Brocade F2Q08 (Qtr End 04/26/08) Earnings Call Transcript

Brocade (BRCD)

Q2 2008 Earnings Call

May 14, 2008 5:00 pm ET

Executives

Alex Lenke – Director Investor Relations

Mike Klayko - CEO

Richard Deranleau - CFO

Tom Buiocchi – VP Marketing

Analysts

Aaron Rakers – Wachovia Capital Markets

Sam Wilson – JMP Securities

Paul Mansky – Citi Investment Research

Kaushik Roy – Pacific Growth Equities

Scott Craig – Banc of America Securities

Mark Moskowitz – JP Morgan

Jayson Noland – Robert W. Baird & Company

Keith Bachman – BMO Capital Markets

David Cahill – RBC Capital Markets

Shebly Seyrafi – Caris & Company

Presentation

Operator

Good day everyone and welcome to the Brocade Q2 2008 earnings conference call. At this time I’d like to turn the conference over to Mr. Alex Lenke, Director of Investor Relations; please go ahead sir.

Alex Lenke

Good afternoon ladies and gentlemen. Joining me today from Brocade are Mike Klayko, CEO; Richard Deranleau, CFO; and Tom Buiocchi, VP of Marketing. Before we begin, let me cover some housekeeping items.

Brocade issued a press release today detailing its second quarter fiscal 2008 financial results via PRNewswire and FirstCall. The Q2 press release is available on our website at www.brcd.com. A PDF version of the presentation will be posted just after the conference call concludes. This conference call is being webcast, and will be archived on our website for approximately 12 months. In addition a telephone replay will be available at approximately 5:00 PM Pacific Time 5:00 PM Pacific Time May 21. To access the telephone replay dial 888-203-1112 or 719-457-0820. The pass code is 6776943.

As a reminder the information the presenters discuss today will include forward-looking statements including without limitation, statements about Brocade's financial results, business outlook and guidance. These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly. These and other risks as set forth in more detail in our Form 10-Q for the fiscal quarter ended January 26, 2008 and 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 Q2 '08 press release, which has been furnished to the SEC on Form 8-K and in the corresponding Q2 '08 slide presentation on our website.

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.

I will now turn the call over to Mike Klayko.

Mike Klayko

Good afternoon everyone and thank you for joining us. Q2 was another very good quarter for Brocade as we continued our excellent operational execution and performance. Our financial performance was better than expected. We added to the momentum of our aggressive cycle and we acquired SBS, a professional services company that significantly broadens our offering and expertise for the evolving data center market.

We continue to feel very good about the trends that are shaping the next generation data center market and our short-term and long-term availability to compete and win. In Q2 we achieved record revenue in a quarter that is traditionally down sequentially. Our performance was bolstered by a strong initial ramp of our new DCX Backbone product, excellent results from our services organization and by a balanced contribution across all regions and OEMs. We continue to win in a market and increase our market presence.

We exceeded EPS estimates for the 11^th consecutive quarter once again demonstrating our ability to generate strong margins. Our robust operations led to a record level of cash generated from operations for the quarter and allowed us to continue to invest in and advance our company growth initiatives. As you know one of the most critical growth drivers for us is the timely execution of our industry leading product cycle and we made tremendous progress on this front across all of our business units in Q2.

In our data center infrastructure business we achieved yet another record revenue quarter with our Director class products and our new DCX Backbone has ramped faster than anticipated in its first few months in the market. In fact, the initial uptake on DCX outpaced other ramps of all similar high end offerings from previous generation products. Our customers tell us that the DCX delivers order of magnitude improvements; five times the bandwidth, the ability to support eight times as many virtual servers and a power efficiency advantage of 10X which are significant differentiators over the competition.

This week we have complimented the DCX and raised the bar in fabric switch market by leveraging DCX technology into a complete family of new 8G switch products. These new fabric switches double the performance of previous products while consuming 40% less energy. We expect the majority of our OEM partners to be in the market with these new switches in our Q3 beginning with IBM and Sun who announced availability this week.

We have also made exciting progress in our server connectivity business and we were very pleased to announce our new intelligent 8G FC HBAs along with our new switches yesterday. Increasingly our partners and customers are recognizing the performance benefits and end-to-end capabilities that our innovative new HBA designs will deliver especially when they are used in conjunction with our large installed base and new family of switches, directors and backbone products.

