Brocade Communications Systems F1Q08 (Qtr End 1/26/08) Earnings Call Transcript

Brocade Communications Systems Inc. (BRCD)

F1Q08 (Qtr End 1/26/08) Earnings Call

February 14, 2008 4:30 pm ET

Executives

Alex Lenke - IR

Mike Klayko - CEO

Richard Deranleau - CFO

Tom Buiocchi - VP, Marketing

Analysts

Aaron Rakers - Wachovia Capital Markets

Brent Bracelin - Pacific Crest Securities

Samuel Wilson - JMP Securities

Kaushik Roy -Pacific Growth Equities

Tom Curlin - RBC

Jason Nolan - Robert Baird

Andrew Neff - Bear Stearns

Paul Mansky - Citigroup

Presentation

Operator

And welcome to the Brocade Communications Q1 2008 Conference Call. Today's conference is been recorded. At this time, I would like to turn the conference to Alex Lenke, Director of Investor Relations. Please go ahead.

Alex Lenke

Thank you, operator, and good afternoon, ladies and gentlemen. Joining me today are Mike 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 first quarter fiscal 2008 financial results via PRNewswire and FirstCall. The Q1 press release along with corresponding slide 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 February 14 through 12:00 PM Pacific time February 21. To access the telephone replay, dial 888-203-111 or 719-457-0820. The pass code is 1833841.

As a reminder, the information that 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 as set forth in more detail in our Form 10-K for the fiscal year ended October 27, 2007. 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 is presented on a non-GAAP basis. The most directly comparable GAAP information and a reconciliation between non-GAAP and GAAP figures is provided in our Q1 '08 press release, which has been furnished to the SEC on Form 8-K and in the corresponding Q1 '08 slide presentation on our website. 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's sales to end users. Brocade does not record revenue based on OEM sell-through information, and this measure is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand, but 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 results. I will now turn the call over to Mike.

Mike Klayko

Thanks, Alex. Good afternoon everyone, and thank you for joining us. Today I will discuss our quarterly highlights, some key market drivers, and the progress we are making on our growth initiatives. Richard will then provide more detail on our financial performance for Q1 and outline our outlook for Q2.

Q1 was another very good quarter for Brocade, and we are pleased with our continued operational execution and performance. In the quarter we reported top-line growth, improvements in our margin, and growth in our bottom line. We continued our strong cash-flow generation. We further honed our balance sheet, and continued to improve our already robust business fundamentals. We extended or competitive and market leadership position and accelerated our innovation with the beginning of our most comprehensive product cycle ever.

During the quarter, we saw particular strength in our Enterprise business, where we once again achieved a record sales performance with our SAN Director products. Our progress and the momentum in this segment was further bolstered by the introduction of our new DCX backbone product on January 22. We also recorded record sales for our bladed switch modules, which are used with bladed servers in the Enterprise.

Each of our four business units made substantial progress during Q1, meeting aggressive product development milestones, which support our growth initiatives. The overall business is healthy, and we are well poised as our product cycle and growth initiatives come to bear throughout 2008.

We've all seen the interest in activity surrounding the data center market over the past several months. And we’re more convinced than ever that our strategy is on target and that our installed based product and execution advantages continue. I would like to recap some of the fundamental customary market trends that we continue to see within the data center and touch on the progress we’re making as we broaden our offerings in this dynamic market.

It is very clear that there are broad customer challenges, business requirements, economic forces and technological innovations that are shaping our business opportunities in the data center. Customers continue to struggle with the management and protection of the rapidly growing data. The cost and complexity associated with managing this data growth is unprecedented, and the challenge is insensitive to industry, to geography, or macroeconomic climate.

The server virtualization trend is attracting more and more investment, and this is a very good dynamic for us. Virtual servers are four- to five-times more likely to connect to storage networks than physical servers are. This drives growth opportunities for us as virtualization scales in the enterprise. But remember, according to most industry sources less than 5% of the enterprise servers are virtualized today. So we’re still at the very beginning of a trend that we believe will be a fundamental long-term growth driver for us.

And as we now know, the quest for efficiency is in the data center is been compounded by other physical constraints such as the scarcity of space and power. Gartner estimates that 70% of the global 1000 organizations will have to modify their data center facilities in the next five years, primarily driven by energy constraints. We have a very strong competitive advantage across all these customer trends and challenges.

Our recently announced DCX Backbone is designed to handle eight times as many virtual servers, have five times the bandwidth of, and be 10 times more efficient than the competition. This is not incremental innovation. These are order of magnitude differentiators for customers. In addition to growing need to re-examine and re-architect data centers, there's a tremendous opportunity for us, given the specific deep domain expertise within Brocade's services organization.

Our ability to continue to grow our services business is largely gated by our ability to hire and train professional services talent with our domain expertise. Let's just look at one specific competitive example where many of these advantages came to bear.

Yesterday we issued a press release stating that Applied Discovery, a unit of LexisNexis chose Brocade for its next generation infrastructure. Because of their growth, Applied had run up against very stringent scaling, space and power, and performance requirements. After a recent architectural assessment, they selected Brocade to displace their existing infrastructure and serve as their current and future platform of choice.

We offered significantly better performance and scale, much lower power and space consumption, and the expertise to confidently architect and implement this solution. That’s a straight-forward equation for any customer.

These current customer and market trends are clearly beneficial for Brocade, but we recognize that we must also continue to execute on our company-specific growth drivers to capitalize on the opportunity. We have made tremendous progress on these company initiatives this quarter, and I'd like to take minute to recap them and discuss our progress on each.

