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 quarterfiscal 2007 financial results conference call. (Operator Instructions) Ms.Noutsios, you may begin.

Nicole Noutsios

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

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

This conference call is being webcast and will be archivedon our website for approximately 12 months. In addition, a telephone replaywill be available at approximately 5:00 pmPacific Time November 29 through 12:00 pmPacific Time December 6. To access the telephone replay, dial 888-286-8010 or617-801-6888. The passcode is 59946846.

As a reminder, the information the presenters discuss todaywill 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 anduncertainties such that actual results may vary significantly. These and otherrisks are set forth in more detail in our Form 10-Q and for the fiscal quarterended July 28, 2007; andForm 10-K for the fiscal year ended October 28, 2006.

These forward-looking statements reflect beliefs, estimatesand predictions as of today and Brocade expressly assumes no obligation toupdate any such forward-looking statements.

Certain financial information that we review on today'sconference call will be presented on a non-GAAP basis. The most directlycomparable GAAP information and reconciliation between the non-GAAP and GAAPfigures is provided in our Q4 2007 press release which has been furnished to theSEC on Form 8-K and in the corresponding Q4 2007 slide presentation on our website.

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

In addition, the presenters will discuss sell-through informationwhich provides a measure of OEM and channel partner sales to end users. Brocadedoes not record revenues based on OEM sell-through information and this measureis not intended to be viewed as a substitute for Brocade’s reported GAAPrevenue. Sell-through is a measure of demand, but is not a GAAP measurement ofrevenue and therefore is not subject to the same level of internal controls asreported GAAP revenue.

Finally, please note that periods prior to Q2 2007 do notinclude McData’s results.

I will now turn the call over to Mike.

Mike Klayko

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

We are very pleased with our Q4 results. Brocade continuesto execute exceptionally well and we have further strengthened both ourprofitability and business fundamentals. In the quarter, we reported sequentialrevenue growth. We also reported strong year-on-year growth. We showed strongimprovements in gross margins. We delivered strong increases in operatingmargins and we continue to generate a significant amount of cash fromoperations. Furthermore, we have improved our competitive position in themarketplace and have gained market share.

Before I walk you through the business strategy that willcarry us into 2008 and beyond, I would like to take a moment to recognize a fewof the many business highlights from the fourth quarter and fiscal year. We sawgood growth in our SAN business, led by a record quarter from our Directorproduct family. We had an outstanding demand for our 48K Director and better thanexpected results on M-Class Directors.

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

In our files business, we were pleased that both IBM and HDSwill be adopting and reselling our StorageX file virtualization products. Thisis a segment where we have added over 300 new customers in 2007 and look tosignificantly expand our position in 2008.

We are pleased to report that our services business grewvery well both sequentially and year on year. More importantly, we had stronggrowth in a number of on-site resident consultants and direct supportagreements with our customers. We are exiting 2007 with strong momentum andvalidation that customers understand and value the direct expertise andexperience they get from Brocade.

2007 has been a very positive and transformational year forBrocade by virtually all measurements. We added scale and expertise via the McDataacquisition. We invested in numerous new technologies and market segments. Westrengthened our business model and fundamentals throughout the year, and inmost cases, we exceeded our goals and internal milestones.

Earlier this month, we held our annual sales kickoff and itwas readily apparent that the company is energized, excited and optimisticabout fiscal 2008 and our long-term future. In fact, we expect 2008 to be evenmore dynamic than 2007. Anumber of key factors are driving transformation in our industry and our targetmarkets. Brocade is uniquely positioned and intently focused on capitalizing onthese factors in solving the needs of the evolving enterprise data centercustomer.

We have numerous opportunities available to us:

First, supplying key elements of the new data centerinfrastructure.

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

Third, delivering the services and support that enable newtechnologies and solutions.

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

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

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

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

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

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

This provides us with a competitive advantage and anenormous cost savings to our customers. We win many transactions because of ourenergy-efficient designs and anticipate even more customer interest in thisarea in the future. From a customer's perspective, these industry dynamics poseboth challenges and opportunities, but the fundamentally IT question remains: howto do more with less, and manage increasingly complex environments with lowerrisk to the business. Brocade is dedicated to helping customers solve this costcomplexity and risk equation.

Looking to our new fiscal year and with a backdrop of theseindustry drivers, we believe that we're in a unique position to continue ourbusiness momentum. We outlined a number of company-specific growth drivers andinitiatives at our September analyst day and we're pleased to report that we'remaking 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 haverecently announced and demonstrated 8-gig capability on our industry-leading48K Director and will further extend our technology leadership advantage with thelaunch of our newest, high end platform in the first half of fiscal 2008.

Several of our OEM partners have already begun theirqualification testing on this new system and it will allow us to lead themarket with a new segment of data center networking that will complement ourexisting Directors.