We expect to add major Tier 1 OEM commitment for our fiber channel HBAs very soon and I am very pleased to note that we recently earned a new design win in the emerging FCoE adapter space with a Tier 1 systems and storage provider. As we have mentioned in prior calls, we believe that the server connectivity segment represents a strong growth opportunity for Brocade and provides us with even more differentiation in the data center.

In Q2 we also enhanced our file management product offering with the announcement of the Brocade file management engine or FME. This product offers a number of industry firsts. Most notably, the ability to migrate files when they are in use. Thereby saving customers a tremendous amount of planned down time that is traditionally reserved for data migrations. We began shipping FME at the end of Q2 and the initial feedback from early customers has been very positive.

Finally we are very pleased to further augment our record services performance with the acquisition of SBS, a data center professional services firm. SBS brings very deep skills in several data center disciplines including networking, security, storage and virtualization. Their ability to deliver projects cost affectively has helped make them an important partner to many of the same OEMs that Brocade currently works with which is obviously very synergistic with our business model. In addition SBS brings significant experience providing services and solutions to the US Federal Government sector.

We are very delighted to have them on board to help broaden our service offerings for the next generation of data centers. As our new products and services hit the market, we continue to stay very close to the market trends and customer needs. The overall industry drivers that help shape our target markets remain positive. As data centers continue to evolve the magnitude of the customer challenges such as data management and data protection have grown which creates opportunities for us to add value.

In addition, technology trends such as server virtualization and the greening of the data center have significant ramifications on how data centers are designed and managed. Data center networks that efficiently connect servers and storage play an increasingly important role. We believe that our position and offerings in this evolving market are second to none and we continue to be extremely proactive with regards to emerging technologies and standards in the data center. Our data center fabric or DCF strategy is resonating with customers and partners and they increasingly choose Brocade for our advantages and differentiation in the market.

Before I turn the call over to Richard, I’d like to briefly comment on the overall market and our visibility in the business. The current economic environment makes the ability to forecast with precision much more difficult. However, we have a very firm grasp on the factors that are under our control. Our product cycle is on track. We are making key investments in our business and we are continuing to solve our customer needs in their data centers.

Our solutions help customers save time and money and our diversification across geographies and industries help us to balance our results globally. We believe that the overall market trends will continue to evolve in our favor and we are very much looking forward to competing and growing in the second half of the year.

With that I’d like to turn the call over to Richard for some more detail on our Q2 performance and outlook going forward.

Richard Deranleau

Thank you Mike and thanks to all of you for joining us today. We are very pleased with our second fiscal quarter where we delivered strong results that offset what is normally a seasonally weak quarter. This is particularly impressive given the continuing uncertainty in today’s economy. Also we continue to improve our already strong financial position with robust earnings and cash flows resulting in a healthy balance sheet.

In the quarter our top line was driven primarily by an excellent quarter in our services business and a record quarter for both our Director product line including our recently introduced DCX Backbone and our imbedded switch product line. This resulted in favorable product mix and higher than expected gross margins helping us deliver operating margins of nearly 23%.

Also we generated a record amount of cash from operations. During the quarter we used cash to purchase SBS, a US based services firm, and for repurchases of the company’s stock. With the strong cash generation and working capital management, our balance sheet remains strong. So now let’s look at our Q2 financial results beginning with the income statement.

First a housekeeping item regarding reporting, over the last 11 quarters, inventory at our OEM channels has remained in equilibrium at approximately two weeks on a forward looking basis. As of the end of this quarter, the majority of our large OEMs are either on a Brocade hub or a third party inventory management arrangement. As a result, any future differences between reported and sell-through revenues are expected to be minimal and channel inventory is expected to remain at approximately two weeks of forward demand.

Therefore after this call, we will no longer be reporting sell-through revenue unless there is a significant change in OEM weeks of inventory. Now regarding our Q2 revenues, Q2 revenues were $354.9 million, up 2% sequentially and up 3% year-over-year. Adjusting for the replacement of McDATA non-strategic low margin third party products with Brocade core revenues, and the impact of the purchase price adjustment, the year-over-year growth is 6%.

