Full Transcript of Brocade’s F4Q05 (Qtr Ending Oct 29, 2005) Conference Call — Prepared Remarks (BRCD)

Here’s the entire text of the prepared remarks from Brocade’s (ticker: BRCD) fiscal Q4 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Executives:

Shirley Stacy, Investor Relations
Michael Klayko, Chief Executive Officer
Tony Canova, Chief Financial Officer and VP of Administration
Tom Buiocchi, VP of Marketing

Analysts:

Samuel Wilson, JMP Securities, Analyst
Andy McCullough, Credit Suisse First Boston, Analyst
Andy Neff, Bear Stearns, Analyst
Paul Mansky, Citigroup, Analyst
Henry Naah, Lehman Brothers, Analyst
Tom Curlin, RBC Capital Markets, Analyst
Nick Flair, Goldman Sachs, Analyst
Kaushik Roy, Susquehanna, Analyst
Frank Timmons, Robert W. Baird, Analyst

Presentation

Operator

Good morning. My name is LuAnn and I will be your conference facilitator. I would like to welcome everyone to Brocade's Fourth Quarter Fiscal 2005 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session.

Operator Instructions

Ms. Stacy, you may begin.

Shirley Stacy, Investor Relations

Good morning. Thank you for joining us this morning. I am Shirley Stacy, Brocade Director of Investor Relations. Joining me today are Michael Klayko, Brocade's CEO; Tony Canova, Brocade Vice President of Administration and CFO; and Tom Buiocchi, Vice President of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing our fourth-quarter and year-end financial results via PR newswire and First Call. This press release is available on our website at www.brocade.com. This conference call is being audio webcast and will be archived on our website for approximately 12 months. A telephone replay will be available today by 9:30 AM Eastern time through end of day Tuesday, December 13. To access a telephone replay, dial 800-642-1687 or 706-645-9291; and the pass code is 2525657.

As a reminder, the information the presenters discuss today will include forward-looking statements including without limitation statements about Brocade's financial results, business outlook and guidance. These forward-looking statements are only predictions and involve risks and uncertainties such that 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 July 30, 2005. The forward-looking statements reflect beliefs, estimates and predictions as of today and Brocade expressly assumes no obligation to update any such forward-looking statements.

Certain financial information that we review 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 Q4 '05 press release, which has been furnished to the SEC on Form 8-K and in the corresponding Q4 '05 slide presentation posted on our website. In addition, the presenters will discuss sellthrough information which provides a measure of OEM and channel partners' sales to end-users. Brocade does not record revenue based on the OEM's sellthrough information and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sellthrough is a measure of demand but is not a GAAP measurement of revenue, and therefore is not subject to the same level of internal controls as reported GAAP revenue.

Please note that certain classifications have been made to prior year’s balances in order to conform to the current year presentation.

With that, I would like to turn the call over to Mike.

Michael Klayko, Chief Executive Officer

Thank you, Shirley. Good morning everyone and thank you for joining us. I am actually speaking to you from Beijing where I am participating in the launch of our Brocade conference series across the Asia-Pacific region. We will be talking with approximately 3000 customers and partners across nine major cities in Asia between tomorrow and December 16th. Today I will briefly discuss our results for the fourth quarter, review our product performance and business trends, update you on our strategic initiatives and provide some insight into the opportunities we see as we enter fiscal 2006. Following my remarks, Tony will provide more details on our Q4 financial results and outlook for Q1.

For the fourth quarter, revenue was 145.5 million and non-GAAP EPS was $0.07. Company sellthrough, a measurement of OEM and channel partners’ sales to end-users was approximately 160.2 million, the second highest level in the Company's history. These results are consistent with the preliminary Q4 results announced on November 16th and brings our fiscal year 2005 totals to 574 million in revenue and approximately 611 million in sellthrough. Overall I was very pleased with our performance this quarter.