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

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

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

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

Finally, ongoing diversification continues to be animportant part of our growth strategy. As I explained in our playbook that waspresented on analyst day, we have a mix of organic and non-organic plays we havemade and will continue to execute next year. These range from new products tonew 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 thequarterly financials, I would like to detail two specific points that I believewill 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 aframework that outlines our perspectives and strategies for this evolution. Wecall this Data Center Fabric Strategy, DCF, and it encompasses and embraces allof the important industry and customer trends that I just discussed.

DCF is a framework to help customers drive the discussionand choices that they have regarding the evolution of data centers for maximumperformance, greater flexibility and lower risk. We are creating a very strongvalue proposition that further enhances and enables our traditional partnerrelationships and provides unmatched investment protection for end usercustomers.

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

Second, we have created an organizational framework that isdesigned to continue and accelerate the rapid execution of our strategy. We haverecently structured the company to provide more dedicated focus on our discretegrowth opportunities, as well as allow us to easily accommodate and assimilatefuture acquisitions and new business initiatives.

The new structure revolves around four distinct businessunits, each with its own general manager. In concert with this, we have formedshared corporate functions to manage companywide initiatives and to efficientlyserve 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 strengthand positive momentum in the market, and I strongly believe it will help us to accelerateour growth strategy. In addition, I am pleased to say that all of the GMs inleadership roles were selected from within, which underscores my confidence inthe strength and depth of our management team.

To emphasize: there will be absolutely no change in theBrocade vision, our strategy or our playbook. This structure will help us toimplement all of these aspects of our strategy for faster growth, increasedprofitability and shareholder value.

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

I will now turn the call over to Richard to provideadditional information on our financial highlights, our income statement andour 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 ustoday. We are pleased with the results of our fourth quarter and are enteringour fiscal 2008 ina very strong financial position.

In the quarter, our top line growth was driven primarily byrecord performance of our enterprise Director platforms. This resulted infavorable product mix and higher than anticipated gross margins which, whencoupled with good expense controls, allowed us to overachieve our operatingprofit target for the quarter.

We continue to generate a significant amount of cash fromoperations. As discussed at our recent analyst day and on our last call, we areusing a significant amount of this cash to repurchase the company's stock. Infact, our board of directors has just increased the company's share repurchasesauthorization by an additional $500 million, reinforcing the company'scommitment to return excess liquidity to our shareholders. With the strong cashgeneration and strong working capital management, we exit our fiscal 2007 witha strong balance sheet.

I would like to echo Mike's comments on the overallperformance in fiscal 2007. It was a transformational year for us bothoperationally and financially and we also achieved an important milestone inour file, services and server connectivity businesses. Additionally, we wereable to continue to optimize and improve our financial model throughout theyear. 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 withthe income statement. Q4 revenues were $340 million, up 4% sequentially and up63% from the same period a year ago. Sell-through revenues for Q4 wereapproximately $336.1 million, up 5% sequentially and up 65% from the sameperiod a year ago. Revenues were driven by a strong performance in our SANproducts, especially Directors, and we believe we took share in the market.

Our services business also performed particularly well inQ4. On a geographic basis, we saw good performance across all geographies withAsia-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 resultsbeginning in our fiscal Q2 2007.

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

For the year, the purchase accounting adjustment reducedrevenue by approximately $17 million and we consciously reduced third-partyrevenues 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 quarterreinforced our leadership position and our strong installed base retention.Additionally, our pending 8-gig product cycle introduction should furtherstrengthen our position in our core SAN business.

We had a record Director quarter. Director revenues were up60% on a year-over-year basis. Switch revenue grew 39% year over year, andembedded switch revenue for bladed server environments was up 106% year over year. In our FAN segment, revenues were up271% year over year.

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

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

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

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

In our newest business initiative, server connectivity, webegan selling our 4-gig HBA products in Q4 and recognized a small amount ofrevenue 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 unitaround this important data center segment.

Turning to our margins and bottom line performance, we hadan excellent quarter, significantly exceeding our earlier guidance. We are alsopleased that we were able to operate within our improved operating model thatwe 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 withinour new, long-term target model range of 57% to 60%. The upside in gross marginwas driven by our higher mix of Directors and related software revenue in thequarter; strong services, and the continued reduction of low margin,third-party revenue.

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

In the quarter, the pricing environment remained relativelystable and sequential ASP declines were again in the low single-digits. Q4non-GAAP operating expenses, excluding the items referred to in the accompanyingwebcast slide, were $119.6 million, at the low end of our prior outlook of $119million to $122 million.

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

The improvement in operating margin was driven by strongexpense management, which allowed revenue growth to drop to the bottom line. Weare very pleased with the company's execution over the last year to drivecontinued improvements in the company's operating margin profile.