Q2 sell-through revenues were approximately $348.9 million, down slightly from a record sell-through quarter in Q1 and up 5% year-over-year. Record revenues in Q2 were driven by a strong performance in our data center infrastructure products especially Directors, and our services business. On a geographic basis we saw particular strength in the AMEA region. Moving on to our business segments, in our core data center infrastructure business revenues were roughly flat quarter-over-quarter and year-over-year. As I said earlier, we had a third straight record quarter in Directors. Director revenues were up 5% quarter-over-quarter and 19% year-over-year.

Our DCX Backbone product contributed nicely to revenues since its introduction in January. The ramp of DCX revenues is faster when compared to the introduction of our 48K Director. International demand for our data center infrastructure products was particularly strong. In Q2 ’08 international revenue percentage normalizing for those large OEMs who take delivery of internationally destined products within the US was approximately 62%.

Switch revenue was down 2% quarter-over-quarter and down year-over-year. We remain very confident in our leadership position in this market and believe we held market share. In addition, we expect to further solidify our position throughout the remainder of the year with introduction of our new 8G switch product family. In our imbedded switch product line, we had our third consecutive record quarter with revenues up 2% quarter-over-quarter and 49% year-over-year. In our services business we had a record revenues which were up a healthy 19% quarter-over-quarter and 32% year-over-year. The impact of the purchase accounting adjustment in Q2 was a $2.3 million reduction.

Revenue and operating margin contribution from our acquisition of SBS were not material in the quarter. On a non-GAAP basis, services gross margins were 46.4%, slightly above our services target model of 38% to 45%. This over-performance was enabled by a leveraged services model where incremental revenue growth drives strong operating margin. In our files business, revenues were up slightly quarter-over-quarter and down year-over-year. Revenue from our recently introduced FME product was not material in the quarter. We expect to see revenue contribution from our FME product ramp throughout the second half of ’08.

But this is not expected to be a material component of our overall company revenues. Gross margins from our files business improved significantly during the quarter driven by a shift of revenues from the resale of [Packateers] WAFS product to Brocade StorageX product family. In our HBA business, we are pleased with our progress in the development of our HBA business and still expect to see initial product revenues on our internally developed 8G products in the second half of FY08. We expect to see significant revenue contributions from our HBA products in FY09.

Turning to our margin and bottom line performance, we had another excellent quarter as demonstrated by our nearly 23% non-GAAP operating margin. While we were careful with our operating expenses we were able to make key investments in R&D, marketing, and selective investments in sales. For the second quarter in a row, we operated above the improved operating model that we shared with you at our Analysts’ Day last September.

In Q2 the pricing environment remained stable and sequential like-for-like ASP declines were again in the low single-digits. On a non-GAAP basis, gross margins for Q2 ’08 was 61.1%, higher than our previously expected range of 58% to 60% and above our long-term target model range of 57% to 60%. The upside in gross margins was driven by a favorable product mix. In addition the significant margin improvement in our services segment also positively impacted our gross margins.

Q2 non-GAAP operating expenses excluding the items referred to in the accompanying webcast slides, were $135.6 million above the high end of our prior outlook of $128 million to $132 million. The increase in R&D related primarily to incremental spending on new product development including the recent introduction of our 8G switch product family. The increase in marketing and sales related primarily to new product launches, and additional marketing programs for the files and HBA product lines.

Non-GAAP operating margin for Q2 was 22.9%, exceeding our prior outlook of 20% to 22% and exceeding our long-term model of 18% to 22% of revenues. Our effective non-GAAP tax rate in Q2 was 30.7%, slightly above our expected rate of 30.3%. Regarding our effective GAAP tax rate in Q2, as mentioned in prior earnings calls the company was maintaining a full valuation allowance on our deferred tax assets. As required by accounting rules, the company is required to evaluate at what point the company believes it is more likely than not that the company’s future earnings will enable it to realize those deferred tax assets.

