirement to better utilize and manage servers, is an equally important factor. Server connectivity rates to SANs continues to increase, primarily due to the dynamic trend of server virtualization, which is also a critical factor and influences our growth opportunity. It has been well-documented that virtualized servers connect to SAN at a rate of over 90%, and that server virtualization is still in its early stages of growth. Most customers that we talk to intend to dramatically increase the number of virtualized servers that they will deploy over the next one to two years and therefore we believe the potential for SAN growth, driven by the attach rates of virtualized servers, is tremendous.

The number of data center consolidations and relocations, often driven by the need for more efficient power, cooling and space requirements, are increasingly important factors. We estimate that over one-third of the SAN customers are currently in the process of redesigning and rearchitecting their data centers based on these needs and that more scalable and efficient storage networks will be an important element of these next-generation data centers.

The desire for operational cost savings, helped by the well-understood efficiencies of shared storage environments, is an important factor as well. Remember, our solutions have a proven, tangible and quantifiable ROI in the enterprise. Most importantly, the growing requirements to manage and protect the vast amounts of digital information, billions of files, e-mails, customer records and company records are driving the fundamental demand in our target markets. The analyst firm IDC recently reported that the amount of digital information that needs to be managed will grow sixfold by 2010, a compound annual growth rate approaching 60%. The management, security and protection of this information are today and will be in the next several years among the biggest challenges in enterprise IT.

These are just some of the factors that have enormous implications for our customers and serve to frame our ongoing strategy and continued optimism. Many of these trends and sentiments were crystallized in the results of a recent customer survey that we concluded. Over 650 enterprise customers responded with details on their biggest challenges, priorities and technology needs for the next 12 months. At the top of the priority list were three strong and recurring themes and requests: (1) reduce the complexity and cost of managing and maintaining storage; (2) reduce the cost and time to provision and allocate enterprise servers; (3) help rearchitect existing SANs to help prepare for next-generation data centers.

We will be sharing more details and trends from this comprehensive survey at our upcoming analyst day in September. This direct customer feedback further indicates a broad-based opportunity, not only driven by storage but also by the challenges of providing next-generation solutions for broader data center infrastructure and management. These are not optional requirements. They are fundamental priorities for CIOs and IT managers, whose responses indicate more, not less, focus on areas where Brocade can help them, given our expertise and experience.

Now, moving back to our Q3 results, I'd like to first highlight two important factors regarding our revenue performance this quarter. As we have stated in the past, we have continued to shed what we believe to be low-margin, non-strategic revenue which we acquired with the McDATA acquisition. This quarter, we actually reduced this type of revenue more than we originally anticipated. Richard will quantify it for you in a few minutes. I want to reiterate that we will not chase this type of revenue, so to speak, as it dilutes our business model and undermines our focus.

Secondly, as part of our communications during the McDATA acquisition earlier this year, we made a conscious decision to foreshadow our next-generation enterprise products. This has resulted in two effects. First and foremost, from a very positive perspective, we were able to immediately build credibility and trust with strategic, classic McDATA customers. They said plainly they like our roadmap and plans. As many of you have noted in your recent reports, prior share loss in these accounts has slowed dramatically or completely stopped. An ancillary dynamic in these accounts is that some are deciding to expand their existing capacity more conservatively as they await our newer platforms. This makes good sense for them in the short term, and is good business for us, as we expect to retain our strategic customer relationships and demonstrate significant advantages on our new platforms. We believe this is a short-term manageable issue, but we like the trade-off, and it makes tremendous sense for customer retention and sustainable, long-term profitable growth.

Let me touch on the progress in mix across our business areas. Overall, we had a strong and balanced quarter with our SAN segment, given that Q3 is historically our weakness SAN quarter of the fiscal year. Growth was led by our switches, particularly our embedded switches for bladed server environments. Our analysis tells us that overall SAN share was flat sequentially and our leadership and share position remain unchanged. We continue to compete aggressively and win in our target markets in industries, including at several customers who have tested the competition in head-to-head bake-offs and in production environments and have returned to Brocade solutions.

In our SAN segment, we continue to see strong year-over-year growth. File data is growing tremendously, and we continue to see significant growth in new customer deployments of our FAN solutions. We are adding between 50 and 100 new customers to our FAN installed base per quarter, and were very pleased that the average size of FAN transaction increased almost 20% sequentially.

In our Services business, revenues grew 203% year over year. We are increasing the amount of direct support we provide to our large customers and increasing the number of resident consultants that are co-located at enterprise accounts. Feedback from our customers is that we are becoming more indispensable in their environments, and we look forward to continuing to help them evaluate, plan and redesign their data centers.