First, as we have stated in the past that our installed base position in the data centers worldwide is a tremendous advantage, and we must retain and grow this footprint. I'm pleased to report that our installed-base position is intact and as strong as ever. Today we estimate that Brocade has an installed base share of approximately 80% of the SAN installations worldwide across all industries and geographies. This diversity helps to buffer us during uncertain economic times and serves as a strong foundation for our growth initiatives.

The second Brocade growth driver that we've talked about is our ability to deliver our new product cycle on time. I am very pleased to report that the January 22, announcement of our new DCX platform was well ahead of schedule, and we expect majority of our OEMs to be active in the market with this product, as well as the 8-gig upgrade to our 48K installed base in our Q2.

These first-to-market capabilities provide us with a major advantage in the market, in terms of time-to-market, in terms of underlying technology and capabilities vis-à-vis our competitors' recent announcements. Our expectation is that our competitors will not have enterprise class 8-gig offerings until the end of 2008.

And as you've seen in the past, we rapidly follow our first-to-market technologies with highly leverage derivative offerings. You can expect us to refresh our SAN product line with new offerings throughout 2008 to further extend our lead across all segments of the market.

As a third growth driver, we have indicated to you that improving our performance in our Files or SAN business is a very important growth driver for us in 2008. Entering 2008 we had three key goals with regards to improving our files program. One goal is to increase the organizational focus on this effort, which we accomplished with the restructuring of our Files Business Unit with dedicated engineering and sales team.

Secondly, we wanted to broaden our distribution channels and rouse the market. Our addition last quarter of IBM and Hitachi data systems as key resellers of our File products joining network appliance has already begun to show promising initial progress. And finally in early 2007, we identified some new innovative technologies and solutions that we wanted to rapidly bring to market. I am pleased to report that we’re on track to demonstrate and begin shipping significant new product advancements for our Files business within the next 30 days, further adding momentum to our company product cycle.

IDC projects that the bulk of new data management challenges in the Enterprise are related to file data, and our upcoming announcements and offerings will help us to more fully address those challenges. The fourth growth driver that seems to garner high interest is our entry into server connectivity or the HBA business. A new generation of server connectivity; one that interacts with the data center network and storage to provide intelligent end-to-end connectivity will be required in a virtualized data center, and we intend to be an innovator in this market.

As for product progress, we’re on schedule to deliver these products by the end of our first fiscal half of ’08. As far for customer progress, we recently received a commitment from Hitachi Data Systems that they will qualify and sell our new HBAs. And we have another commitment from Fujitsu, Siemens in Europe that they will qualify and include our HBA products in certain segments of their server portfolio.

The fifth company driver for us is to ensure that our customers and partners understand the unique benefits of our Data Center Fabric or DCF strategy and architecture. As you may recall last quarter, I described the roll out of our DCF strategy. This perspective on the evolution of the data center was developed in response to our customers needs and desires to achieve new levels of efficiency and flexibility.

DCF is an umbrella strategy and architecture that encompasses all of Brocade’s product, service and solution initiatives. From an end users perspective, our approach helps them to transform their data centers for maximum performance and greater flexibility. With the lowest cost and operation risk, we allow customers to maintain and extend existing assets while bringing new capabilities and new technologies into their network. That’s a very unique value proposition.

In a recent independent online poll by CMP Media, 85% of respondents indicated that developing a data center fabric strategy was extremely important for them this year. And a majority of those respondents replied that Brocade had the most intriguing and compelling data center fabric vision.

Likewise, our strategic partners have embraced our message of co-operation not competition in the battle for the next generation data center. They clearly understand that our technologies are designed to highlight and enable their solutions, from virtual servers to storage to datacenter software and management tools. We will have strong allies as we move ahead, and our value proposition to our partners is highly differentiated and very much appreciated.

In summary, our business is very healthy. We are growing very profitably with a myriad of new opportunities ahead of us. The enterprise market segments is performing well, and we will continue to exercise stringent financial discipline as we work our way through the economic ebbs and flows that we can't control. We are focused on execution and developing and delivering innovative products and services to address emerging opportunities, and we will continue to drive our diversification plan for healthy, profitable and sustainable growth.

With that, I'd like to turn the call over to Richard.

Richard Deranleau

Thank you, Mike, and thanks to all of you for joining us today. We are very pleased with the result of our first quarter, particularly given today's uncertain economy. We believe we are in a particularly strong financial position with strong earnings, cash flows and a very healthy balance sheet. In the quarter, our top line was driven primarily by their record performance of our Enterprise Director platform. This resulted in favorable product mix and higher than expected gross margins, which helped us to over achieve our operating profit target for the quarter. This quarter we delivered operating margins of nearly 24%.

We generated a significant amount of cash from operations in what would normally be a seasonally weak cash-flow quarter. We used most of this cash to repurchase the company stock. With the strong cash generation and strong working capital management, our balance sheet remained strong. From a market segment perspective, the Enterprise segment continued to be strong as reflected in our record director and embedded switch quarter.

From a vertical's perspective, in our Enterprise segment, the financial vertical was down from a very strong Q4 and was offset by strength in the general commercial business vertical. So now let's look at our Q1 financial results beginning with the income statement. Q1 revenues were $347.8 million up 2% sequentially and up 55% from the same period a year ago. Company Q1 sell-through revenues and indicator of end user demand were approximately $353.2 million up 5% sequentially and up 55% from the same period a year ago.