As of Q2 we believe that the future profitability of the company enables us to reverse our $218 million valuation allowance of which $167 million was a benefit to the P&L and the remaining $51 million was a reduction to goodwill. Moving on to our operating results on an earning per share basis, Q2 non-GAAP diluted EPS was $0.15, at the high end of our guidance of $0.13 to $0.15. Reporting on a GAAP diluted basis, Q2 EPS was $0.47 reflecting the $0.42 impact of the reversal of the deferred tax asset valuation allowance.

Without the tax benefit of the valuation allowance reversal, our GAAP EPS would have been $0.05, which would have been flat from the $0.05 GAAP EPS reported in Q1. Our Q2 EPS was negatively impacted from the loss of $4.2 million or $0.01 per share from a sale of a strategic investment. Our diluted shares outstanding were 393 million shares in Q2, which included a 12.1 million share impact of the dilutive McDATA convertible debt.

Without the impact of the McDATA convertible debt, our diluted shares outstanding would have been approximately 381 million shares, down from 391 million in the prior quarter. This reduction in diluted shares outstanding increased our non-GAAP diluted EPS by less than a quarter cent. 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 investment balance at the end of the quarter was $796 million. Net of convertible debt the balance was $628 million, slightly up from last quarter. This reflects record cash flows offset by the acquisition of SBS and stock repurchases made during the quarter. At the end of calendar 2007 the company restructured our investment portfolio to address concerns we had in the financial market at that time. In early Q1 the company eliminated our investments in auction rate and asset-backed securities and significantly increased our holdings of federal securities while shortening the weighted average maturity of our portfolio.

While this negatively impacted the yield of our investment portfolio we significantly reduced the market risk to that portfolio. Cash flow from operations in the first quarter was an impressive $111 million, significantly above our expected range of $40 million to $50 million. This increase was principally driven by the linearity of our quarterly revenues and our continued strong working capital management. In Q2 we used approximately $50 million to repurchase approximately 6.9 million shares of Brocade common stock. The stock repurchases during Q2 were executed under our corporate 10B51 automatic stock purchase plan. To date we have purchased a total of 45.8 million of Brocade stock for a total of approximately $348 million.

At the end of Q2 we had approximately $452 million remaining available under our total stock buyback authorizations. Now turning to our outlook for Q3, here are some assumptions for you to consider.

When considering the IT spending environment consistent with our peers and partners, we remain cautious about spending at a macro level. However, while we remain more optimistic about spending at the enterprise level on large projects in the deployment phase, we are concerned about the potential for reduced IT budgets coming on top of our seasonally weakest quarter. For our internal financial planning purposes, our assumption is that there will not be a recovery in the macroeconomic environment until the beginning of calendar 2009.

From a visibility standpoint our best visibility is at the enterprise level which primarily impacts our Director products. Because of our OEM model our visibility into the mid-range space which primarily impacts our switch products is more limited. With this as a backdrop we plan to manage our expenses and control our headcount growth until we have a clearer visibility into the remainder of 2008.

While our core markets remain very competitive we believe that our new product introductions and our installed base advantage put us in a uniquely strong competitive position. We successfully introduced our DCX and FME products to the market and announced the availability of our new 8G switch products. We expect these new products to contribute to revenue in the second half of FY08. From a pricing perspective we expect quarterly ASP declines to remain in the low single-digits but up slightly from recent prior quarters as enterprise customers try to stretch their available budget dollars.

Historically Q3 is our weakest seasonal quarter with revenues flat to slightly down from Q2. While at the end of Q1 we believed that our new DCX product introduction we would have a product cycle advantage in the market that somewhat dampens this normal seasonality, we now believe this upside has been offset by the macroeconomic uncertainty. We are therefore expecting the net result will be a typical normal seasonal pattern of flat to slightly down.

Historically we would expect Q3 to have a higher mix of switches versus Directors than in Q2 which would put slight sequential downward pressure on our gross margins in Q3. Now taking all these factors into consideration our outlook is as follows. We expect our revenue in Q3 to be in a range of $345 million to $355 million. A percentage range of negative 3% to flat sequentially and an increase of 5% to 8% year-over-year. Again this reflects normal seasonal patterns.

We expect non-GAAP Q3 gross margin to be between 59% and 60% within our targeted long-term model of 57% to 60%. For Q3 we expect total non-GAAP operating expenses to be in a range of $138 million to $142 million. While we expect to be disciplined about our spending we plan to make additional investments in strategic R&D and sales and marketing programs in order to maintain our product cycle momentum and our strong position within the markets. At the same time we plan to manage non-strategic spending very carefully until our top line visibility improves.