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

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

Moving on to our operating results on an earnings-per-sharebasis, 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 ratecontributed only marginally to our EPS this quarter by less than $0.01 pershare. Even without the benefit of the lower tax rate, our non-GAAP EPS wouldstill have been $0.16 per share.

Reporting on a GAAP diluted basis, Q4 EPS was $0.08, whichis double the high end of our prior outlook of $0.03 to $0.04 and up $0.05sequentially. This was driven by lower indemnification spending net ofinsurance 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 alittle less than 409 million shares for Q4, which reflected for the first timethe diluted impact of the McData convertible debt. At GAAP profit levels ofapproximately $0.04 per share, the McData convertible debt is expected to bedilutive in the amount of approximately 12.1 million shares.

Please note the effective tax rate will impact thesensitivity on the EPS breakpoint. The differences between GAAP and non-GAAPnet 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 andinvestment balance at the end of the quarter, net of convertible debt, was$625.8 million, slightly down from last quarter, reflecting continued strongcash flow offset by stock repurchases during the quarter. Cash flow fromoperations in the fourth quarter was $54.5 million, slightly above our expectedrange of $40 million to $50 million in what is typically a stronger cash flowquarter.

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

For the year, we have repurchased a total of 22.3 millionshares 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 buybackauthorizations.

Now turning to our Q1 and fiscal 2008 outlook. As we moveinto fiscal 2008, I am going to outline a number of factors for you toconsider. We are still keeping a close eye on enterprise spending at a macrolevel, and as you have heard from several of our customers and partners, it isstill 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 havedone a good job of customer retention and with our performance this quarter, wefeel that we had a strong competitive position.

In addition, as part of our competitive expectations, it isimportant to consider our upcoming product cycle and new product pipeline.Remember, on the day of the McData acquisition we announced our product roadmapwith our new high end platform for the data center. We did this as part of astrategy to build confidence with and to retain our new combined installedbase.

We understood at the time that we could be causing somedelay in the purchase of existing products by doing this, but we felt it wasthe 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 newplatforms 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 anew segment of the data center market. As such, it will not replace ourexisting Directors; but as with any imminent new product, it may causecustomers to delay some short-term decisions in order to evaluate the newertechnology. We continue to expect sequential ASP decline in the low single-digits.

Regarding channel inventory levels, our expectation is thatour OEM inventory may decline going into the traditionally slower Q2 and Q3selling seasons and as they reconfigure their optimal mix for upcoming productcycles.

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

We expect our revenues in Q1 to be in a range of $345 millionto $360 million, a growth of 2% to 6% sequentially and 54% to 61% from the sameperiod a year ago. We expect non-GAAP Q1 gross margins to be between 58% and59%, within our targeted model range of 57% to 60%.

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

Regarding our tax rate, as we stated last quarter weanticipate that in the short-term, our tax rates may be volatile. We expectthat our Q1 and annual non-GAAP tax rate will be 30%. The increase from fiscal2007 is being driven by the pending expiration of the federal R&D taxcredit 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 ofcalendar 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. Wecurrently expect our fiscal 2008 GAAP tax rate will be 70%, reflecting a one-time,non-cash McData acquisition-related intercompany purchase of IT into ourinternational tax structure; and, the non-deductibility of the amortization ofour acquired intangible assets.

Please note also that we continue to carry a full valuationallowance on our deferred tax assets. If our profitability continues, it mayresult 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 395million to 400 million shares. As noted earlier, if our GAAP EPS exceedsapproximately $0.04 per share, then the McData convertible debt will be dilutedin the amount of approximately 12.1 million shares. Again, the EPS is sensitiveto the GAAP tax rate. Based on these factors, we expect Q1 '08 non-GAAP EPS ina range of $0.14 to $0.16.

For the full year, we continue to accept our non-GAAP EPS tobe in the prior announced range of $0.55 to $0.60. We expect Q1 '08 GAAP EPS inthe range of $0.02 to $0.03, and we expect the difference between non-GAAP andGAAP 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 millionto $20 million and we do not expect any significant gains from the sale ofinvestments.

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

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

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

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

Mike Klayko

Looking forward to 2008, it is clear that massive datagrowth is driving a need for new approaches and solutions, and we are focusedon helping customers manage the evolution of their data centers for maximumperformance, lower cost and minimized risk. We believe our strategy deliversthe most compelling value proposition in the market today and as our productscan continue to deliver the industry's best quality we have a combination thatpaints a very bright opportunity for us.

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

We have a strong product cycle coming in 2008 and we will beclosely managing and monitoring the key milestones for our new productqualifications and adoptions in the market, and look forward to updating you onthis progress.

As Richard just outlined to you, Brocade finished the yearon a high note. We continue to drive financial efficiencies in the model anddeliver consistent revenue and earnings growth. The growth strategies we executedin 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 strengthand look forward to capitalizing on that.

Now I would like to ask the operator to open the line forquestions.