As a reminder, when comparing our results against the same period a year ago, our Q1 '07 results do not include McDATA revenues of the acquisition closed at the end of January ’07. In addition, as stated in our prior calls, we have made a strategic decision to reduce former McDATA revenues from the resale of non-strategic, third-party products, which had very low gross margins. In addition, under purchase accounting, our maintenance revenues have been reduced. These factors have resulted in reduction in our revenue growth by approximately $22 million or 6% from the Q1 ’07 McDATA run rate when we closed transaction.

At the same time, reducing the third party revenue has improved our gross margins by more than two points, and we continue to believe this is a positive tradeoff. Revenues in Q1 were driven by strong performance in our core SAN or data center infrastructure products, especially directors and we believe we held share in the Enterprise market. On a geographic basis, we saw strong performance in the Asia Pacific region, and our North America region was up sequentially.

Moving on to our Business segment. In our core SAN or data center infrastructure or DCI segment, revenues were up 3% quarter-over-quarter and 43% year-over-year. As I stated earlier, we had a second straight record quarter in Directors. Director revenues were up 13% quarter-over-quarter and 69% year-over-year. International demand for our DCI products remained strong.

Over the last three quarters, normalizing for those large OEMs [intake] delivery of international destined product within the US has growth from 50% to 57% of total revenues. Because of this demand, we plan to open a new manufacturing and distribution center in eastern Europe through our partnership with Foxconn in Q3 '08. This will further increase our ability to service our European market and improve the cost efficiency of our supply chain.

Switch revenues were slightly down quarter-over-quarter, and grew by 15% year-over-year in what is normally a seasonally-down switch quarter. We remain very confident in our strong leadership position in this segment, and we expect to further solidify that position throughout the remainder of the year.

Our distance and extension revenue was down quarter-over-quarter, reflecting the lumpy nature of that business. Our embedded, switch-market segment had another record quarter with revenues up 23% quarter-over-quarter and 53% year-over-year.

In our Services business, revenues were down 8% quarter-over-quarter, but revenues grew by 208% year-over-year. The impact of purchase accounting adjustment in Q1 was a $3.2 million reduction. Service bookings decreased 50% quarter-over-quarter but increased 115% year-over-year.

As a reminder, as we noted in our Q4 earnings call, our service revenues and bookings in Q4 '07 were unusually strong due to the timing of the Q4 services revenue stream. In Q4, service bookings grew 169% year-over-year. On a non-GAAP basis, service gross margins were 35%, which was slightly below our services target model up 38% to 45%. Going forward, we would expect our service-gross margins to be within our target model. In our File segment, revenues were down quarter-over-quarter, but roughly flat year-over-year.

In the quarter, we had over 100 transactions, of which approximately half were from net new customers. In our HBA segment, we are pleased with our progress in the development of our 8-gig HBAs, and we still expect to introduce new products in the first half of fiscal '08.

Turning to our margins and bottom line performance. We had another excellent quarter, as demonstrated by our nearly 24% non-GAAP operating margin. For the second quarter in a row, we are operating above the improved operating model that we shared with you at our September '07 Analyst Day. Looking at our gross margins, in Q1 the pricing environment remained stable, and sequential ASP declines were again in the low single-digits. On a non-GAAP basis gross margins for Q1 '08 were 60.5% higher than our previously expected range of 58% to 59%, and slightly above all long-term target model range of 57% to 60%.

The upside in gross margin was driven by a higher mix of Directors' and related software revenue in the quarter. On our operating expenses and operating margins, Q1 non-GAAP operating expenses, excluding the items referred to in the accompanying webcast slides, were $127.8 million, at the high end of our prior outlook of a $125 million to a $128 million driven by selective investments made in marketing and sales. This included expenses associated with the launch of our new DCX Director platform. Non-GAAP operating margin for Q1 was 23.8%, exceeding our prior outlook of 21% to 22%, and exceeding our long-term model of 18% to 22% of revenues. Our effective non-GAAP tax rate in Q1 was 30.3%, slightly above our expected tax rate of 30%.

Moving on to our operating results on an earnings-per-share basis; Q1 non-GAAP diluted EPS was $0.16 at the high end of our guidance of $0.14 to $0.16. Reporting on a GAAP-diluted basis, Q1 EPS was $0.05 higher than our prior outlook of $0.02 to $0.03, reflecting increased profitability, lower indemnification, and stock compensation charges. GAAP EPS was down $0.03 sequentially from Q4, which included a non-recurring gain of $11 million from sales of a strategic investment. Our diluted shares outstanding stood at a little more than 403 million shares in Q1, a reduction of approximately 6 million share from the 409 million diluted shares outstanding in Q4 ’07. This reduction in diluted shares outstanding increased our non-GAAP EPS by less than $0.25.

Our Q1 '08 diluted shares outstanding included a 12.1 million share impact from the dilutive McDATA convertible debt. As a reminder, at GAAP profit levels of approximately $0.04 per share, the McDATA convertible debt becomes dilutive in the amount of approximately 12.1 million shares. Without the impact of the McDATA convertible debt, our diluted shares outstanding would have been approximately 391 million shares. The difference 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 investments balance at the end of the quarter was $783 million. Net of the convertible debt, the balance was $615 million down slightly from last quarter. This reflects continued strong cash flows offset by aggressive stock repurchases during the quarter. Cash flow from operation in the first quarter was a very strong $79.2 million, significantly above our expected range of $35 million to $45 million in what is typically a seasonally weaker cash flow quarter. This increase was principally driven by the linearity of this quarter's revenue, increased profitability, and our continued strong working capital management.