We expect our Q3 non-GAAP operating margin to be in a range of 19% to 20% which is within our long-term target model. We expect non-GAAP other income/other expense net in Q3 to be approximately $5 million to $6 million. Regarding our tax rate, we expect that our Q3 and annual non-GAAP tax rate will be approximately 30% to 31%, although there may be some level of volatility in the non-GAAP tax rate. We expect our GAAP tax rate will be 61% to 62% reflecting a one-time non-cash McDATA acquisition related intercompany purchase of IP into our international tax structure and the non-deductibility of the amortization of purchased intangible assets.

We expect diluted shares outstanding to be in a range of 390 million to 394 million shares including the dilutive impact of the McDATA convertible debt. Based on these factors we expect Q3 ’08 non-GAAP diluted EPS in a range of $0.13 to $0.14. We expect Q3 ’08 GAAP diluted EPS in a range of $0.04 to $0.05. And we expect the differences between non-GAAP and GAAP results in Q3 will consist primarily of the same items as in Q2 other than the Q2 reversal of the deferred tax valuation allowance.

You can find the GAAP to non-GAAP reconciliation slides on our website. Now turning to our balance sheet and cash flows, we expect capital expenditures in Q3 to be in the $12 million to $15 million range. We expect DSOs in Q3 to remain within our target range of 40-50 days and on-hand inventory to be in a range of $12 million to $15 million. We expect to generate cash from operations in Q3 of approximately $50 million to $60 million in a seasonally weaker cash flow quarter. We expect to continue to be active in the market regarding stock repurchases.

In summary in Q2 ’08 financially, we had an excellent quarter bucking typical seasonal trends and macroeconomic headwinds. We executed well across all of our business fundamentals including a recovery in our services business compared to Q2 and continued to extend our product leadership position. With our current product cycle market advantage we expect to retain a strong market position. We made the necessary investments to maintain and improve our market position while continuing to deliver on the improved business model, growth, profit, and cash flow targets that we outlined in our Analyst Day last September.

Going forward we will continue to balance the need for strategic investments against the discipline in our operating spending in these uncertain economic times. And we remain committed to continue optimizing our growth initiatives, our business model, and the return to our shareholders.

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

Mike Klayko

Thanks Richard. We had an excellent Q2. We are staying focused on our strategy and we are executing very well. Our product cycle in on track, the initial acceptance of our new products has exceeded expectations and we are beginning to see the results of our investments in new initiatives. Based on the unprecedented strength of our product pipeline we feel extremely well positioned to take advantage of our leadership position and broad install base.

Thank you for joining us today. Before I end my comments I want to announce that we will be hosting a Technology Day in New York City on June 26^th, where we will go into detail on our products and market strategies across each of our business units. This will be an excellent opportunity for you to spend time with our senior management team discussing important trends, emerging standards, and new technologies that are shaping our market opportunities.

And now we’d like to open up the call to take any questions you might have.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Aaron Rakers – Wachovia Capital Markets

Aaron Rakers – Wachovia

First in terms of the guidance, you talked a little bit about visibility as well as linearity through the quarter, but now we’re talking about some slowing that you’re seeing despite the product cycle. I guess I’m just curious of what you’re seeing in terms of the pipeline and specifically around the mid-range or the switch business that’s causing you to be a bit more cautious. Was there something at the end of the quarter that happened in terms of the macroeconomic that you’re seeing pressure?

Mike Klayko

Visibility standpoint, we’ve got great visibility in the Directors, in the enterprise space. We track all those transactions. The mid-range space as you know, goes through our OEMs, makes it a little more challenging to take a look. However you know, it was fairly widely known also that we had a whole product refresh coming out and so we also factor that in so we’ve got a brand new set of products also coming into the marketplace.

Aaron Rakers – Wachovia Capital Markets

So you did see a pause with regard to your switch business at the end of the quarter ahead of that cycle.

Mike Klayko

No I didn’t say that. We didn’t see a pause, actually what I was making mention is, I was more making a reference on the go-forward basis.