Our reported revenue and sellthrough were better than we had planned. Strong demand, solid gross margins, and some onetime expense savings led to increased profitability and helped generate 39 million in cash from operations. The strong demand was driven by a record quarter in directors, good growth in our embedded business and a solid quarter from our switch family. The SilkWorm 48,000, our new 4 gig director and our new 200E entry switch were both qualified by all of our major OEM partners during the quarter and our 4 gig products represented approximately 50% of our sellthrough, indicating a very strong transition to 4 gig in the industry.

Let me spend a few minutes describing our performance in our SilkWorm SAN conductivity business. Similar to last quarter, given the OEM inventory dynamics, I will focus my comments on the sellthrough aspects of our performance, the actual sales through to end-users. Q4 sellthrough for our fabric switches increased slightly from Q3. During the quarter, sellthrough of our 4 gig 4100 was up double digits and our new 4 gig 200 E, which was qualified by all of our major OEM partners during Q4, began its initial ramp with strong early acceptance.

In the embedded space, we saw renewed growth in sellthrough for our embedded fan switches for bladed servers and achieved strong double-digit sequential growth. Fujitsu Siemens added a Brocade bladed server module to their portfolio during Q4 and we also recently announced our second generation bladed server module for the IBM blade center. We continue to view this segment as a long-term high-growth opportunity.

Sellthrough for the multiprotocol router was up single digits following a very strong Q3 performance. The router has become a fixture in larger enterprise opportunities and is a requirement in the majority of large director deals. This quarter we also announced the availability of the router to nondisruptively link McDATA and Brocade fabrics, providing customers a capability they have been asking for and facilitating a more seamless two-vendor strategy for customers in certain situations.

In the enterprise category, sellthrough for directors increased significantly and represented a record quarter. Q4 demand for the SilkWorm 48,000, the industry's only 4 gig director, was very strong aided by some pent-up demand from its announcement last quarter. In addition we are finding that in many cases customers are utilizing both the 128 Port SilkWorm 24,000 and the 256 Port 48,000 in deployments, effectively configuring their San fabrics around our two distinct density and performance points in the director space. We are continuing to offer both products to meet the needs of our customers.

Now the sales pattern in the enterprise space is lumpier than our fabric switches and the magnitude of large transaction varies quarter to quarter. This quarter we had several very large transactions we won in competitive situations. Some in our installed base and some not. Customer wins for the quarter include brand names from around the world, including China Netcom, Daimler Chrysler, Hynix, Nokia, Petronas, the State of California's strategic sourcing initiative, and Volvo. In a number of these cases, our FICON capabilities have opened new doors for us in terms of overall director opportunity.

Overall, we feel very good about our position and momentum the director space. Our director sales funnel is larger than it has ever been. Our average deal size is larger than it has ever been, and we believe that the 48,000 has helped us increase our addressable market in the enterprise space.

I would now like to turn to our strategic initiatives and discuss the progress that we have made with the new Tapestry product family and with our service offerings. We have often referred to the magnitude of our install base of SAN ports, which is now approaching 6 million ports. We also recognize that our customers have broader data center challenges beyond SAN conductivity. Our unique position connected to both servers and storage and providing the data path for mission critical applications affords us an excellent understanding of many of these challenges in and around the SAN and our Tapestry and service initiatives aim to help customers address these challenges head on.

Our Tapestry family is really about bringing new functionality to the shared storage environment with a combination of innovative software and intelligent hardware. Last month we announced a third member of our growing Tapestry family, the Tapestry Data Migration Manager or DMM. Data migration is one of the most pervasive customer challenges in data centers today. According to the research from the Enterprise Strategy Group, 83% of data migrations exceed planned staffing time, 61% exceed planned downtime and 54% exceed planned budgets. In addition, 48% of data migration customers reported technical compatibility issues.

Tapestry DMM is a system of Brocade developed software running on our fabric application platform, which allows customers to perform data migrations in a very fast, simple manner with two unique capabilities, predictable results and the ability to migrate data across heterogeneous storage devices. Recently a large IT services organization used Tapestry DMM to migrate 13 terabytes of data for a key end-user customer on a very tight weekend schedule. They not only were impressed at the immediate ease-of-use of the solution, but they were able to shave 40% off their planned migration time and get the customer back on line much earlier than anticipated. We look forward to many more successes like this with Tapestry DMM in upcoming quarters.

