Brocade Communications Systems F4Q07 (Qtr End 10/27/07) Earnings Call Transcript

Brocade Communications Systems, Inc. (BRCD)

F4Q07 Earnings Call

November 29, 2007 4:30 pm ET

Executives

Nicole Noutsios - IR

Mike Klayko - CEO

Richard Deranleau - CFO

Tom Buiocchi - VP, Marketing

Analysts

Paul Mansky - Citi Investment Research

Mark Moskowitz - JP Morgan

Aaron Rakers - Wachovia

Samuel Wilson - JMP Securities

Kaushik Roy - Pacific Growth

David Cahill - RBC Capital Markets

Matt Whittaker - FTN Midwest

Operator

I would like to welcome everyone to Brocade's fourth quarter fiscal 2007 financial results conference call. (Operator Instructions) Ms. Noutsios, you may begin.

Nicole Noutsios

Thank you, operator and good afternoon, ladies and gentlemen. Joining me today are Michael Klayko, Brocade's CEO; Richard Deranleau, Brocade's CFO; and Tom Buiocchi, VP of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release today detailing its fourth quarter and fiscal 2007 financial results via PR Newswire and First Call. The Q4 press release, along with the corresponding presentation, is available on our website at www.Brocade.com.

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 5:00 pm Pacific Time November 29 through 12:00 pm Pacific Time December 6. To access the telephone replay, dial 888-286-8010 or 617-801-6888. The passcode is 59946846.

As a reminder, the information the presenters discuss today will include forward-looking statements, including without limitations, 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 and for the fiscal quarter ended July 28, 2007; and Form 10-K for the fiscal year ended October 28, 2006.

These 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 will be presented on a non-GAAP basis. The most directly comparable GAAP information and reconciliation between the non-GAAP and GAAP figures is provided in our Q4 2007 press release which has been furnished to the SEC on Form 8-K and in the corresponding Q4 2007 slide presentation on our website.

Please note that the slides will be automatically advanced as part of the webcast presentation and a PDF version will be posted just after the call concludes.

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 revenues based on OEM sell-through information and this measure is not intended to be viewed as a substitute for Brocade’s reported GAAP revenue. Sell-through 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.

Finally, please note that periods prior to Q2 2007 do not include McData’s results.

I will now turn the call over to Mike.

Mike Klayko

Thank you. Good afternoon, everyone and thank you again for joining us. Today I will briefly discuss our Q4 and fiscal year highlights, and then update you on the industry drivers and trends we are seeing, as well as the progress we are making on our growth initiatives. Following my remarks, Richard will review the Q4 results in more detail and provide additional information on our outlook.

We are very pleased with our Q4 results. Brocade continues to execute exceptionally well and we have further strengthened both our profitability and business fundamentals. In the quarter, we reported sequential revenue growth. We also reported strong year-on-year growth. We showed strong improvements in gross margins. We delivered strong increases in operating margins and we continue to generate a significant amount of cash from operations. Furthermore, we have improved our competitive position in the marketplace and have gained market share.

Before I walk you through the business strategy that will carry us into 2008 and beyond, I would like to take a moment to recognize a few of the many business highlights from the fourth quarter and fiscal year. We saw good growth in our SAN business, led by a record quarter from our Director product family. We had an outstanding demand for our 48K Director and better than expected results on M-Class Directors.

In addition, our SAN switch business grew quarter on quarter in what is typically a seasonally down switch quarter. We also had strong performance from our [DIP] SAN extension products.

In our files business, we were pleased that both IBM and HDS will be adopting and reselling our StorageX file virtualization products. This is a segment where we have added over 300 new customers in 2007 and look to significantly expand our position in 2008.

We are pleased to report that our services business grew very well both sequentially and year on year. More importantly, we had strong growth in a number of on-site resident consultants and direct support agreements with our customers. We are exiting 2007 with strong momentum and validation that customers understand and value the direct expertise and experience they get from Brocade.

2007 has been a very positive and transformational year for Brocade by virtually all measurements. We added scale and expertise via the McData acquisition. We invested in numerous new technologies and market segments. We strengthened our business model and fundamentals throughout the year, and in most cases, we exceeded our goals and internal milestones.

Earlier this month, we held our annual sales kickoff and it was readily apparent that the company is energized, excited and optimistic about fiscal 2008 and our long-term future. In fact, we expect 2008 to be even more dynamic than 2007. A number of key factors are driving transformation in our industry and our target markets. Brocade is uniquely positioned and intently focused on capitalizing on these factors in solving the needs of the evolving enterprise data center customer.