Aaron Rakers – Wachovia Capital Markets

And in then in terms of going forward, are we reiterating the full-year guidance that you’ve already laid out for fiscal ’08?

Mike Klayko

Actually what we’ve done is, seeing past Q3 right now is a little more challenging then you can imagine. It’s tough for a lot of the companies in the marketplace including us. So we have visibility in Q3. Q4 just from a standard operating model I think we’re typically up 6% to 8% Q4 over Q3 and we’re doing our planning.

Aaron Rakers – Wachovia Capital Markets

You’re talking a bit more about the HBA opportunity, it would be helpful if we could wrap some color around what you mean by significant or meaningful HBA revenue looking into the fiscal ’09 and I’m assuming when you’re talking about Tier 1 OEMs you’re talking about a Tier 1 server platform that you expect to win or announce over the next quarter or so?

Tom Buiocchi

Tier 1 certainly means that it’s Tier 1 OEM from our perspective server and storage platform, yes.

Richard Deranleau

And then from a level of revenue you’re going to have to wait I think until we do our Analyst Day later in this year when we can breakout what it looks like in ’09.

Operator

Your next question comes from the line of Sam Wilson – JMP Securities

Sam Wilson – JMP Securities

Can you talk a little bit about uptake of 8G products on the SilkWorm platform? I know that’s been in the market for a little while now, it sounds like DCX is going phenomenally well is that mainly to the McDATA customer base? Can you just give us an update in general on the financial services vertical and what your feelings are there? And can you just give us a competitive update; are you seeing anything unique in the competitive environment?

Richard Deranleau

From an 8G versus 4G the way we’re really looking at it because the DCX can be operated in either mode, its more important to us how fast the DCX chassis itself is ramping up and from that perspective that’s where we’re very happy with how fast the DCX is ramping as well as the interest. And the interest in the DCX is very broad both to the McDATA as well as the Brocade installed base and we’re particularly pleased with the level of interest from the Brocade installed base. From a verticals perspective, again just as Mike had mentioned, our visibility is really limited to the Director level and on that we, so using that as a proxy if you will, the financials segment was down from last quarter and it was offset by the services sector and some other verticals that we track.

Tom Buiocchi

From a competitive standpoint the tactics haven’t changed in the competitiveness hasn’t changed. It’s very, very competitive out there especially in [Greenfield] accounts. I think you’ll see when the share numbers come out; we’re winning more than we’re losing in those accounts but essentially the field remains competitive and our product advantage is really helping us.

Operator

Your next question comes from the line of Paul Mansky – Citi Investment Research

Paul Mansky – Citi Investment Research

Looking a little bit further out, now that we’ve got 8G rolled out pretty much across the product set, can you talk just a little bit about how we should be thinking about the longer term gross margin trends on the product side as we obviously there’s some components in common there.

Richard Deranleau

I think that we would be comfortable saying that we would want to stay within our targeted range. We’ve been operating very close to that, a little above it, but over the long-term the 8G is a little bit more expensive. Services are becoming more important part of our business so I think we’re still comfortable with the long range model.

Paul Mansky – Citi Investment Research

I just wasn’t sure if there were going to be any moving parts in there relative to maybe product gross margins taken up services margins maybe taken down a little bit as you more aggressively kind of build out that capability.

Richard Deranleau

Yes, there’s a lot of moving planes, there’s assumption around pricing of the new technology, there’s assumption about ASP, typical ASP erosions, portfolio management between the HBAs file, there’s just a lot of moving parts which is you net it all back together and we’re back to where we are with our model.

Paul Mansky – Citi Investment Research

This past quarter, can you talk just a little bit about what’s your, I know in past quarters you mentioned probably about 15% of the market is mainframe attached, can you talk just about what you’re [ficon] connectivity looked like during the past quarter?

Tom Buiocchi

We don’t really get real time visibility to that, its tough to know because the box is the same and the operating system is the same so we don’t get that level of granularity and its more of an estimate on an annual basis, sorry.

Paul Mansky – Citi Investment Research

Would you leave us with the impression that you’re probably getting some updraft off of the IBM mainframe cycle, stated a different way?