In Q1 we used approximately $80 million to repurchase approximately 11.1 million shares of Brocade common stock. Stock repurchases during Q1 were executed under our corporate 10b5-1 automatic stock purchase plan. Today we have purchased a total of 38.9 million shares of Brocade stock for a total of approximately $298 million. At the end of Q1, including the $500 million increase in purchase authorization from our Board of Directors last quarter, we had $502 million remaining available under our total stock-buyback authorization.

Now turning to our outlook for Q2. There are some assumptions for you to consider when developing your financial models. From an IT-spending-environment perspective consistent with our peers and partners, we remain regarded about spending at a macro level. However, we are more optimistic about spending at the enterprise level and the related positive implications to our Director-class products. From a visibility point of view, our best visibility is at the enterprise level, which primarily impacts those Director products. Because of our OEM model, our visibility into the mid-range space which primarily impacts our switch product is more limited.

With this as a backdrop, we plan to be very disciplined in managing or expenses and controlling our headcount growth until we have clear visibility in to the remainder of fiscal year '08. While our core markets remain competitive, we believe our new product introductions and our installed base advantage put us in a uniquely strong competitive position. We have now introduced our DCX product ahead of schedule, and as Mike mentioned we have several upcoming new product announcements beyond the DCX. We expect our DCX product to contribute to revenue beginning in Q2 ’08, and the other new products to contribute to revenue in the second half of fiscal year ’08.

From a pricing perspective, we expect quarterly ASP decline to remain in the low single-digits. Historically, we would have expected that Q2 revenues would be sequentially down from Q1 by 6% to 8%. However, we believe that with our new DCX product introduction we have a product-cycle advantage in the market that should dampen somewhat this normal seasonality. Historically, we would expect Q2 to have a higher mix of switches versus Directors than in Q1. In addition, our new 8-gig products will initially have higher cost than our 4-gig products. Therefore, we expect slight sequential downward pressure on our Q2 gross margins.

Now taking all these factors into consideration, our outlook as follows: We expect our revenues in Q2 to be in a range of $340 million to $355 million. This range is a decline of 2% at the low end to an increase of 2% at the high end on a sequentially basis. The improvement over normal seasonal patterns is driven by the strength of our new product cycle, including our new DCX Backbone Director. On a year-over-year basis, this represents a decline of 2% at the low end to an increase of 2% on the high end. Excluding the third party and purchase price accounting revenue adjustments discussed previously, our year-over-year revenue growth would have been 1% to 5%. We expect non-GAAP Q1 gross margin to be between 58% and 60%, within our targeted model range of 57% to 60%.

For Q2, we expect total non-GAAP operating expenses to be in a range of a $128 million to $132 million. Again, we plan to be very disciplined about where we make additional investments until we have a clearer picture of our top-line growth. We expect our Q2 non-GAAP operating margin to be in a range of 20% to 22%, well within our target model. We expect non-GAAP other income, other expense net in Q2 to be approximately $5.5 million to $6.5 million, reflecting recent interest-rate declines on our investment portfolio. For the full fiscal year '08 outlook, while the current economic environment has reduced the confidence in our visibility, we believe our prior full-year guidance for the top- and bottom-lines is still appropriate.

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 Q2 and annual non-GAAP tax rate will be 30.3%. We expect our GAAP tax rate will be 62.5%, reflecting one-time non-cash McDATA acquisition related inter-company purchase of IP into or international tax structure, and the non-deductibility of the amortization of purchased intangible assets. Please also note that we continue to carry a full valuation allowance on our deferred tax assets. If our profitability continues, it may result in a reversal of that valuation allowance during fiscal year '08, which would result in a significant tax benefit for the year.

We expect diluted shares outstanding to be in a range of 396 million shares to 401 million shares, which includes the diluted impact of the McDATA convertible debt. Based on these factors, we expect Q2 '08 non-GAAP EPS in a range of $0.13 to $0.15. We expect Q2 '08 GAAP EPS in a range of $0.04 to $0.05, and we expect the differences between non-GAAP and GAAP EPS in Q2 will consist primarily of the same items as in Q1.

Now turning to our balance sheet and cash flows. We expect capital expenditures in Q2 to be in the $12 million to $15 million range. We expect DSOs in Q2 to be within our target range of 40 days to 50 days, and on-hand inventory to be in a range of $12 million to $15 million. We expect to generate cash from operations in Q2 of approximately $40 million to $50 million. We expect to continue to be active in the market regarding stock repurchases under our 10b5-1 automatic stock repurchase program.

In summary, in Q1 ‘08, we had another good quarter financially. We executed well across all of our business fundamentals and extended our product leadership position. We remain committed to the improved business model, growth, profit and cash flow targets that we outlined in our September ’07 analyst day. Due to our upcoming product cycle and introductions, we expect to retain a strong market position. We plan to be discipline in our spending in these uncertain economic times, and we remain committed to continuing to optimize our growth initiatives, our business model and the return to shareholders.

Thank you everyone and with that, I will now turn the call back over to Mike.

Mike Klayko

Thank you, Richard. We had a very good Q1 and landed within or above our expectations on virtually every metric. Well, we recognize today’s economic reality, and we believe that our product leadership, diversified customer base, and relentless financial discipline will serve us well. We’re confident about our strategy and plans that Brocade continues to execute very well. We have made significant investments into new initiatives and will aggressively see them through, as they will uncover new growth opportunities for Brocade and a broader even more strategic role in the datacenter. We are participating in a large and dynamic target market, the Enterprise data center, and we are fortunate that our experience, partnerships and ability to innovate serve us tremendous advantages.