We have also continued to make significant progress with the first two offerings in our Tapestry family. Tapestry Wide Array File Services or WAFS; and Tapestry Application Resource Manager, ARM, as they begin their initial customer acceptance ramp. When we first spoke to you about Tapestry in June of this year, we indicated that we believed it could be 5% of our revenue by the fourth quarter of fiscal 2006. While the current revenue for Tapestry is not yet material to our overall results, we believe that our early customer successes and feedback from late stage evaluation trials have us on track to achieve this goal.

In Q4, Tapestry WAFS began shipping and we are very pleased by the initial customer interest and ramp. WAFS addresses some very extensive and difficult IT issues regarding branch offices and data files. During Q4 we enhanced our Tapestry WAFS offering in Q4, Tapestry WAFS began shipping and we are very pleased by the initial customer interest and ramp. I will repeat a little just to be clear.

In Q4, Tapestry WAFS began shipping and we are very pleased by the initial customer interest and ramp. WAFS addresses some very extensive and difficult IT issues regarding branch offices and data files such as remote file access, backups consolidation, and centralized file management for better consistency, security and compliance. During Q4 we enhanced our Tapestry WAFS offering so that it now provides support for the most important branch office application, e-mail and e-mail attachments, as well as for network services that make it even more robust branch office solution. We believe that our WAFS solution continues to offer the highest performance in the market and is the only WAFS solution that delivers native integration with Microsoft products.

Our working partnership with Microsoft in the field has been invaluable in helping to secure our very first large WAFS customers in Q4, including some well-known international banks and financial services companies. Given the enormous number of branch offices and straightforward value proposition of WAFS, we see very strong interest levels in this segment for quite some time ahead.

We have secured our first two partners for Tapestry WAFS, Fujitsu Siemens and Nortel Networks. We are very pleased to announce that they have selected Brocade Tapestry as a key building block for their next generation of storage solutions. In addition, we are working with HDS on qualification of our Tapestry WAFS solution.

Tapestry ARM is a technology that addresses the problem of how to quickly get operating systems, applications and the critical storage information to servers in a network storage environment. It is especially beneficial to bladed server environments, where there is often no hard drive on the server and where the relevant Software resides in the SAN. We are attached to almost 2 million servers in our install base and we believe that number will grow significantly as bladed server environments mature and grow. We are receiving very positive feedback from the brand-name customers that are currently evaluating Tapestry ARM, substantiating our belief that it is a very unique solution to a very large data center challenge.

In addition, Tapestry ARM affords us the opportunity to engage in server and application discussions with both end-users and OEM partners, helping us to deliver significant value to additional parts of the IT organization beyond our traditional storage focus.

Our services strategy is straightforward. In response to growing demand from our customers and partners for our technical expertise and thought leadership in the network storage, we plan to provide a full portfolio of services in this area. These services in combination with our SilkWorm and Tapestry products form solutions that are designed to better enable our customers to meet their mission critical business objectives through greater reliability, greater utilization, and increased functionality of their storage networks.

In 2005, over 100 customers relied on Brocade to deliver key service components of their storage solutions around the world. Our SAN customers are undoubtedly not done building out or upgrading their storage networks and they typically don't have a surplus of the right resources to help them, so we strongly believe we can add a tremendous amount of value to complement their existing capabilities.

In order to structure and grow our services business, we recently hired Ray Wolf, an executive who has built and run service businesses across two industries, most recently with Dell as our Vice President of Worldwide Services.

Before I turn the call over to Tony, I would like to quickly summarize. During 2005, we identified significant growth opportunities in and around the SAN and within the data center; began delivering a new Tapestry family of products; and began adding service offerings we believe best address a number of customer needs.