Last quarter, we announced that we would be entering a new category, the Server Connectivity segment. We believe the transformation to next-generation data centers involve greater levels of connectivity, intelligence and simplification. Enhanced server connectivity is an important part of the equation. With a complete line of intelligent server connectivity offerings designed to address the emerging needs of the data center, we plan to be able to provide seamless end-to-end solutions that have been directly requested by our customers, innovate across a broader platform and deliver an increased level of end-to-end support and services to our customers.

We recently started shipping our 4 gig HBAs as our first products of our long-term intelligent server connectivity strategy. Over a dozen distributors worldwide have placed initial orders, and we are very pleased about the early feedback we have received from both the channel and our OEM partners. We believe this industry segment is ripe for innovation and change. Our next-generation intelligent server adapters, which are in-house developments, are on track for availability beginning in the first half of fiscal 2008. Utilizing 8 gigabit fiber channel and 10 gigabit Ethernet technologies, we believe our future offerings will deliver enhanced HBA functionality to further consolidate and simplify data center environments.

Lastly, we believe the emergence of new standards, such as fiber channel over Ethernet or FCoE, will protect the investment customers have made in today's SAN and extend the value of the fabric to a wider range of servers and applications. We are working closely with our peers and partners to enable customers to leverage the rich set of FC fiber channel fabric services delivering unified architecture and manageability. Regardless of underlying protocol, Brocade is taking steps towards enabling consolidation of these separate networks into a unified data center fabric.

Before turning the call over to Richard to review the financials in more detail, I want to comment directly on our bottom line performance this quarter. We continue to execute to our business model, drive margin expansion and demonstrate excellent leverage in our bottom line results. We have exceeded our expectations on the merger synergies and have integrated very quickly and smoothly. We know how to deliver and execute, whether it be in changing dynamics or through major transitions and acquisitions as we continue to diversify our business.

With that, I will turn the call over to Richard to provide additional information on our business segments, income statement and balance sheet, and then return for a few concluding remarks before Q&A.

Richard Deranleau

Thank you, Mike. Before I begin, I'd like to draw your attention to the increased level of disclosure we have included in our press release. Historical comparisons and other numeric detail have been provided in the release, which will give us the opportunity to provide you with some more color during the conference call.

So now let's look at our Q3 results, beginning with the income statement. Q3 revenues were $327.5 million, up 73% from the same period a year ago, slightly above our updated guidance of August 8th and slightly below or original guidance of $330 million to $340 million for the quarter. Q3 sell-through revenues were approximately $321 million. During the quarter, our OEM partners increased their inventory positions in preparation for a seasonally stronger 4Q07 and 1Q08. As a result, reported revenue is higher than sell-through. On a forward-looking basis, weeks of inventory at our OEMs are actually down, so we are comfortable with the levels of OEM inventories.

As Mike outlined, we believe revenues were affected by a couple of factors. First, Q3 revenues were affected by a more cautious environment for enterprise IT spending, combined with a traditionally weak seasonality. Q3 was less linear than in previous periods, with sales in May and June slower than expected and activity increasing in July.

Second, in a portion of our classic McDATA installed base, we are seeing a more conservative approach to expanding capacity as they await our newer platforms. As Mike mentioned, we are tempering our short-term expectations in these accounts, but are very pleased at the customer retention dynamics.

Finally, Q3 revenue levels reflect an $8.3 million reduction in the sales of non-strategic, low margin, third-party products, exceeding our original target reduction of $5 million for the quarter. Over the last two quarters, we have consciously reduced revenues by approximately $13 million of low margin, third-party products, which has had a positive effect on our gross margin. We have now completed this realignment and remaining sales of these low margin, non-strategic third-party products will not be significant.

As a percent of sales, OEM revenues followed a similar pattern to 2Q07 in comprising a smaller portion of overall sales than they did a year ago. This reflects a more diverse revenue profile. EMC, HP and IBM were again 10% customers this quarter, and accounted for the largest proportion of our OEM sales. On a geographic basis, domestic sales were down from historical levels as a percent of revenue, reflecting weaker performance in North America due to a cautious enterprise spending environment. This was offset by stronger demand in Asia Pacific and Europe.

Moving on to our business segments, SAN, FAN and services, we once again had a solid and balanced quarter overall in our SAN segment, despite Q3 being historically our weakest quarter from a seasonal perspective. As Mike mentioned, growth was led by embedded switches for bladed server environments, and we continue to have the strongest offering across all server OEMs for bladed server deployments. Standalone switches performed well, led by the Brocade 5000. This is our first interoperable platform, with sales tripling sequentially after just two quarters in the market.

Directors were down slightly, as expected, based on our historical seasonal trends for product mix. Continued strong performance of the market-leading 48000 Director offset much of the dynamics with legacy McDATA Directors, which was described by Mike earlier. Our analysis shows that our market share remained flat in the face of our competitors' new product shipments and presumed pent-up demand for those new products. Overall, we maintained our strong leadership position in the SAN market. Our SAN segment grew 17% year over year, with average deal sizes continuing to increase.