Thank you again for joining us. I look forward to updating you on upcoming announcements and further progress. We'd now like to take any questions you have. Operator, please open the line for questions.

Question-and-Answer Session

Operator

Very good. (Operator Instructions). Our first question will come from Aaron Rakers with Wachovia Capital Markets.

Aaron Rakers - Wachovia Capital Markets

A couple of questions. First, just looking at the reported results, it looks like for the first time in a while we've actually the sell-through outpacing the sell in. And I guess I just want to understand that, if that’s predominantly just the function of the 8-gigabit per second cycle, and if you should think about that continuing into this next quarter?

Richard Deranleau

Hey, Aaron this is Richard. The reality is, this is been driven by demand on our overhaul products. So this isn't related to the 8-gig, this is based on our 4-gig or standard products. Again as a reminder, the OEMs over the last year have been carrying roughly two weeks worth of forward looking demand and this phenomenon we talked a little about expecting at last quarter during the analyst call, and it pretty much came in what we had anticipated which is, as the OEMs look for a softer Q2, historically they are just managing their inventories back down to maintaining a two week supply.

Aaron Rakers - Wachovia Capital Markets

And then around the DCX product in particular, obviously buffering some of the macro concerns right now, can you help us, you know qualitatively or even quantitatively think about that product ramp and how we should think about that potentially materializing as an incremental revenue stream?

Tom Buiocchi

Yeah, Aaron, this is Tom, are you talking in terms of timing in this kind of the slope of the ramp there?

Aaron Rakers - Wachovia Capital Markets

Yeah, I am just trying to think of it, any which way you can give us color would be helpful, because it is an incremental, I am assuming it's an incremental business.

Tom Buiocchi

Yes, here's a couple of way to think about it. We transition from 2-gig to 4-gig very rapidly by pricing 4-gig right on top of 2-gig, and that's took about three quarters for most of our revenues transition. This will be a much different transition timeframe because we are pricing the 8-gig DCX product at a premium to the market right now, to our current existing products so we see a shallower ramp then you would have expected able to 2-gig to 4-gig ramp.

And then you guys think about used cases, heavy sever virtualization will require the 8-gig at the server side, massive consolidation projects in the data center or a lot of customers looking for net new data centers that they are building out now to future proofs that next five years will probably go to the 8-gig product. So it's going to be a minority of our Director class product sales for a period of time, think of it as more of a kind of feathering in at that kind of ramp.

Aaron Rakers - Wachovia Capital Markets

Right, okay. And then on the HBA side positive qualification at Hitachi and Fujitsu. Can you give us some flavor, do you expect over the next couple quarters to get some higher volume sever business be it at the HP or others out there in terms of your Host Bus Adapters, and then I have got one follow up?

Mike Klayko

Aaron, its Mike. As we have as you know we're probably talking to all of the folks out there right now. And as we qualify them and they get this permission announced, we'll be announcing them to you.

Aaron Rakers - Wachovia Capital Markets

Okay. And then the final follow up from me. As we transition through the 8-gig cycle, I think you are still carrying probably three contract manufacturing relationships. Any update there in terms of getting some cost savings and potentially consolidating some of those relationships?

Richard Deranleau

Aaron this is Richard. There's probably two dynamics to think about first of all is there is mix shift benefit as we move away from the McDATA classic product, and that's obviously going to help us. On other side of the coin, though the 8-gig is a more expensive technology and we have to write the volume curve. So probably you are not going to see much in the early quarters, but as we move out and write the cost curve down, in the later half the year and earlier of ’09 you would see some benefits.

Aaron Rakers - Wachovia Capital Markets

Very helpful, thank you.

Mike Klayko

Thanks Aaron.

Richard Deranleau

Thank you.

Operator

Our next question is from Brent Bracelin with Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you, I guess first question has to do with call it the January quarter; obviously revenue came in here towards the low end of the guidance range. Could you give a little color on the order linearity in the quarter and more specifically what were the demand trends you saw in the January period?

Richard Deranleau

Sure. Brent this is Richard. So we had an incredibly linear quarter, as you can see from our DSO. A couple of things to think about in the quarter is, we had a fantastic quarter with Directors and the Blades were just on fire. So that helped us in terms of the areas that are a little softer for us. It was really - service were down for often incredibly strong Q4, and then we didn't get the quite attraction that we are looking for in FAN.

So that's kind of the over all story, very, very linear, lots of demand. At the Enterprise we were a little surprised at the strength of the Enterprise and you can see that in our Director sales.

Brent Bracelin - Pacific Crest Securities

Okay, great. And then as you think about that mix shift of Directors in the quarter even with kind of some of the transition issues, what do you think is driving that? Was it seasonality; is there some sort of customer preference shifting towards Director's? Help us kind of explain, kind of why you saw that unexpected strength in the Director side?

Mike Klayko

That’s a great question. In fact we are engaged in quite a few architectural assessments and redesigns right now, and frankly a lot of folks as they are doing consolidating for cost savings were benefiting from that, and so we got involved early on in the year and actually a lot of the transactions just, they were staring to do the implementations. And so we've got a, kind of hit a sweet spot. We got a brand new product cycle, we have consolidation going on. People are trying to figure out how to eliminate some cost complexity in their business and we happen to be a benefactor of that.