As we enter 2006, we believe we are poised to continue to grow and maintain a leadership position in SAN switching and connectivity with our SilkWorm family and innovate to help solve broader customer problems in the data center with our new Tapestry and service solution offerings.

I would now like to turn the call over to Tony for review of our financial results and outlook for Q1. Then I will come back to summarize and address Q&A.

Tony Canova, Chief Financial Officer and VP of Administration

Thanks, Mike. I will now turn to a review of our Q4 results, beginning with our income statement. Q4 revenues were $145.5 million compared to $122.3 million in Q3 '05 and 155.6 million that we reported in Q4 '04. Our total cumulative ports shipped were nearly 6 million ports, which is up 26% over Q3. Q4 sellthrough was approximately $160.2 million. This is an increase of 12% sequentially from sellthrough of approximately 143.4 million in Q3 '05 and an increase of 7% year-over-year from approximately 150.4 million in Q4 '04.

Note that in Mike's earlier comments he referred to pent-up demand from Q3 that affected our director sellthrough in Q4. While it is not possible to precisely track every transaction impacted by this pent-up demand, we estimate that our director sales in Q4 included approximately 5 to $7 million in pent-up demand from Q3 for the 48,000. If you normalize our Q4 sell-through for that pent-up demand, it would have been closer to 153 to $155 million, still representing a healthy 7 to 8% increase in sequential sellthrough.

In Q4, several of our OEM partners reduced inventory requirements during the product transition greater than we had expected, reducing inventory on hand by nearly one week across our switch and director product categories. This is attributed principally to the increased demand we saw toward the end of our quarter. We believe that we are now at about 2.5 weeks of OEM inventory, which is lower than the three weeks of supply we believed our partners would end the quarter with. As we have indicated in the past, the decision on the level of inventory to maintain rests with our OEM partners.

Non-GAAP diluted EPS was $0.07. This compares to non-GAAP diluted EPS of $0.01 in Q3 '05 and non-GAAP diluted EPS of $0.08 in Q4 '04. Note that Q4 '05 non-GAAP EPS includes $2.7 million of tax expense adjustment which represents a benefit of approximately $0.01. Reporting on a GAAP basis, Q4 '05 EPS was breakeven; comparing to Q3 '05 GAAP net loss per share of $0.03, GAAP EPS for Q4 '04 was $0.08. Our effective non-GAAP tax rate in Q4 was a benefit of 8.6%, translating into an annual non-GAAP tax rate of 10.3%.

Non-GAAP net income for Q4 excludes charges of approximately $5.2 million loss on investment associated with the defeasance of the companies 2% debt; $4.7 million for taxes and other fees in connection with the repatriation of $78 million of foreign earnings; $5.2 million related to the internal review and SEC investigation costs; and $700,000 for stock-based compensation; 500,000 in reversal of previously recorded restructuring charges; and a 2.7 million income tax expense adjustment.

Non-GAAP gross margin for Q4 '05 was 55.3%, as compared to 51.1% in Q3 and 56.2% in Q4 '04. Q4 non-GAAP gross margin included a $1.8 million reserve for excess and obsolete inventory due to the faster than expected transition from 2 gig to our new 4 gig products. Excluding this additional reserve for excess and obsolescence, our Q4 non-GAAP gross margin would have been about 56.5%. Q3 '05 gross margin also included a reserve for excess and obsolete inventory of $3.4 million. Excluding this, our non-GAAP gross margin for comparability purposes in Q3 '05 would have been about 53.8%. The increase in gross margins from Q3 to Q4 primarily reflect the impact of higher volume and favorable product mix.

Our underlying product margins in Q4 remain consistent from Q3 '05. ASP declines were mid single digits, slightly better than the prior quarter. Q4 non-GAAP operating expense excluding the items referred to previously were $67.1 million. This is below our target range of 69 to 71 million. Q4 included some onetime savings in sales and marketing relating to the year-end true-up of commissions and the timing of certain non-recurring engineering expenses that were originally planned for Q4 and are now falling in Q1 of '05. Our actual non-GAAP expense run rate excluding these items was closer to a 71 million, which is consistent with the guidance that we provided last quarter.