We have numerous opportunities available to us:

First, supplying key elements of the new data center infrastructure.

Second, providing solutions to more efficiently manage the rapidly growing amounts of corporate information.

Third, delivering the services and support that enable new technologies and solutions.

I will now highlight just a few of the key market drivers that impact Brocade's short and long-term business prospects. First and most fundamentally, the continued, wide-ranging growth of digital data has been, and will continue to be, the overarching market attribute that will provide opportunities for Brocade.

In the hundreds of customer meetings I have attended, virtually every customer has told me they expect their data to continue to grow with no end in sight. This data must be easily accessible, efficiently managed and well protected.

Simply stated, no business or industry sector is immune to the trend and its implications. Data growth does not take a time out based on a company's financial results. For example, even in this quarter on the heels of some unfortunate industry results, the financial services sector accounted for a number of our largest transactions. This data growth trend will continue to be a growth driver for us as this digital data keeps proliferating and the management of this data is a priority. We expect the opportunities for us will actually increase as companies turn to our solutions in order to become more efficient in managing their data.

One approach businesses take to handle the cost and complexity of managing this data and infrastructure growth is to consolidate their data centers. Our research indicates that over one-third of our customers are currently undergoing a data center redesign. We have and will continue to design products and technology tailored to enable these consolidations, including: storage consolidation, server consolidation, network consolidation and file consolidation, thereby helping customers save costs and simplify their data center environment.

We are a key enabler of server virtualization solutions. Sever virtualization solutions typically require connections to storage networks in emerging data center fabrics. Several virtualization is still in its infancy and its growth will continue to drive corresponding growth opportunities for Brocade products and services.

Finally, Brocade is a pioneer in the grand initiative that is permeating virtually all aspects of businesses worldwide. We're one of the most direct contributors to the greening of the data center as our products require two-thirds less power and cooling than the competition.

This provides us with a competitive advantage and an enormous cost savings to our customers. We win many transactions because of our energy-efficient designs and anticipate even more customer interest in this area in the future. From a customer's perspective, these industry dynamics pose both challenges and opportunities, but the fundamentally IT question remains: how to do more with less, and manage increasingly complex environments with lower risk to the business. Brocade is dedicated to helping customers solve this cost complexity and risk equation.

Looking to our new fiscal year and with a backdrop of these industry drivers, we believe that we're in a unique position to continue our business momentum. We outlined a number of company-specific growth drivers and initiatives at our September analyst day and we're pleased to report that we're making solid progress on all of them as we head into 2008.

To touch on a few, our upcoming product cycle is on track. We are the technology leaders and we expect to extend that leadership. We have recently announced and demonstrated 8-gig capability on our industry-leading 48K Director and will further extend our technology leadership advantage with the launch of our newest, high end platform in the first half of fiscal 2008.

Several of our OEM partners have already begun their qualification testing on this new system and it will allow us to lead the market with a new segment of data center networking that will complement our existing Directors.

As you can see from our results this quarter, our install base is intact. We're gaining share and with our upcoming product cycle, we are in a strong position to extend our leadership.

Our recent initiative to enter the server connectivity business is proceeding very well and is meeting our internal milestones. To recap, we believe that the transformation to next-generation data centers will require greater levels of end-to-end connectivity, intelligence and simplicity. Enhanced server connectivity is an important part of that equation, and we believe that this billion dollar segment is ripe for innovation and change.

In the first half of fiscal 2008, we are on track to deliver differentiated solutions with simplified management that will go well beyond legacy HDA. Our effort to evangelize the market on enterprise file management solutions is gaining more and more validation with IBM and HDS joining Network Appliance’s resellers of our FAN products, we have an opportunity to build a much more expanded presence in this emerging market segment.

We are driving standards that will help provide greater abilities for customers to scale and consolidate over the next several years. As the leading author of the emerging FCoE standard, we expect to benefit from this market adoption of this standard in the 2009-2010 timeframe, as customers continue to expand and extend their existing Brocade data center infrastructures.

Finally, ongoing diversification continues to be an important part of our growth strategy. As I explained in our playbook that was presented on analyst day, we have a mix of organic and non-organic plays we have made and will continue to execute next year. These range from new products to new services to new channel expansion initiatives, to new ongoing partnerships, and to M&A where appropriate.