We also saw increased bookings for some of the newer FAN products, including FLM and MyView, showing increased customer adoption of these products.

Service revenues, which include both service and support, were up 203% compared to 3Q06, and were relatively flat quarter over quarter. As a reminder, service revenues reflect a purchase accounting adjustment related to deferred McDATA service revenue. The impact of this adjustment in Q3 was approximately $5.8 million, and we expect the impact of the purchase accounting adjustment will be approximately $4.6 million in Q4.

Service bookings, which are a key indicator of our demand and progress, increased 69% year over year. Growth in bookings was led by demand for resident consultants and direct support contracts, as customers are increasingly relying on our expertise and experience. In the quarter, the pricing environment remained relatively stable and sequential ASP declines were again in the low single-digits. From a gross margin standpoint, non-GAAP gross margins for Q3 were at 55%, at the high end of guidance of 53% to 55%. The improved gross margins reflect a favorable product mix and the decline of the non-strategic, low margin, third-party sales I noted earlier.

Moving on to our operating results, Q3 non-GAAP diluted EPS was $0.12, consistent with our updated guidance of August 8th and $0.01 higher than the consensus estimate of $0.11 per share. This better than expected performance is the result of improved gross margins and the continued strong management of expenses. Reporting on a GAAP diluted basis, Q3 EPS was $0.03, within the range of our prior outlook and up from a small profit last quarter. The difference between GAAP and non-GAAP net income primarily included $9.7 million for stock-based compensation; amortization of acquired intangibles of $19.3 million; acquisition and integration costs of $4.1 million, which was higher than our prior outlook of $2 million to $3 million; $18 million in net expenses for indemnification obligations related to various ongoing legal proceedings involving certain former employees and other related costs, compared to our prior outlook of $9 million to $11 million; and related net income tax adjustments of $10.9 million.

Our effective non-GAAP tax rate in Q3 was 30.5% above our expected rate of 27% to 28%. Due to the complexities of the McDATA acquisition and the full valuation allowance of our combined deferred tax assets, we expect our tax rate for both GAAP and non-GAAP to be more volatile than in the past.

Q3 non-GAAP operating expenses, excluding the items referred to previously, were $117.2 million, significantly below our prior outlook of $123 million to $126 million, as we continued to overachieve against our targets for removing costs from our combined business following the acquisition of McDATA. To date, we have realized annualized synergies well above our targeted range of $150 million on an annualized basis. Non-GAAP operating margins for Q3 was 19.2%, exceeding our prior outlook of 15% to 17% and at the high end of our long-term model of 15% to 20% of sales.

Let me pause here for a moment to highlight some year-over-year metrics and to emphasize the operational progress that we have made over the last four quarters. From a year-to-year view, non-GAAP operating expenses increased 45%, which is well below our 73% growth in revenues. Strong expense management and superior execution against our plan to realize synergies from our acquisition of McDATA resulted in an increase in operating income on a non-GAAP basis of 92% year over year, and expansion of our operating margin, again on a non-GAAP basis, of nearly 2 percentage points. These operational improvements clearly demonstrate our ability to manage and improve our business through major transitions and through growth.

Now, turning to our balance sheet, our cash and investment balance at the end of the quarter, net of convertible debt, was $639.2 million, reflecting continued strong cash flow offset by stock repurchases during the quarter. In Q3, we used $81 million to purchase approximately 9.4 million shares of Brocade common stock. This represented an increase from the $60 million used in stock repurchases in Q2. At the end of Q3, we had $132.7 million remaining under our $300 million stock buyback authorizations.

During Q3, we implemented a corporate 10b5-1 automatic stock purchase plan for repurchasing our common stock, so that we can continue to conduct open market purchases in periods in which we would otherwise be out of the market.

Cash flow from operations in the third quarter was $36.3 million, above our expected range of $25 million to $30 million, in what is typically a weak cash flow quarter. Strong cash flow was again driven by tight control over working capital items. Year-to-date cash flow from operations was $115.9 million. As a reminder, our cash flow is typically strongest in our fiscal second and fourth quarters and weaker in our fiscal first and third quarters.

Days sales outstanding in Q3 was 45 days, at the high end of our guidance of 40 to 45 days, reflecting a less linear quarter. Our on-hand inventory in Q3 was $21.8 million, below our outlook for a range of $30 million to $40 million, which principally is due to the better management of McDATA product inventory at our manufacturers and suppliers. Finally, deferred revenue was $128.8 million in Q3, compared to $126 million in Q2 of '07, and $57.3 million in Q3 '06.

Now, turning to our outlook for fiscal Q4. As you contemplate your models for our fiscal fourth quarter, here are some items to consider. Enterprise spending. First, we recognize that there is mixed sentiment about the enterprise IT spending environment, as reflected by commentary from our peers and partners. The potential for continued softness in North American enterprise accounts gives us some caution in our guidance for Q4. Should there be a return to a more positive spending environment in Q4, this would provide upside to our guidance.