Brent Bracelin - Pacific Crest Securities

Okay, fair enough. And then as I think about, kind of the opportunity around the 8-gig cycle, you did talk about a large installed base and having 80% share there. Could you share us, maybe a little more specific numbers around how large of an installed based from an unit standpoint do you have on the Director side and then how many of those Directors are 2-gig, 4-gig, that would be helpful. Thank you.

Tom Buiocchi

Brent this is Tom. I don’t think I have it at the tip of my finger tips here. Some industry reports will come out in the next week or two that are pretty good approximation of that, but we'd have to get back to you. I apologize.

Brent Bracelin - Pacific Crest Securities

Okay. Fair enough. And then my last question really has to do, kind of with the guidance. As you think about being able to grow sequentially, is that solely based on the interest in the new product or what are you seeing from a pipeline perspective, and tied to that have you seen any sort of delays or push-outs you get with your customers.

Richard Deranleau

Yeah, Bred; Richard. I think as you know, but probably we are stating, we have pretty darn good visibility on our enterprise or our Director space, because we have an end user sales force, we have a pipeline that we track, and that's rough cut 40% of our business. So, then on the other side of the coin we're behind the OEMs on our Switch and embedding some of our other products. So that's how we create that visibility. We are not seeing - so our pipeline at the enterprise gave us the confidence to come out with the guidance we did which again is substantially better than historical trends and it's based on that visibility into the enterprise space.

Brent Bracelin - Pacific Crest Securities

And do you ever or have seen any sort of push-outs or delays yet with any large customers?

Richard Deranleau

Again in the enterprise space where we would have the visibility, no we've not.

Brent Bracelin - Pacific Crest Securities

Okay. Thank you.

Richard Deranleau

You're welcome.

Operator

Our next question is from Samuel Wilson, JMP Securities.

Samuel Wilson - JMP Securities

Good afternoon everyone, just a couple of small questions for you. First, did you recognize any revenue at all in the quarter for 8-gig products?

Richard Deranleau

Yes we did.

Samuel Wilson - JMP Securities

Okay.

Richard Deranleau

It was fairly small, but I mean we did recognize some revenue.

Samuel Wilson - JMP Securities

So those of you who like the data side they could actually convert it in to revenue in the quarter?

Richard Deranleau

Or some early shipments early adopted programs.

Samuel Wilson - JMP Securities

Got it. And then really a question for Mike and this is specifically on the financial services vertical. Obviously there's been a tremendous amount of disruption in that vertical, could you just give us sort of your two sense on what you think is going on with the customers and their storage needs specifically in that vertical.

Mike Klayko

Yeah, actually we take a look at that with a lot of interest, because there are large consumers of technology. Frankly one of the things we are seeing in that space is, contrary to what you think or say, there's actually acceleration to consolidation, and in some areas we're trying to accelerate the consolidation plans they have. It's all around cost cutting and saving money at this point in time, kind of placed to our sweet spots. So it's not intuitively obvious in some of their, maybe some of the other buys they have, but in our space they are trying to figure out how to consolidate and how to do more with less. So we’re very, very active in that market right now.

Samuel Wilson - JMP Securities

And then last question for you is, can you just give us sort of an update on your fields on how the international business went and what you see for that or maybe over the next year just qualitatively?

Mike Klayko

Yes its interesting as Richard pointed out on the preferred remarks. Our international business is very strong. It's very strong in not only just in Asia but in Europe also, and so outside the U.S. and you have to read some of the papers of what’s going on in the US if your in Europe to find out that there is a lot of crisis going on that you hear about. But frankly our business is very robust in not only developed countries but a lot of the emerging countries there. So we’re seeing great growth across all of the different entities, in China as well as we’re seeing very good strength in Japan, as well as some of the larger European countries.

Samuel Wilson - JMP Securities

Perfect. Thank you very much gentlemen.

Mike Klayko

You bet. Thank you.

Operator

Our next question is from Kaushik Roy with Pacific Growth Equities.

Kaushik Roy -Pacific Growth Equities

Thanks. Congratulations on the nice margin improvement. But it seems like you missed the top-line three quarters in a row. And Directors have been good all three quarters, but FAN and switches have been somewhat weak. Can you comment, is it more competitive that you are seeing the Cisco 91/24/34 or is it that the market it self is not growing that much? Any comment will be helpful.

Tom Buiocchi

Hey Kaushik this is Tom. Just on the first point and then the other guys will chime in. Well it looks from a share perspective we’ve been gaining share the last couple of quarters. I guess the industry reports will come on in another couple of weeks, but we don’t we believe we’ve lost any share in the space at all to our competitors. So I don’t believe it's that factor.

Kaushik Roy - Pacific Growth Equities

Is the market not growing as much or is it?

Tom Buiocchi

Well when you look at the market a couple of things to consider right. Richard made some apples-and-apples adjustments in the prepared remarks as well. We got to adjust for that third party revenue loss and the purchase accounting when you do your year-over-year comps. And remember we’re just anniversarying the McDATA acquisition, and during that year long period we had pre-announced an entire product cycle to the entire industry. So that consolidation of the industry may have caused some short-term TAM minimization. But I think we are coming out of that right now, given the strength in our Director and Blade products, especially at the enterprise.

Mike Klayko

And Kaushik also, it's Mike. Although we are landing within the range, we've giving guidance in terms of the top lines.

Kaushik Roy -Pacific Growth Equities

Yeah.

Mike Klayko

With our being in the bottom line, and I want to make sure that people don’t get lost on, lose that fact that we really do focus on high quality revenue, building a sustainable long-term company business model. So, we are very, very focused on the quality of the revenue that we bring in.