Our non-GAAP operating margin for Q4 '05 was 9.2% compared to Q3 '05 non-GAAP operating margin of -1.5% and Q4 '04 non-GAAP operating margin of 15.5%.

Now I'd like to turn to our balance sheet. Cash flow from operations in Q4 was $39 million, compared to 2.8 million in Q3. The increase in cash flow from operations is primarily resulted increased profitability as well as lower days sales outstanding. Our cash and investment balance at the end of Q4 '05 which includes restricted cash related to our debt defeasance was 764.4 million. Net cash excluding our convertible debt was $485.5 million, up from 454.9 in the prior quarter.

Days sales outstanding in accounts receivables was a 44 days in Q4 '05. This compares with 59 days in Q3 '05. Our DSOs were below our target range of 50 to 60 days, primarily due to improved linearity of our business as well as improved collections from the prior quarter.

Inventory levels of our on-hand inventory were 11 million in Q4 '05 compared to 13.5 million in Q3 '05. The reduction reflects the completion of our contract manufacturer consolidation which we have been discussing for several quarters. We expect now that we are complete with this that we would return to our historical levels of inventory, which have traditionally been in a range of 8 to $10 million.

Capital expenditures for the fourth quarter were 8.4 million, which is consistent with our target range of 6 to $8 million but the slightly higher level of CapEx relates to the buildout of our software applications lab which support our Tapestry product family, and this is close to completion.

Finally, deferred revenue increased to $45.5 million in Q4, compared with 43.2 million in Q3. The increase is primarily due to continued growth in service bookings, a portion of which is deferred and then recognized over the life of the service contract.

Now for our outlook. As you compile your models and estimates, here are some factors to consider. Q1 is historically our strongest sequential quarter because it corresponds with several of our major OEMs' calendar year ends. Our average deal size in our business has increased with the enterprise products we now offer and this is making our business somewhat lumpier than in the past. 50% of our business is now 4 gig and we are confident in our competitive position and our product momentum across our product family. We expect the environment will remain competitive as our competitors begin to come to market with their 4 gig platforms. And while we have not seen the effects of their efforts, we have considered this in our outlook.

Having said this, we are expecting ASP declines to remain in line with what we've seen historically, which represents mid single digit sequential declines. When we take all of these factors into consideration, our outlook for Q1 is as follows. On revenue in Q1, we expect it to be in the range of 156 to $161 million. We expect our Q1 gross margins to be in the 55 to 56% range, which reflects the effects of the buildup of our service and support organization, the initial mix of our new Tapestry applications, which are not yet shipping in volume.

As I said earlier, we had some onetime expense savings in Q4 without which our spending level would have been closer to $71 million. For Q1, we are expecting total non-GAAP operating expense to be in a range of 73 to $75 million. We expect the majority of the increase to be in R&D as well as in sales and marketing. As Mike discussed earlier, we are investing in new technologies related to SAN related applications, services and support, and other growth initiatives. We are balancing these investments against our operating margin goals, but we realize that the long-term growth of the Company in expanding our total addressable market requires investments to realize growth in these areas.

We expect other income and other expense to be in the range of 4 to 4.5 million in Q1. We expect our tax rate to be in a range of 20 to 25%, an increase from our previous guidance. Our tax rate is increasing as we consume our net operating tax carryforwards and thus are moving to a higher alternative minimum tax bracket.

Before addressing EPS guidance, I would like to make a few comments on stock compensation. Effective Q1 '06, we're adopting FAS 123 R which requires us to include expenses related to stock compensation based on fair values. We're providing non-GAAP EPS estimates with and without option expense for comparability purposes. We're adopting FAS 123 R prospectively and as such we will not be restating prior period financial results. We expect the impact of FAS 123 to be approximately 3.9 to $4.5 million per quarter in fiscal 2006.