Competition. The market is extremely competitive, and our competitors have recently expanded their product offerings. Nevertheless, we believe that our competitive position remains strong, and we believe we will continue to execute on our strategy and will retain market share. From a pricing perspective, the pricing environment for the past several quarters has been more favorable than historical levels. While we believe ASP declines may eventually return to mid single-digits per quarter, as competitors ramp their new product offerings, our current outlook is for a relatively benign pricing environment in Q4, with ASP declines once again in the low single-digits.

Regarding our income tax rate, working with our outside tax advisors, in Q4 we will finalize our analysis of the income tax effect of the McDATA acquisition. Because of the complexity and materiality of these analyses, there may be volatility in the GAAP tax rate in Q4, as our current estimates regarding acquisition tax impacts are refined. Such acquisition-related tax adjustments would not, however, impact our non-GAAP tax rates. But as noted before, we expect both GAAP and non-GAAP tax rates will likely become more volatile than in the past under the approaching FIN 48, the financial pronouncement that is now coming out.

Now, taking all of these factors into consideration, our outlook for Q4 is as follows: we expect our reported revenue in Q4 to be within a range of $330 million to $345 million. We expect non-GAAP Q4 gross margin to be between 55% and 56%, which is within our targeted model range of 55% to 58%. For Q4, we expect total non-GAAP operating expenses to be in a range of $119 million to $122 million; for non-GAAP operating margin to be in a range of 19% to 20%, which is at the high end of our target model. We expect non-GAAP other income, other expense net in Q4 to be approximately $7.5 million to $8 million. We currently expect our Q4 non-GAAP effective tax rate to be approximately 28%, although as I mentioned a moment ago, our tax rate is more volatile than in the past.

We expect diluted shares outstanding to be in a range of 400 million to 405 million shares. We expect Q4 '07 non-GAAP EPS in a range of $0.12 to $0.13. We expect 4Q07 GAAP EPS in a range of $0.03 to $0.04. We expect the difference between non-GAAP and GAAP EPS in Q4 will consist primarily of the same items as in 3Q07.

Specifically, we expect expenses for the indemnification obligations related to various ongoing legal proceedings against certain former employees and other related costs will continue to be difficult to forecast going forward. For modeling purposes only, levels similar to Q3 can be assumed. We expect amortization of intangibles to be in line with previous two quarters at $19.3 million. We expect a small amount of acquisition-related expenses of around $1 million. We expect stock compensation expense to be $11.4 million.

We also expect capital expenditures in Q4 to be in the $12 million to $14 million range. We expect DSOs in Q4 to be within our targeted range of 40 to 50 days. We expect on-hand inventory in Q4 to be in a range of $20 million to $25 million. Q4 is historically a strong cash flow quarter, and we expect to generate cash from operations in the quarter of approximately $40 million to $50 million. As a reminder, the company has $132.7 million remaining under our $300 million stock repurchase program. With our 10b5-1 plan in place, we are currently active in the market.

With that, I will now turn the call back over to Mike.

Michael Klayko

Before we open the call for questions, I would like to summarize our key points. Our business strategy aligns to evolving market trends and opportunities, and we are continuing to invest in the growth and diversification of our offerings to intersect these opportunities. Customers are clear on their needs for newer and expanded solutions, and we are very confident about our ability to innovate and address their growing challenges. Our operational results continue to reflect our ability to execute through changing dynamics and major transitions as we continue to diversify our business. We will continue to hone our operational model to produce outstanding results. We are competing very well, maintaining and enhancing our leadership position. We are confident in our technology and solution leadership and in our ability to maintain and grow our strategic customer base.

Operator, please open the call for questions.

Question-and-Answer Session

Operator

Your first question comes from Mark Moskowitz – JP Morgan.

Mark Moskowitz – JP Morgan

I want to see if you could help us understand more the revenue guidance, in terms of give us a little more context about how much is driven by the US enterprise versus some of your commentary points regarding legacy McDATA accounts and some of their buying patterns presently?

Michael Klayko

I will take kind of a macro view, and let some of these guys jump in on maybe the micro view and so forth. There is a lot of complexity and there is a lot of regulation in the marketplaces right now, not to mention many people that are quite nervous on the financial crisis that was going on in some of the sub-prime market. Now, that has a cause and effect. One is the financial market is a pretty big market. I mean, we supply all the top ten financial services firms with their infrastructure. But there is a good news story, and it also is we also supply telco companies and pharmaceutical and retail and manufacturing and so forth. We are in the top ten suppliers to those also. So we have a pretty well-balanced portfolio, and when one is up, and others are down. So when we look at it in a broad-based market, you have got to factor that in. However, we actually feel that's a pretty good guidance when you think about what is going on, and if there's any turnaround at all in these marketplaces, I think we're going to benefit from the upside.