Kaushik Roy -Pacific Growth Equities

And then on services it was down 8% sequentially, and I thought you were focusing more and more on services. So can you comment what happened or what are your expectations going forward for Q2 maybe?

Richard Deranleau

Yeah, the services have been just a great story for us. If you look at it where we've come over the last year, and what we talked about last quarter was that our services revenue performance is pretty much off the chart and I tried to be very explicit that that just wasn't going to be able to continue at that level. And so when you normalize over the last three quarters or even just last two quarters, we are very, very pleased with what we've done both financially and also from a strategic point of view of getting that intimacy with our customers, either directly or in conjunction with our OEM. So, we are extremely happy with what's going on in our services business and frankly we are quite proud of it.

Mike Klayko

Kaushik let me just add one comment to that. We are limited by the - I mean that is a people intensive business, and we are kind of tapped out at this point too. We've won some very, very nice contracts and now we are in the process of delivery. So, as I stated earlier we are -- our growth is only limited by the people we can put into that position.

Kaushik Roy -Pacific Growth Equities

And so in Q2 you expect it to be up sequentially?

Richard Deranleau

Yeah, I would expect, Q2 to be up sequentially in services and also as I said in my prepared remarks I am expecting the gross margin to improve to be back within our target model.

Kaushik Roy -Pacific Growth Equities

Okay, thank you.

Mike Klayko

Thanks Kaushik.

Operator

Our next question will come from Tom Curlin with RBC.

Tom Curlin - RBC

Hi, good afternoon. Maybe on some of the emerging stuff. So on the (inaudible) FAN revenue can you just walk through what's happening there quarter-to-quarter and year-over-year, is the product cycle driven or what's the outlook there?

Richard Deranleau

Tom, this is Richard. The FAN revenue was basically flat year-over-year and down sequentially, it's still less than 5% of our revenue. From a product set point of view, we believe that we have a very good product and Mike hinted that we've got other products in the pipeline. And then Mike also has talked about how we have reorganized to refocus on that market, I think it's a great opportunity for us, and but for good things to come.

Tom Curlin - RBC

And is there correlation with services just with what's happening with FAN and it seems like that was an area that was a service opportunity.

Richard Deranleau

It is. It is not so - on services in Q1 performance that's really just again it's a -- you can't keep up that kind of a rapid pace quarter-after-quarter in the services business, the way we have it structured. But your point I think is well noted that the FAN opportunity as it goes up in revenue we'll drag along with it a pretty significant service portion.

Tom Curlin - RBC

Okay. And then again just a few different emerging items. So on the adapter stuff for Hitachi as a [call] can you give us the scope of that from a server platform perspective? Is it targeted at purely Windows environment or does it expand UNIX, Linux is it specific Windows environment, how does that look?

Tom Buiocchi

Yeah Tom this is Tom. We can't give you the scope of it right now, because they haven’t given us permission to do so. But I can tell you that the products as they come out will have windows capabilities, Linux capabilities, Solaris capabilities and VMware capabilities. So they are applicable all across all those segments.

Tom Curlin - RBC

Okay. And then finally moving to well whatever the latest name for it is, data center or Ethernet etcetera, so forth and then fiber channel over whatever that is. Where do you think that is?

Tom Buiocchi

Well in the alphabet soup of emerging standards. Well the standards are progressing, you saw some [pressing] options this week that the standard bodies are continuing to make progress and we’re optimistic that hopefully by the end of the year the fiber channel while reaching its standard will be solidified. But recognize also that that technology is going to require some customer adoption, its going to require a more robust version of data center Ethernet to run over, and we expect it to become standardized late in the year early part of ’09 potentially, and then for products to start rolling out a little after that. So, by the time customer ramp occurs, we believe is my more of a late ’09 maybe early 2010 kind of thing

Tom Curlin - RBC

And is that you're talking about the fiber channel mapped over Ethernet standard what about DCE or [IMS/Convergence] whatever you want to call it.

Tom Buiocchi

Sure. The DCE standard is currently in the IEEE standards body and I believe it's on roughly the same timetable Tom which is late ’08 early ’09 type of standardization in parallel with the FCOE standard.

Tom Curlin - RBC

Alright thank you very much.

Richard Deranleau

You bet Tom.

Operator

Our next question is from Jason Nolan with Robert Baird.

Jason Nolan - Robert Baird

Thank you. First question on the 8-gig side. We heard from a storage company last night about somewhat of a lack of confidence in pipeline. Could you talk a little bit about visibility and do you feel that you are being included in '08 budgets right now with that product?

Richard Deranleau

Yeah, Jason this is Richard. Yeah, actually I'd be a little bit surprise by that, because what we are seeing is just a tremendous amount of interest in the DCX product. We have lots of activity in our pipeline; we have lots of code activity going on. So, I struggle to correlate it with what you are seeing. We are not -- certainly we are not seeing that on our end of the pipeline.

Jason Nolan - Robert Baird

Okay. And then on the optics' piece of the 8-gig product, I believe optics is reasonably expensive now. As the cost of optics comes down throughout the year, is that something you would use to drive gross margin or would you bring your price down in order to drive share.

Richard Deranleau

Jason optics in -- any time you go into a new product cycle, its volume driven. And it was the same issue with 4-gig, and overtime prices come down; margins go up, improve and so forth. We don’t think that’s going to change at all on the 8-gig. It's going to follow the same trend lines.