Now before turning the call over to Richard to review the quarterly financials, I would like to detail two specific points that I believe will help to accelerate our strategy and position as we enter our fiscal 2008.

First, in response to the trends that are driving customers’ needs and desires to transform their data center, we recently unveiled a framework that outlines our perspectives and strategies for this evolution. We call this Data Center Fabric Strategy, DCF, and it encompasses and embraces all of the important industry and customer trends that I just discussed.

DCF is a framework to help customers drive the discussion and choices that they have regarding the evolution of data centers for maximum performance, greater flexibility and lower risk. We are creating a very strong value proposition that further enhances and enables our traditional partner relationships and provides unmatched investment protection for end user customers.

Furthermore, this framework helps customers to achieve the benefit they are looking for in a pragmatic, low-risk manner with a wide variety of choice and flexibility. The initial feedback from our customers has been this is exactly the type of thought leadership and direction that they expect from Brocade. When you consider this framework will further enable the upcoming product cycle, it gives us optimism that our momentum exiting 2007 will extend into 2008.

Second, we have created an organizational framework that is designed to continue and accelerate the rapid execution of our strategy. We have recently structured the company to provide more dedicated focus on our discrete growth opportunities, as well as allow us to easily accommodate and assimilate future acquisitions and new business initiatives.

The new structure revolves around four distinct business units, each with its own general manager. In concert with this, we have formed shared corporate functions to manage companywide initiatives and to efficiently serve the needs of the respective business units.

The four business units are:

Data Center Infrastructure, or DCI business unit, which includes our traditional SAN business including Director switches and extension products.
The files business unit, which will manage our files strategy and products, including FAN.
Server edge business units will include our new HBA/ISA product line as well as our SAN switch modules for bladed server environments.
And then service, support and solutions business unit, which is fairly self-explanatory.

We're moving to this structure from a position of strength and positive momentum in the market, and I strongly believe it will help us to accelerate our growth strategy. In addition, I am pleased to say that all of the GMs in leadership roles were selected from within, which underscores my confidence in the strength and depth of our management team.

To emphasize: there will be absolutely no change in the Brocade vision, our strategy or our playbook. This structure will help us to implement all of these aspects of our strategy for faster growth, increased profitability and shareholder value.

Again, I am very pleased with how we have performed over the last year and I feel that with our strategies directly linked to key market dynamics, we have an even brighter future. For that, I want to thank our employees who have helped Brocade capitalize on our opportunities in 2007 and challenge them to raise the bar even higher in 2008.

I will now turn the call over to Richard to provide additional information on our financial highlights, our income statement and our balance sheet before I return for a few concluding remarks and Q&A.

Richard Deranleau

Thank you, Mike and thanks to all of you for joining us today. We are pleased with the results of our fourth quarter and are entering our fiscal 2008 in a very strong financial position.

In the quarter, our top line growth was driven primarily by record performance of our enterprise Director platforms. This resulted in favorable product mix and higher than anticipated gross margins which, when coupled with good expense controls, allowed us to overachieve our operating profit target for the quarter.

We continue to generate a significant amount of cash from operations. As discussed at our recent analyst day and on our last call, we are using a significant amount of this cash to repurchase the company's stock. In fact, our board of directors has just increased the company's share repurchases authorization by an additional $500 million, reinforcing the company's commitment to return excess liquidity to our shareholders. With the strong cash generation and strong working capital management, we exit our fiscal 2007 with a strong balance sheet.

I would like to echo Mike's comments on the overall performance in fiscal 2007. It was a transformational year for us both operationally and financially and we also achieved an important milestone in our file, services and server connectivity businesses. Additionally, we were able to continue to optimize and improve our financial model throughout the year. We exceeded virtually all of our milestones regarding the synergies, integration and customer retention from the McData acquisition.

So now let's look at our Q4 financial results beginning with the income statement. Q4 revenues were $340 million, up 4% sequentially and up 63% from the same period a year ago. Sell-through revenues for Q4 were approximately $336.1 million, up 5% sequentially and up 65% from the same period a year ago. Revenues were driven by a strong performance in our SAN products, especially Directors, and we believe we took share in the market.

Our services business also performed particularly well in Q4. On a geographic basis, we saw good performance across all geographies with Asia-Pacific, and Japan in particular, performing very well.