Question-and-AnswerSession

Operator

Your first question comes from Paul Mansky - Citi InvestmentResearch.

Paul Mansky - Citi Investment Research

First for clarification, I had a fair amount of feedback onmy line. On the Q1 revenue outlook, did you say that that was $345 million to $350million, 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 thequarter. Can you maybe drill down a little bit more on that in thatspecifically, what was it as a percentage of the mix and was that up or downsequentially, 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 importantcontributor in the quarter, despite some of the woes in the industry right nowbecause the data growth in that segment continues to increase and their needsfor our solution continue to persist in that environment.

Paul Mansky - Citi Investment Research

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

Mike Klayko

I look at all of thedifferent customers we deal with, not just financial services customers but allof the different industries. Everybody's actually looking at how to optimizetheir infrastructure around cost as well as somewhat an elimination ofcomplexity, because we live in a very complex environment, so when you put thecost element and the complexity together and the inherent growth in some of theapplications 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 actuallygoing through a re-architecture and they are going through andre-architecturing some of the data centers. There are a lot of different waysto re-architecture. Some people are just building out brand new data centersand doing some consolidation. Others are doing it within the confines of theirenvironment.

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

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

Tom, do you have anything you want to add?

Tom Buiocchi

Paul, just one other thought. Your intro to your questionwas the headcount reductions and loss of expertise in some of theseenvironments, 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 predominantlyby putting our experts on site or having more direct support relationships withthese 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 aroundyour data migration solutions over the upcoming year?

Tom Buiocchi

Sure. That's one ofthe service offerings where as you add more storage, definitely there's goingto be legacy migrations to new devices and so forth, so that is a big part ofthe 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 servicesimpacts. Clearly Brocade was probably one of the first to get wild about theconcerns back in the summer and I think some folks maybe forgot about it, but Iguess 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 morecautious ahead of other folks out there, what was the driver that led tofinancial services being a positive contributor? If you can you give us alittle more detail? Was it broad-based, was there some sort of emergenttechnology trend or technology disruption? Or could it be budgets being used upbefore maybe they are lost and shrunk next year?

Mike Klayko

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

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

Richard Deranleau

I'd just put a little more color around my concerns goinginto the quarter. That was off of our Q3 and as we entered our quarter, if youmay 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 startedcoming out of the summer, it was slower than we had anticipated and it reallypicked up toward the end.

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

Mark Moskowitz - JP Morgan

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

Tom Buiocchi

What is going on basically is if you remember the firstcouple of quarters with the legacy McData customers, they were looking at us todetermine what our roadmap would be; we were articulating it to them. They neededto get a comfort zone in our ability to execute and we've done everything wesaid 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 newerplatform it's becoming very, very clear to them that new platform is going tobe complementary to -- not a replacement for --their existing install base ofclassic McData Directors. So the confidence factor is way up and that has beendriving 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 theM-Class, I guess McData Directors. I think last quarter you had noted that wewere seeing a little bit of hesitation there. Is this just a dynamic wherewe're getting closer to the 8-gig cycle, people comfortable that we're notreplacing existing Director classes and that's really what's driving and thatshould continue? Is that how to read into that?

Tom Buiocchi

Yes, as people understand that our new platform will not bea replacement for the MI-10K or the M-6140 and those customers continue to havecapacity requirements, they're comfortable now to go ahead and buy those withthe knowledge that the new platform coming out in the first fiscal half of '08will 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 youguys retained from McData, is there a way you can quantify how many might havealready upgraded or are sitting out there that would be upgrading here over thenext few quarters, given that dynamic?

Tom Buiocchi

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

Aaron Rakers - Wachovia

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

Richard Deranleau

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

Aaron Rakers - Wachovia

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

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

Mike Klayko

Sure. On the channelthing as we have talked about in every one of our conference calls, we show youthe different things, so our revenue that we recognize versus what has soldthrough the channel in the last couple of quarters we've shown you that movinginto the strength of our quarters, the busy part of our seasonal year, the OEMshave been increasing their inventory levels, keeping weeks of inventoryrelatively the same.

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

I wouldn't say that's why we're conservative in terms of ourforecast, but our expectation, all things being equal, is when we came to nextquarter, we would be showing you $5 million to $10 million higher sell-throughthan 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 theanswer before I even start talking. Frankly, this is all around buy versusbuild and speed and time to market and we have announced a very robust, we callit 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 ofopportunity and it's just prioritizing what we want to go ahead and do andwhere we want to spend our money to get the best return back.

Aaron Rakers - Wachovia

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

Mike Klayko

Actually, no. We haveactually structured our company to look at the files business, our data centerinfrastructure group. We have an overall strategy and framework called Data CenterFabric. 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 thispoint in time. There are lots of opportunities there.

Operator

Your next question comes from Samuel Wilson - JMPSecurities.