Jason Noland - Robert Baird

Okay, and then a couple of question on your emerging categories. On FAN specifically, I believe there was a push to try to bring VARs into the mix in addition to OEMs. Have you made much traction with the channel?

Tom Buiocchi

We are starting to make some traction Jason, this is Tom. We've got some education and training programs and some certifications going on in the channel. A lot of it's aligned with our new relationships with IBM and HDS, and their particular resellers in the channel who would sell file type systems that would software products would work on top of. So think of it as an intersection of our OEM agreements and their reseller channel in building that up.

Jason Noland - Robert Baird

Okay, fair enough, and then last question on the HBA side. Is there a cost associated with calls from a staffing standpoint maybe or resources as we look out through the year?

Richard Deranleau

Well, I mean there always is because think from a personnel point of view; we are going to have people dedicated to supporting the calls if nothing else. But the bottom line is that's already contemplated and included in our model.

Jason Noland - Robert Baird

Okay, fair enough and thanks for the color on Q2 guidance, Richard.

Richard Deranleau

No problem.

Alex Lenke

Operator two more questions please.

Operator

All right, very good. And we'll next then go to Andrew Neff with Bear Stearns.

Andrew Neff - Bear Stearns

Sure, just can you give us some more color on the HBA outlook in your plans? How things change relative to where you think were last quarter and how are things looking in that respect? Are you still as optimistic about that and tell me about your rollout plans?

Mike Klayko

Andrew we said early on. I think all the way back until going back to September we said that it would -- we'd be releasing in the product in our first fiscal half all the way and we're still on that track right now of doing that. So actually from a planning perspective and development perspective, we are right on the money of where we thought we'd be right now.

Richard Deranleau

And Andy from a revenue perspective, we'd see the contribution there coming online in the second half ramping in Q3 and then contributing we would expect materially in Q4.

Andrew Neff - Bear Stearns

Okay. Thanks a lot.

Mike Klayko

You bet.

Operator

And our final question will come from Paul Mansky with Citigroup.

Paul Mansky - Citigroup

Under the wire, thank you. I wanted to go back to the Director strength; hopping you can elaborate a little bit more on that. Particularly in the context of that weak mainframe performance at IBM, I know that that's historically a pretty good driver. So I wanted to speak about A; impact on the most recent quarter, and B; presumably with the refresh upon us here, is there opportunity for upside on the Director side as we look at the upcoming quarters' guidance.

Tom Buiocchi

This is Tom, Paul how are you doing. Glad we got you under the wire here. So it's kind of interesting to know where we had two Director quarters that have been records consecutively in light of our new product DCX announcement that came on board. Sometimes you expect the otherwise, but we’re gaining momentum there. A lot of it's due to consolidation as Mike talked about. And the Mainframe although it’s a very, very important segment for us, it is a low double-digit portion of our Director sales. So it's not a majority by any means. And although it’s a good indicator, but majority of our demand is driven in open systems environments.

Richard Deranleau

And then Paul this is Richard. We’ve given a bit of range right on our guidance 340 to 355. So that contemplates that if DCX is running better and a little harder, that’s where you get into the 355 which I think given normal seasonally down patterns everybody will be pretty happy with the 355 quarter.

Paul Mansky - Citigroup

Yes, absolutely. And then just Richard for you by way of follow up on kind of the headcount discussion. At first congratulations for taking a somber view relative to layering your expenses in some sort of an environment is certainly I think a pragmatic approach. But can you help me reconcile your comments there around the other comments about the service revenue growth and just being a function of how many people you can put in the seats.

Richard Deranleau

Yeah I think that the comment Mike made, he is trying to just point out that there is a natural there that you’ve to grow by. And I think when I look at that, I look at that as something that is important for us to focus on over multiple quarters.

Paul Mansky - Citigroup

Okay.

Richard Deranleau

When I - because you and I think Mike has talked about this before, which is you have to hire somebody and then train them up so there's this lag time. For us and Q1 versus Q2 in services, obviously, these people are already on board and we are getting utilization of them, right? So that’s whats going to drive us back. We don’t to hire and train new people within 30 days in order to get that natural flow back.

Paul Mansky - Citigroup

Okay.

Richard Deranleau

When we look at hiring new people, we are looking at applying in services, but service as relative is a small part of our business, and the much bigger business, we are also going to be very, very careful about so that we don't get our in front of skis. So, it's a combination of, we are going to be attracting service people where we can and it's a -- we are opportunistic for the skill set and then the rest of our organization which again is proportionately much, much larger, you know we are going to be very careful.

Paul Mansky - Citigroup

And then just lastly, just if we were to try to put a little of a finer point on it. You just grew headcount about 4% sequentially in Q1. Care to put a number of growths in or flat in Q2?

Richard Deranleau

Well, I probably wouldn't think about in terms of heads. That gets a little bit too fine. But I think if you look at our spending, and you look at our spending guidance, we are basically flat to marginally up. You know we hired X number of people, it's in our press release. You can do the math and come up to 80 or 90 people. Those people now are going to be on board in entire quarter. You know, we don’t have the holidays and vacation, so I think that gives you a pretty good indication that we are going to be fairly conservative in what our plans are.

Paul Mansky - Citigroup

Great. Thank you very much.

Richard Deranleau

You are welcome.

Mike Klayko

Thanks Paul.

Alex Lenke

Operator?

Operator

Thank you again everyone for joining us today. This concludes our Q1 fiscal 2008 conference call. If you have any further questions, please call me at 408-333-6758. Thank you.

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