For the fiscal year 2007, revenues were $1.24 billion, up 65% from fiscal 2006. Remember that McData revenues were included in our results beginning in our fiscal Q2 2007.

Also as a reminder, there were two items that impacted our revenues during fiscal year 2007: a purchase accounting adjustment to revenue and our ongoing reduction in low margin, non-strategic third party product sales inherited from McData.

For the year, the purchase accounting adjustment reduced revenue by approximately $17 million and we consciously reduced third-party revenues by approximately $35 million.

Moving on to our business segment. In our SAN business, overall SAN revenues were up 51% year over year. Our share gain in the quarter reinforced our leadership position and our strong installed base retention. Additionally, our pending 8-gig product cycle introduction should further strengthen our position in our core SAN business.

We had a record Director quarter. Director revenues were up 60% on a year-over-year basis. Switch revenue grew 39% year over year, and embedded switch revenue for bladed server environments was up 106% year over year. In our FAN segment, revenues were up 271% year over year.

In 2007, we added over 300 new customers, and as Mike mentioned, we are looking to improve that footprint in 2008 with the new addition of IBM and HDS as important reseller partners.

In our service business, we are very pleased with the progress that we have made, having grown revenues 178% year over year. The impact of the purchase accounting adjustment in Q4 was a $4.7 million reduction in what we would have otherwise reported. We expect the impact of the purchase accounting adjustment will be approximately $3.2 million in Q1, 2008.

Service bookings, which are a key indicator of our actual customer demand, increased 169% year over year. Growth in bookings was led by demand for resident consultants and direct support contracts as customers are increasingly relying on our depth of experience in the data centers.

On a non-GAAP basis, service gross margins were an unusually strong 47%. We would expect this to return to approximately 40% in fiscal 2008.

In our newest business initiative, server connectivity, we began selling our 4-gig HBA products in Q4 and recognized a small amount of revenue with some surprising strength in our AP-J region. As Mike mentioned, our development milestones for 2008 are on track and we have structured a dedicated business unit around this important data center segment.

Turning to our margins and bottom line performance, we had an excellent quarter, significantly exceeding our earlier guidance. We are also pleased that we were able to operate within our improved operating model that we shared with you on our September analyst day.

On a non-GAAP basis, gross margin for 4Q07 was 58.5%, exceeding the high end of our previously expected range of 55% to 56% and within our new, long-term target model range of 57% to 60%. The upside in gross margin was driven by our higher mix of Directors and related software revenue in the quarter; strong services, and the continued reduction of low margin, third-party revenue.

Non-GAAP gross margin for all of fiscal 2007 was 57.1%, down from our pre-acquisition fiscal 2006 margin of 60.4%. The lower margins year-over-year were the result of a lower product margin structure of the M-Class Directors. However, we have driven improvement of 5 points in our gross margin since the close of the acquisition.

In the quarter, the pricing environment remained relatively stable and sequential ASP declines were again in the low single-digits. Q4 non-GAAP operating expenses, excluding the items referred to in the accompanying webcast slide, were $119.6 million, at the low end of our prior outlook of $119 million to $122 million.

Non-GAAP operating margin for Q4 was 23.3%, exceeding our prior outlook of 19% to 20% and exceeding our new, long-term model of 18% to 22% of sales. For all of fiscal 2007, non-GAAP operating margin was 20.9%, up 2.6 points as compared to 18.3 points in 2006.

The improvement in operating margin was driven by strong expense management, which allowed revenue growth to drop to the bottom line. We are very pleased with the company's execution over the last year to drive continued improvements in the company's operating margin profile.

Full year, non-GAAP operating profit increased 87.9% year over year, again demonstrating our ability to manage and improve our business through major transitions and growth; and, reflecting the leverage and strength of our business model. Our effective non-GAAP tax rate in Q4 was 24.4%, below our expected rate of 28%.

As you may recall, we mentioned last quarter that we expected some volatility in the tax rate as we completed our fiscal year. The volatility in Q4 was primarily driven from greater than expected international profits and from year end finalization of our timing differences. Our effective non-GAAP tax rate for all of 2007 was 27.3%.

Moving on to our operating results on an earnings-per-share basis, Q4 non-GAAP diluted EPS was $0.16, higher than our guidance of $0.12 to $0.13 and up $0.04 quarter over quarter. Please note that our lower tax rate contributed only marginally to our EPS this quarter by less than $0.01 per share. Even without the benefit of the lower tax rate, our non-GAAP EPS would still have been $0.16 per share.