We expect Q1 '06 GAAP EPS to be $0.02 to $0.03. Excluding stock compensation and other onetime items, we expect Q1 '06 non-GAAP EPS to be about $0.05. We expect capital investments to be in the 8 to 10 million range. We expect days sales outstanding will be back in the 50 to 60 day range. As I said earlier, we expect our inventory levels to be in the 8 to 10 million now that our contract manufacturer transition is complete. We expect to remain cash flow positive and expect to generate on average 20 million in operating cash flow per quarter. Note that some quarters will be greater than 20 and some may be lower than 20 depending upon the quarter. Historically Q1 and Q3 have been our lower cash flow quarters and Q2 and Q4 have been higher cash flow quarters.

We have an outstanding stock buyback authorization of $93 million and we expect to be active.

As you update your models for fiscal 2006, here are factors you should consider. Just as Q1 has historically been one of our strongest sequential growth quarters, Q2 has been our weakest sequential quarter and we expect Q2 to be down slightly from Q1. We expect our overall revenue to grow 8 to 10% in fiscal 2006. We expect Tapestry and services to represent approximately 5% each by the fourth quarter of fiscal 2006, with higher growth characteristics than our SAN connectivity business in fiscal 2007.

We will continue to run SAN connectivity business based on the current long-term financial model, and expect gross margins for SAN connectivity to be in the range of 55 to 58% and expect operating income to hit 15% by the fourth quarter of fiscal 2006. We expect SAN connectivity to remain a healthy, profitable and cash flow positive business that will enable us to make incremental investments to transform the Company and its future growth prospects. To that end, we are looking to Tapestry and services to exhibit the following attributes in 2006.

We expect Tapestry and service gross margins combined to be in the 40 to 50% range initially, improving in fiscal '07. As a result, we expect our overall corporate gross margin for fiscal 2006 to be in a range of 54 to 56%. Regarding non-GAAP operating expenses in '06, this area is new, so predicting the level of spending necessary to drive new products in new markets is not easy; however, we will evaluate the progress we're making on execution on our product plan and to the extent we see the opportunity, we may increase our spending in the balance of '06 up to 75 to $80 million per quarter.

Finally we expect our stock buyback to benefit EPS in fiscal '06 by $0.02 depending on the timing of when we execute on the buyback programs.

I will now turn the call back to Mike.

Michael Klayko, Chief Executive Officer

So in closing, Q4 was a strong quarter for Brocade and a great way to end the year. During fiscal 2005, we refreshed our entire product family from embedded to enterprise with the industry's only end-to-end 4 gig offering; significantly strengthen our competitive position in the director space; shored up our share in the fabric switch market; (technical difficulty)

Shirley Stacy, Investor Relations

We're going to actually closed from here then.

Tony Canova, Chief Financial Officer and VP of Administration

I will go ahead and close. We significantly strengthened our competitive position in the director space. We shored up our share in the fabric switch market, secured design wins at all the major bladed server vendors for embedded switches, and launched our new Tapestry product family and new service offerings. 2005 was also a year where Brocade bolstered and solidified its internal infrastructure and processes. We further optimized our business model and expense structure and locked down the most comprehensive product roadmap in our history.

As we enter fiscal 2006, our products, our technology roadmaps, and our Company infrastructure is strong and we've establish the core foundation for our growth and diversification plans. Our strong position in SAN connectivity and the initial positive trends from our new initiatives gives us the conviction to pursue Tapestry and service opportunities and to drive additional growth from these complementary areas.

We look forward to updating you on our progress as the year unfolds on our quarterly conference calls and at our upcoming analyst meeting which is targeted for late this winter. We'll have more information on the analyst meeting soon. That concludes our prepared remarks. Thank you for joining our call and for your interest in Brocade.

I will now open the call to your questions. Operator, please move to Q&A.

Related:

• The Q&A from this call is here.
• A list of full conference call transcripts available on the Seeking Alpha Network.
• The complete list of hardware stocks (and links to articles about them) covered by The Hardware Stock Blog.

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