Richard Deranleau

I would say to answer your question specifically that our guidance was heavily impacted by our conservative view on the enterprise macro environment in North America. What we have said is that we intend to hold share, so as a result, if the TAM grows faster than we anticipate, that would be an upside to our market.

Mark Moskowitz – JP Morgan

As far as the lead times or sales cycles, has there been any sort of tonal shift in terms of working with your OEM partners and the end customer?

Tom Buiocchi

Not really, not at all. At least, none perceptible to us.

Mark Moskowitz – JP Morgan

Maybe you could help us understand more of the competitive dynamics. Obviously, Richard, you have been pretty candid here as far as the price dynamics not really deteriorating as some had feared. Is it still too early to really gauge the competitive activity in terms of will they have an impact? Or is it just going to be more where you are just being quite cautious, and this really could be a reasonable duopoly going forward, in terms of rather benign pricing dynamics?

Richard Deranleau

Just to make sure I was clear, we are assuming that in Q4 that pricing dynamics, ASP decline will remain as they have been last quarter, which we would characterize as benign. That is included in our guidance. When we look at it, if we're going to see an increase in the amount of ASP decline, it is really going to need to be something that happens prior to the next technological turn on the products. I guess I would leave it at that.

Mark Moskowitz – JP Morgan

Tom, could you just help us understand what have been the market dynamics of late, in terms of the fabric switch market, your flex solution versus the competition, in terms of has there been any sort of changes there in terms of your competitive position?

Tom Buiocchi

Not really, Mark. In terms of this quarter in particular, our strongest segment was our fabric switch segment and our bladed server segment as well. So those product categories are seasonally strong this time of year, and competitively, we maintained our position there quite nicely.

Operator

Your next question comes from Aaron Rakers - A.G. Edwards.

Aaron Rakers - A.G. Edwards

First of all, there has been a lot of mixed data points around server virtualization and the impact that it's had on the storage market in general. Maybe you could touch on that?

Tom Buiocchi

I will be really crystal clear on this. We have reiterated this a few times. Server virtualization brings with it SAN attach at a very, very high rate; over 90% in the case of VMware. If you look at traditional enterprise servers, they attach to SANs at about a 20% clip rate, so one in five, whereas virtualized servers attach to SANs at a nine out of ten clip rate. So we love the trend of virtualized servers, as it drives more SAN attach of server ports.

Aaron Rakers - A.G. Edwards

A second question on the pricing question earlier. You had mentioned that it would really come with the next generation, I'm guessing you are referring to 8 gig. We have seen the host bus adapter guys announce 8 gig platforms here recently. Can you give us any indications of what the timing looks like for you guys on the switch side with 8 gig starting to roll out?

Tom Buiocchi

Yes, we have made comments about two categories, our Director category, which we have said first half of FY08, and also on our HBA side, as well, where we've said first half of FY08. Those are the only two categories we've have made comments on thus far.

Aaron Rakers - A.G. Edwards

Are there any metrics that you can provide us with regard to your top ten customers with regard to up, down sequentially in the quarter?

Richard Deranleau

It is in the press release, too. But at the end of the day, there really hasn't been much of a change from prior quarters. The top three OEM comprised a little bit smaller percentage of total revenue from the past. But it is pretty stable.

Aaron Rakers - A.G. Edwards

F5 purchasing Acopia, can you maybe at a high level tell us how that could or could not compete against you guys in the Tapestry or FAN product line?

Tom Buiocchi

Obviously, Acopia was a player in the file area network market segment. What you saw in the last quarter or two is the validation of that segment. As customers continue to have that challenge, a couple of the smaller startups started to get picked off via acquisition. We're really optimistic about that space. We continue to add roughly 50 to 100 new customers every quarter and what we see is a validation. There will be competition in that space, but it's a validation that the market is evolving and growing and other players want to participate in it.

Operator

Your next question comes from Paul Mansky - Citigroup.

Paul Mansky - Citigroup

I don't want to beat a dead horse here, but the financial services, do you have visibility into what that is as a percentage of revenue?

Michael Klayko

We track all the large different categories, but as a percentage of revenue, although it is a large piece of our business, it by far in no way can influence the result quarter on quarter. We participate with all the different financial services entities. But again, we also participate in all the top Global 2000 accounts also.

Paul Mansky - Citigroup

Obviously, you commented that the driver behind sell-in ahead of sell-through in July is a function of OEM customers positioning for that normal back half seasonality. But at the same time, you seem to be taking a more cautious stance than your customers around the macro. Can you maybe reconcile that a little bit more? Is this a macro concern, or are you really looking at more purchase deferrals in front of the Neptune rollout?