Reporting on a GAAP diluted basis, Q4 EPS was $0.08, which is double the high end of our prior outlook of $0.03 to $0.04 and up $0.05 sequentially. This was driven by lower indemnification spending net of insurance proceeds, and a gain on the sale of an investment.

Non-GAAP diluted EPS for all of fiscal 2007 was $0.56, up $0.11 or 24% compared to fiscal 2006 while diluted shares outstanding stood a little less than 409 million shares for Q4, which reflected for the first time the diluted impact of the McData convertible debt. At GAAP profit levels of approximately $0.04 per share, the McData convertible debt is expected to be dilutive in the amount of approximately 12.1 million shares.

Please note the effective tax rate will impact the sensitivity on the EPS breakpoint. The differences between GAAP and non-GAAP net income are reconciled in today's press release and in today's webcast slides.

Now turning to our cash flow and balance sheet. Our cash and investment balance at the end of the quarter, net of convertible debt, was $625.8 million, slightly down from last quarter, reflecting continued strong cash flow offset by stock repurchases during the quarter. Cash flow from operations in the fourth quarter was $54.5 million, slightly above our expected range of $40 million to $50 million in what is typically a stronger cash flow quarter.

In fiscal 2007, we generated $170 million in cash flow from operations, net of legal indemnification payments. In Q4, we used $50 million to repurchase approximately 6.6 million shares of Brocade common stock. As a reminder, during Q4 we were executing on our corporate 10b-51 automatic stock purchase plan.

For the year, we have repurchased a total of 22.3 million shares for approximately $191 million. At the end of Q4, including the just-announced $500 million increase in share purchase authorization from our board of directors, we had $583 million remaining available under our total stock buyback authorizations.

Now turning to our Q1 and fiscal 2008 outlook. As we move into fiscal 2008, I am going to outline a number of factors for you to consider. We are still keeping a close eye on enterprise spending at a macro level, and as you have heard from several of our customers and partners, it is still a mixed environment out there.

We witnessed some strength in the U.S. in fiscal Q4 and strong performance from Asia-Pacific. We are not, however, expecting any major changes to enterprise spending patterns in the near future. Our target market remains extremely competitive, but we believe that we have done a good job of customer retention and with our performance this quarter, we feel that we had a strong competitive position.

In addition, as part of our competitive expectations, it is important to consider our upcoming product cycle and new product pipeline. Remember, on the day of the McData acquisition we announced our product roadmap with our new high end platform for the data center. We did this as part of a strategy to build confidence with and to retain our new combined installed base.

We understood at the time that we could be causing some delay in the purchase of existing products by doing this, but we felt it was the right trade-off to make as customer retention was -- and is -- a priority. We are now getting closer to the qualification and shipment of our new platforms which we expect to occur in the first half of fiscal '08.

The new platform will be a higher end data center backbone Director, significantly differentiated from our existing Director products and targeting a new segment of the data center market. As such, it will not replace our existing Directors; but as with any imminent new product, it may cause customers to delay some short-term decisions in order to evaluate the newer technology. We continue to expect sequential ASP decline in the low single-digits.

Regarding channel inventory levels, our expectation is that our OEM inventory may decline going into the traditionally slower Q2 and Q3 selling seasons and as they reconfigure their optimal mix for upcoming product cycles.

Now taking all of these factors into consideration, our outlook is as follows: we are reaffirming the FY 2008 guidance we provided at our analyst day in September 2007. The slide we present today reflects that prior guidance.

We expect our revenues in Q1 to be in a range of $345 million to $360 million, a growth of 2% to 6% sequentially and 54% to 61% from the same period a year ago. We expect non-GAAP Q1 gross margins to be between 58% and 59%, within our targeted model range of 57% to 60%.

For Q1, we expect total non-GAAP operating expenses to be in a range of $125 million to $128 million. We expect our Q1 non-GAAP operating margin to be in a range of 21% to 22%, which is at the high end of our target model. We expect non-GAAP other income/other expense net in Q1 to be approximately $7.5 million to $8 million.

Regarding our tax rate, as we stated last quarter we anticipate that in the short-term, our tax rates may be volatile. We expect that our Q1 and annual non-GAAP tax rate will be 30%. The increase from fiscal 2007 is being driven by the pending expiration of the federal R&D tax credit and the consumption of our R&D tax credit carryforward in our 4Q07. Should Congress extend the R&D tax credit, effective at the beginning of calendar 2008 we would expect our non-GAAP tax rate to decrease by 1% to 29% for fiscal 2008.

We expect our GAAP tax rate will continue to be volatile. We currently expect our fiscal 2008 GAAP tax rate will be 70%, reflecting a one-time, non-cash McData acquisition-related intercompany purchase of IT into our international tax structure; and, the non-deductibility of the amortization of our acquired intangible assets.

Please note also that we continue to carry a full valuation allowance on our deferred tax assets. If our profitability continues, it may result in the reversal of that valuation allowance during fiscal year 2008, which would result in a significant tax benefit for the year.

We expect diluted shares outstanding to be in a range of 395 million to 400 million shares. As noted earlier, if our GAAP EPS exceeds approximately $0.04 per share, then the McData convertible debt will be diluted in the amount of approximately 12.1 million shares. Again, the EPS is sensitive to the GAAP tax rate. Based on these factors, we expect Q1 '08 non-GAAP EPS in a range of $0.14 to $0.16.

For the full year, we continue to accept our non-GAAP EPS to be in the prior announced range of $0.55 to $0.60. We expect Q1 '08 GAAP EPS in the range of $0.02 to $0.03, and we expect the difference between non-GAAP and GAAP EPS in Q1 will consist primarily of the same items as in our Q4 '07. However, we expect the indemnification obligation to be in a range of $15 million to $20 million and we do not expect any significant gains from the sale of investments.

Now turning to our balance sheet and cash flows. We expect capital expenditures in Q1 to be in the $15 million to $18 million range. We expect DSOs in Q1 to be within our target range of 40 to 50 days, and on-hand inventory to be in a range of $18 million to $20 million. We expect to generate cash from operations in Q1 of approximately $35 million to $45 million, reflecting a seasonally weak cash generation quarter. We expect to be active in the market regarding stock repurchases.

In summary, in fiscal 2007 we executed extremely well against our plan. At our September analyst day, we raised our operational model and have already shown that we can operate at these new and improved levels. We remain committed to the growth, profit and cash flow targets we outlined at our analyst day.

Due to our upcoming product cycle and introductions, we expect to retain a strong market position and we remain committed to continuing to optimize our growth initiative, our business [inaudible] our return to shareholders.

Thank you, everyone and we certainly look forward to continuing and extending these strong results into 2008. With that, I would like to turn the call back over to Mike.

Mike Klayko

Looking forward to 2008, it is clear that massive data growth is driving a need for new approaches and solutions, and we are focused on helping customers manage the evolution of their data centers for maximum performance, lower cost and minimized risk. We believe our strategy delivers the most compelling value proposition in the market today and as our products can continue to deliver the industry's best quality we have a combination that paints a very bright opportunity for us.

The market is clearly in a transformational phase and our strategy supports and enables many of the key industry and customer drivers and trends. We believe we are in an excellent position from which to assist customers and to benefit as a company. It's very important that we continue to execute to drive top line growth as our leverage model delivers excellent margin expansion opportunities.

We have a strong product cycle coming in 2008 and we will be closely managing and monitoring the key milestones for our new product qualifications and adoptions in the market, and look forward to updating you on this progress.

As Richard just outlined to you, Brocade finished the year on a high note. We continue to drive financial efficiencies in the model and deliver consistent revenue and earnings growth. The growth strategies we executed in 2007 are succeeding and providing us positive momentum as we move into 2008. As we look forward to the future, we feel that we are in a position of strength and look forward to capitalizing on that.

Now I would like to ask the operator to open the line for questions.

Question-and-Answer Session

Operator

Your first question comes from Paul Mansky - Citi Investment Research.

Paul Mansky - Citi Investment Research

First for clarification, I had a fair amount of feedback on my line. On the Q1 revenue outlook, did you say that that was $345 million to $350 million, or $360 million?

Richard Deranleau

It's $345 million to $360 million.

Paul Mansky - Citi Investment Research

We talked a little bit about financial services in the quarter. Can you maybe drill down a little bit more on that in that specifically, what was it as a percentage of the mix and was that up or down sequentially, or flat?

Tom Buiocchi

We don't really track industry-specific performance because, as you know, most of our sales lead solutions are going through OEM partners. What we did say, however, is that financial services was an important contributor in the quarter, despite some of the woes in the industry right now because the data growth in that segment continues to increase and their needs for our solution continue to persist in that environment.