Richard Deranleau

Good question, Paul. What we're trying to say is this is all around the macro environment. So to reconcile a little bit on what we've said on the sell-through and the provisioning, keep in mind that Q4 as our second-strongest quarter of the year. Q1 is our strongest quarter of the year. It just makes sense for the OEMs to position the inventory to fulfill that. We're talking about a couple of weeks of inventory anyway. So at the grand scheme of things, it is really not that big a driver. What we are saying is, we are going to do very well. We're going to hold share. If the economy picks up, we will do even better.

Michael Klayko

To add one more comment, the demand is there. The need remains. Nothing has changed from the fundamentals of the business, either. So customers do have this requirement. It is just a matter of when.

Paul Mansky - Citigroup

Just one last clarification point. We do expect revenue from the next-generation platform in the first half of the fiscal year?

Michael Klayko

In the first half of next fiscal year, absolutely.

Operator

Your next question comes from Samuel Wilson - JMP Securities.

Samuel Wilson - JMP Securities

Just a couple of small questions. First, on the FAN StorageX side of the business, can you talk a little bit about your partnership strategy versus acquisition, and how some of those partners are going? Clearly, on the WAN optimization space in particular, there has been a lot of activity, and I just want to know how you feel like you're positioned there?

Tom Buiocchi

I'm sorry, we kind of lost the first half of your question. Can you just repeat it one more time a little louder?

Samuel Wilson - JMP Securities

On the FAN StorageX side of the business, and in particular how you feel like you're positioned in partnership versus selling your own products?

Tom Buiocchi

Well, our portfolio today is a combination of things. We have our own products on the software side, a suite of products that we acquired with the StorageX product line. Then we've partner with Packeteer on our WAFS technology, obviously.

Samuel Wilson - JMP Securities

How you feel you're positioned there vis-à-vis the competition?

Tom Buiocchi

Well, pretty good. It is the most complete product line in the industry right now. We have a number of different offerings that our competitors don't have. There are competitors or adjacent markets of WAN optimization as well. But we view that as an ancillary complementary market because people using WAN optimization still need to figure out how to place their data, and where that data resides and how to migrate it and protect it. So if you're referring to the WAN-op segment, we view that as complementary. If you're referring to the file management segment, we believe we have by far the most comprehensive product line today.

Samuel Wilson - JMP Securities

In terms of the long-term model gross margin goal of 55% to 58%, can you give us a sense as to what you think the ASP declines you're thinking about longer term as being the baseline number when you think about that goal?

Michael Klayko

Let me take a first crack, and then Richard will give you the real details underneath it. When you look at the model that we are building right now, it is not just ASP decline in terms of SAN switching ports, because frankly, we're in not only the SAN market but also in the software market, which has different gross margins, in addition to the services space. So we have an aggregate gross margin model as well as an operating model so frankly, you just can't look at one space.

When we deal with customers today, they are no longer looking at just price per port, because they have an enormous amount of complexity that exists in their environment, and it is how do you service it? How do you implement it? How do you design it? There's a lot more parts that are involved. So we don't actually look at just the ASP in one segment.

Richard Deranleau

The 55% to 58% long-term model contemplates a historical ASP decline in the mid single-digits. But having said that, just reiterating what Mike was pointing out, is that today, because we have such a larger component of our product around services and around some software that carries a different dynamic around ASP that becomes less meaningful than it was maybe two years ago.

Operator

Your next question comes from Brent Bracelin - Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

I wanted to really talk a little bit more on the op margin trends. Clearly, you guys are at the high end of the range this quarter, guiding next quarter to the high end of your long-term range, yet most of the benefit is coming from OpEx. At what point do you expect to start to see COGS benefits when you move to that converged platform? Do you think you could start to get some gross margin leverage in the first half of '08, or will that be more of a second half of '08 driver?

Richard Deranleau

That is a good question, Brent. First of all, yes, I think we have had a good quarter when you look at the execution on the synergies, when you look at the management of our expenses. Going forward, we're basically done from the synergies point of view when it comes to headcount. Now, we have to look at more longer-term, more structural things that are most likely going to be around COGS. In that perspective, you're going to see us being able to improve COGS. In fact, in our guidance, you see that within just two quarters of combined operations, we have moved way back into our long-term model. We have not shown an increase in our next-quarter guidance. So we are showing increased improvement, and next year, we'll obviously be looking at it. But at this point, given all the changes that are going on between the combined companies, we're still comfortable with the long-term model of 55% to 58%.

Michael Klayko

By the way, if you did take from quarter on quarter, we do feel there is an increase in gross margin going forward, and I think we actually gave that in our guidance. Then the mixes change as we go forward also, some of the products that as we incorporated some of the McDATA products and some of the mix is changing also to different margin products, so pretty comfortable that we can continue this trend.

Brent Bracelin - Pacific Crest Securities

Then just a quick follow-up on the guidance on op margin. I know a year ago, you guys had a 15% to 20% op margin long-term target. You guys exceeded that. I think it got as high as a 25%, 26% operating margin, even though your longer-term range was in that 15% to 20%. As you think about your overall business, why couldn't you continue to see improvements in op margins going forward, if you do believe there is still leverage on gross margins?