Paul Mansky - Citi Investment Research

That gets me to my ultimate question. Mike, you led off the call talking about data growth, it doesn't really take a break on bad results. Given some of the headcount reductions in financial services specifically, I would assume data growth may take a pause on the reduced headcount. Can you lay out, from that vertical specifically, what you are looking at as it relates to a source of confidence as we go forward here for the next couple of quarters?

Mike Klayko

I look at all of the different customers we deal with, not just financial services customers but all of the different industries. Everybody's actually looking at how to optimize their infrastructure around cost as well as somewhat an elimination of complexity, because we live in a very complex environment, so when you put the cost element and the complexity together and the inherent growth in some of the applications around compliance and so forth and risk mitigation; I'll tell you, Paul, people are really struggling with it.

One way that they are addressing this is they are actually going through a re-architecture and they are going through and re-architecturing some of the data centers. There are a lot of different ways to re-architecture. Some people are just building out brand new data centers and doing some consolidation. Others are doing it within the confines of their environment.

The point is, as they go through this re-architecture that really bodes pretty well for us going forward. It's going to be really difficult to say how fast is data growing on a percentage basis, because by industry, by application it's all growing rapidly but it really depends upon when you drill underneath it. Is it the server side of the business that is driving some of this and is it consolidation there? Is it on some of the archiving and compliance side? Lots of different issues.

The point is, we sit in the middle of all of this and we are actually starting to benefit from a variety of different opportunities from the data center consolidation to server consolidation and so forth. So it's hard to quantify it in just terms of just raw numbers, but we have a lot of research on that.

Tom, do you have anything you want to add?

Tom Buiocchi

Paul, just one other thought. Your intro to your question was the headcount reductions and loss of expertise in some of these environments, that has created a huge opportunity for us in our services business. You have seen some of our annual growth numbers in that business. It's driven predominantly by putting our experts on site or having more direct support relationships with these large clients. So it does open a few other doors for us as well.

Paul Mansky - Citi Investment Research

Presumably you have a fairly robust expectation set around your data migration solutions over the upcoming year?

Tom Buiocchi

Sure. That's one of the service offerings where as you add more storage, definitely there's going to be legacy migrations to new devices and so forth, so that is a big part of the component. Yes.

Operator

Your next question comes from Mark Moskowitz - JP Morgan.

Mark Moskowitz - JP Morgan

I would like to first also talk about the financial services impacts. Clearly Brocade was probably one of the first to get wild about the concerns back in the summer and I think some folks maybe forgot about it, but I guess as things got to be -- as you guys said -- pretty woeful out there; but yet it didn’t really impact your business.

I'm just trying to get a sense, given you were a lot more cautious ahead of other folks out there, what was the driver that led to financial services being a positive contributor? If you can you give us a little more detail? Was it broad-based, was there some sort of emergent technology trend or technology disruption? Or could it be budgets being used up before maybe they are lost and shrunk next year?

Mike Klayko

Let me take a part of that, Mark, and I will ask Richard to add a little bit. Part of it is when we have an opportunity to go in and help a customer with an architecture, we actually can show them how they can be more efficient. When there's efficiency, there's cost savings.

In some areas where there's areas that are feeling a financial pinch in one area, they're trying to figure out how to save cost in others and we actually have a very, very good value proposition allowing them to squeeze more out of what they currently have by implementing some of our new technologies. It benefits us, it benefits them.

Richard Deranleau

I'd just put a little more color around my concerns going into the quarter. That was off of our Q3 and as we entered our quarter, if you may remember, we had a very linear, very healthy business in excess of a year. This quarter was less linear that we had seen in the past. So as our Q4 started coming out of the summer, it was slower than we had anticipated and it really picked up toward the end.

That reaffirms the caution that we had going into the quarter. As Mike had said, some of the financial companies had some pretty good-sized deals for us during the quarter toward the end.

Mark Moskowitz - JP Morgan

Shifting gears if we could to the market landscape in terms of market share and pricing. The way to look at the market share, it seems that the M-Class Directors were pretty strong here this quarter, based on your commentary. Are we safe in presuming that's really an endorsement of your customers, particularly the legacy McData customers, their comfort in the overall product roadmap for Brocade over the next year or two? Is that lending to some of the market share shifts in your favor?