Michael Klayko

Well, I will give you my view. One of them is we continue to invest in the company for growth and diversification. There are some very good market opportunities that we see that we can grow the top line of the company and expand in some new market spaces, and yet stay within that 15% to 20%, which is a very, very good, healthy business model to be in. A lot of companies would kill for that kind of problem, and yet we think we can stay within that, yet take and grow into new businesses also.

Brent Bracelin - Pacific Crest Securities

Fair enough. My last question is really on the 8 gig. When you talked about kind of shipping that product and the Neptune product in the first half of '08, does that imply you will be sampling it and getting it qualified with OEMs in the first half of '08, or would you actually anticipate shipping the product broadly in the first half of '08?

Tom Buiocchi

Yes, we are not going into a lot of granularity on the schedules. As you know, different OEMs have different times and so forth. So as we get a little closer, we will be a lot more granular on that. Sorry.

Operator

Your next question comes from Min Park - Goldman Sachs.

Min Park - Goldman Sachs

First, you mentioned that you have been meeting or exceeding the vast majority of your McDATA targets. Does that mean that the shortfall this quarter was really due to more of your Brocade core business? If so, can you tell us what changes are occurring in the core business to cause this?

Richard Deranleau

I would recharacterize that. If you look at the metrics that we put out, and you look at the metrics around synergies, you look at the metrics around time to get back into our model, if you look at any of those that we have published and talked about for the last year, and you compare our actuals against that, that is what we are saying. We have achieved or beat every single one of those.

Min Park - Goldman Sachs

How about on the top line?

Richard Deranleau

So on the top line, if you recall, what we have said is we could absorb up to 30% attrition. We also explained that over time, that characterization was really around the purchase accounting adjustments, and it was also around getting rid of $13 million worth of low margin, non-strategic, third-party product. So when you have those two things, that is really the attrition. If you add up those numbers and you do the math against what we talked about in what McDATA did in our first quarter, I think it was $136 million. So yes, we have done much better than that as well.

What I would characterize in terms of this quarter, keep in mind that we gave guidance of $330 million on the low end. We're in at $327 million. For my characterization, this is our slowest quarter from a demand point of view historically. I think, quite frankly, given the macro environment that we had to deal with, which other people have talked about, our peers and partners, it was a pretty good quarter.

Michael Klayko

We made choices. These are just good business choices. We discontinued some lines of business. We eliminated some lines. We made some very, very good choices that position us very well. Our core business is very strong. It is very healthy. Customers that we have shared our current plans and our future plans with are resonating, and they love the plan. So I want to make sure that you don't have the perception that our core business may have lost strength. In fact, if anything, it has gotten stronger.

Min Park - Goldman Sachs

Then as far as the OEM channel buildup, how much were you actually expecting to build this quarter versus what you actually did build?

Richard Deranleau

If you are talking about Q3, it would be roughly consistent. Again, you are talking about a nominal amount of money anyway. When you look about Q4, Q4 we would expect the OEMs to already be provisioned for Q1, so you would not be looking to see further build in this quarter coming up.

Operator

Your next question comes from Harry Blount - Lehman Brothers.

Analyst for Harry Blount - Lehman Brothers

Would you be able to give us a sense of what the percentage of software mix was in this quarter?

Richard Deranleau

It is really hard to look at that perspective now, because there's so much software in every one of our parts of our business. Obviously, SAN is heavily influenced by software. But even now, on the SAN side with our fabric manager, and the FCM that is coming from the McDATA acquisition, there is just a lot more. So I'm not sure it helps for us. So we don't really track it from that prospective. We really track around the services lines of business, the SAN line of business and the FAN line of business.

Analyst for Harry Blount - Lehman Brothers

Is it significantly different than what you've said in the past, though? I think at some point it was probably under 5%.

Richard Deranleau

Well, I think when we talked about that, we were talking about our plan for the SAN business and giving some parameters, if you will, or some metrics. We had talked about SAN and services being 5% each as a percent of business. When you look at services and support now, it is 13%, obviously a little higher. From a SAN perspective, I think obviously, when we bought McDATA, the bar went way up, but we're still using 5% of revenue as a target for our SAN business.

Analyst for Harry Blount - Lehman Brothers

It sounds like there might be some delay and purchasers are waiting ahead of the combined platform. If you think that is the case, do you know what kind of magnitude that might be? Also, how you think the product refreshes at some of your largest customers are going to impact your business?