Tom Buiocchi

What is going on basically is if you remember the first couple of quarters with the legacy McData customers, they were looking at us to determine what our roadmap would be; we were articulating it to them. They needed to get a comfort zone in our ability to execute and we've done everything we said we were going to do for those customers; continuity of supply, support, services, et cetera.

As we're getting closer to the introduction of our newer platform it's becoming very, very clear to them that new platform is going to be complementary to -- not a replacement for --their existing install base of classic McData Directors. So the confidence factor is way up and that has been driving the increase in McData business over the last quarter.

Operator

Your next question comes from Aaron Rakers - Wachovia.

Aaron Rakers - Wachovia

You mentioned that you're seeing some decent strength in the M-Class, I guess McData Directors. I think last quarter you had noted that we were seeing a little bit of hesitation there. Is this just a dynamic where we're getting closer to the 8-gig cycle, people comfortable that we're not replacing existing Director classes and that's really what's driving and that should continue? Is that how to read into that?

Tom Buiocchi

Yes, as people understand that our new platform will not be a replacement for the MI-10K or the M-6140 and those customers continue to have capacity requirements, they're comfortable now to go ahead and buy those with the knowledge that the new platform coming out in the first fiscal half of '08 will be backward compatible with that but will not replace that product. Yes, absolutely.

Aaron Rakers - Wachovia

With that in mind, of the existing install base that you guys retained from McData, is there a way you can quantify how many might have already upgraded or are sitting out there that would be upgrading here over the next few quarters, given that dynamic?

Tom Buiocchi

That's tough to quantify. Again, given our model it's tough to see all those directly. I can tell you and I believe we mentioned this at our September analyst day that the great majority of the classic McData top 100 accounts worldwide had continued purchasing in the period leading up to our analyst day, but I don't think we have an update on that.

Aaron Rakers - Wachovia

The gross margin structure, very strong. If you could give us some quantification of the drivers of the upside in the quarter? I know you gave us some ideas of what were the drivers, but if you could quantify that between those drivers, it would be helpful.

Richard Deranleau

I don't have the quantification for you, but what you might look at is I think you can go into our press release and you can calculate the impact of the overall strength in service and how that drove things up and that was probably a point or so. The other improvements which would be ongoing, particularly when you look at our guidance into next quarter, is really driven by the strength of the product mix, Directors, software and then also the contingent improvement we're making in our overall COGS structure.

Aaron Rakers - Wachovia

You mentioned that you could see the potential for channel inventories to come down here this next quarter. Is that a dynamic that is causing you to be a little bit more cautious in the revenue guidance? To what extent do you think that channel inventory could come down?

Finally, you threw out the comment that M&A activity could be an area that you look to be more aggressive in going forward. Can you give us any color around that as well?

Mike Klayko

Sure. On the channel thing as we have talked about in every one of our conference calls, we show you the different things, so our revenue that we recognize versus what has sold through the channel in the last couple of quarters we've shown you that moving into the strength of our quarters, the busy part of our seasonal year, the OEMs have been increasing their inventory levels, keeping weeks of inventory relatively the same.

Now as we head into what is seasonally a weaker quarter for us, although there are other issues in terms of our product cycle, the actual conclusion is you would expect them to look at potentially honing down or optimizing/reducing their inventory. If I were to quantify that, probably somewhere between the $5 million to $10 million range. So not huge numbers, but enough.

I wouldn't say that's why we're conservative in terms of our forecast, but our expectation, all things being equal, is when we came to next quarter, we would be showing you $5 million to $10 million higher sell-through than our revenue that we recognize.

Aaron Rakers - Wachovia

That's very helpful. And then the M&A question and I will cede the floor.

Mike Klayko

Aaron, you know the answer before I even start talking. Frankly, this is all around buy versus build and speed and time to market and we have announced a very robust, we call it Data Center Fabric Strategy which we previewed with you at the analyst day. We have been now formally announcing it out there. There are some areas of opportunity and it's just prioritizing what we want to go ahead and do and where we want to spend our money to get the best return back.

Aaron Rakers - Wachovia

So it's fair enough it would be focused still in the file area networking side of the market?

Mike Klayko

Actually, no. We have actually structured our company to look at the files business, our data center infrastructure group. We have an overall strategy and framework called Data Center Fabric. There's lots of componentry there that there's a lot of opportunity. We're just trying to figure out where the best bang for the buck is at this point in time. There are lots of opportunities there.

Operator

Your next question comes from Samuel Wilson - JMP Securities.