Tom Buiocchi

It is tough to quantify that. But let me tell you the conscious plan we're walking through with our customer base. One, we said we were going to clearly communicate to them very proactively what our next-generation platform looks like. Then we reinforced that by visiting those top accounts. Then we wanted to demonstrate our interoperability, our ability to deliver interoperability and investment protection, which we have done with our 5000 switch and our bladed products as well. We are doing this all while providing them with continuity of supply and continuity of support and so forth. So the strategy is working. They are not migrating to the competition. They are staying with us and they're going to grow with us. It is tough, though, to tell you exactly or quantify what percentage of our business that is and when it actually kicks in.

Michael Klayko

There is also another dynamic that I just want to add to Tom's comment, is a lot of the customers right now are in the midst of rearchitecting their data center. Quite a few, as they rearchitect their data center, what they actually are going to be doing is depending more on us to provide more of the parts to that. So there's a lot of those that are in flight at this moment in time. So it is not so much a delay, it is just making sure that they have all the componentry as they build out these new data centers.

Operator

Your next question comes from Roy Kaushik - Pacific Growth.

Roy Kaushik - Pacific Growth

Congratulations on the great OpEx management. Now that you have reached close to the target of 20% on operating margin, my question is on the revenue growth may be beyond one or two quarters. So has your expectation on the SAN market changed lately? What is the fiber channel SAN revenue growth rate, keeping in view that virtualization is actually shrinking the server units, iSCSI and InfiniBand are gaining traction and everybody's talking about fiber channel over Ethernet?

Tom Buiocchi

We still view, aided by the third-party analysts, a 10% to 15% market growth for SAN. We believe, and most of the analysts believe, that server virtualization is actually driving that to a higher end. Because the proposed reduction in server unit count you are talking about is really more than offset, many, many magnitudes offset by the higher connect rate of servers that are in virtualized segments. So we believe that is a positive impact to that. I'm sorry, I forgot the second part of your question.

Roy Kaushik - Pacific Growth

Because QLogic said that they are getting negatively impacted with virtualization, because of the server units coming down.

Tom Buiocchi

We absolutely disagree with that statement. We believe that it is a positive impact to us.

Michael Klayko

It is positive to us.

Roy Kaushik - Pacific Growth

Then are you seeing the Cisco 9124 in the market?

Michael Klayko

I just came from a customer who evaluated it, we were talking about the product, and their comment to me was, it was too small for the high end and too big for the midrange. It did not quite fit. He said and actually, I have been deploying product from you for the last two years that had the same feature set.

Operator

Your next question comes from Tom Curlin – RBC Capital Markets.

Tom Curlin – RBC Capital Markets

On the macro stuff, are you saying that the weakness that you're seeing is evenly distributed across OEMs? Because obviously, at least from reported results, some have been impacted more than others. Or is it fair to assume that it's proportional to the kinds of performance that the OEMs have reported?

Michael Klayko

Let me qualify that a little bit. First off, in the marketplace, weakness we're not seeing; I'm not saying it is weak. I think there's demand there at this point in time. All the different partners that we have are at different stages and they have to respond to their business model. The good news for us is data is growing, the demands are growing. Our product set is designed to focus on operational costs and some of the problems that our customers are facing today. We are not limited just to the financial sector. It is a piece of our business, but by the way, other pieces of our business, our telecom business is growing rapidly. Other businesses are growing very, very rapidly. So it really depends, quarter to quarter. On average though, what's good for us is we have a very, very balanced partner portfolio, a very balanced product portfolio and a customer base. So there are some macro trends that are going on, but frankly, I think we're in a trough. I mean, I can't see any more negative news coming out of Wall Street as bad as it has been, so if there's any upside and we start to turn around some of the financial crisis, it is only upside for us.

Tom Curlin – RBC Capital Markets

Then just turning to technology, the adapter initiative, the 4 gig stuff under way, can you clarify on the 8 gig product just how that's structured? LSI on 4 gig, the prior comment was that it's your own technology on 8 gig. But is it fair to assume that there's some kind of exclusive licensing arrangement or technology agreement with LSI on their 8 gig design? Otherwise, frankly, to me it would take you a lot more effort to get to market with 8 gig.

Michael Klayko

Understand why we got into this space, is it was directly driven from our customers who asked us to go ahead and provide more touch points and compatibility throughout their enterprise. The 8 gig product is developed here. There is no other licensing and so forth here, and it is relatively straightforward, Tom.

Tom Curlin – RBC Capital Markets

So there's no existing 8 gig design from LSI that you kind of used to get started and to bring this up to market?

Michael Klayko

There is not, Tom.

Richard Deranleau

We're pretty far along on the 8 gig as it is.

Michael Klayko

Well, it will be there when our products are there. When our complete family of products are there, this product will be there with them also.

Operator

At this time, I would like to turn to call back over to Ms. Yin Cantor for closing remarks. Please proceed, ma'am.

Yin Cantor

Great. Thank you, everyone, for joining us today. We look forward to seeing you at our next financial conference in New York on September 5th and also at the Brocade Fall Analyst Day, September 20th, and that is in Boston this time. Take care.

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