Tom Buiocchi

It’s tough to tell, it would probably go more inline with their typical seasonality which I think is much more Q4 backend loaded. But it’s really tough for us to see that right now real time.

Paul Mansky – Citi Investment Research

What was headcount at the quarter close?

Richard Deranleau

It was, it wasn’t in the script. It is in the press release. The headcount was 2,759 employees.

Operator

Your next question comes from the line of Kaushik Roy – Pacific Growth Equities

Kaushik Roy – Pacific Growth Equities

Investors are a little concerned about the fact that upside came from services, can you quantify how much were the revenues from SBS, how many people, if you can quantify, that would be helpful.

Richard Deranleau

From a product versus services, so remembering that Q1 is our strongest quarter and that Q2 is seasonally down, and its seasonally down 6% to 8%, so all things being equal we should have seen hardware come down 6% to 8%. When you look at the actual product sales, it was down less than 2%. We’re pretty pleased with that frankly given the economic situation that we’re in. So from our perspective great quarter on product sales and we think a lot of that was driven by the interest the DCX. From a SBS acquisition point of view, I had said in the prepared remarks that it was not material from a revenue or expense point of view, it was a private company so we’re not splitting out a lot of the details on that. From a headcount perspective I could give you a little color that says the biggest amount of the headcount growth which was by my math about 302 people, by far the number of people we added was in the services delivery section which is something Mike had talked about in the past as an area that he was constrained on. And then once you go by that, the next biggest area was really in R&D. Once you go below that headcount was nominal in every other area of the company.

Kaushik Roy – Pacific Growth Equities

Was it less than $5 million in revenues or you can’t quantify?

Richard Deranleau

Well it was immaterial so you can take it from, if that provides some color for you.

Kaushik Roy – Pacific Growth Equities

I’m assuming that services in Q3 will be up, or at least flat, that means the product revenues will go down further or how should we model the product as well as the services for Q3?

Richard Deranleau

That’s probably a good clarify question, what we’re doing ourselves when we’re trying to give guidance on is for essentially either slightly down for product in a consistent with our historical seasonal trends, or flat. And I wouldn’t be, and then so service would be somewhat similar to that but we’re not looking for anything on product beyond normal seasonality.

Kaushik Roy – Pacific Growth Equities

So you are reiterating your full-year guide of 1.43 to 1.47 in revenues and EPS is easy, but on the revenue side you feel comfortable with that 1.43 to 1.47.

Richard Deranleau

Yes, I think what Mike was trying to say is that in this time we live in right now, its really hard to give that level of looking out to two quarters. What he did say though was that in typical seasonal patterns revenue in Q4 would be up over Q3 6^ to 8% and then the other thing, I think what we’ve tried to signal is that we are committed to our long-term targeted model.

Operator

Your next question comes from the line of Scott Craig – Banc of America Securities

Scott Craig – Banc of America Securities

On the international business, last quarter you mentioned Europe being strong but also China and Japan, this quarter you just mentioned the AMEA being strong, can you describe a little bit what about, what is going on outside of the AMEA and the US?

Richard Deranleau

Yes, the way I would look at it is that APAC was very strong last quarter. We had, I think Mike would say, reasonable balance across our geographic portfolio but within that I’ve highlighted out that AMEA was particularly strong; very good quarter for AMEA. And I think there continues to be a lot of deployment in India and China which are fast growing economies and Japan is either seasonally up or down but that’s the color I would add.

Scott Craig – Banc of America Securities

On the services business, last quarter you mentioned that you were constrained and you needed to add people, does the acquisition that you did as well as some of the headcount you added this quarter solve that problem so you have enough bandwidth going forward to capture the service opportunities that you see?

Mike Klayko

I think it helps, I’m not sure it solves it. But it is definitely a step in the right direction because it’s primarily focused on the domestic market with a real focus in the Federal space which is an interesting area for us.

Operator

Your next question comes from the line of Mark Moskowitz – JP Morgan

Mark Moskowitz – JP Morgan

I want to get back to the overall issue in terms of the offset to your DCX ramp here in terms of your confidence in the first quarter and where you are now, can you give us a little more sense of the swing factors in terms of how much of it is based on the macro getting worse here in the US versus Europe? How much are you contemplating in terms of Europe weakness maybe popping up here as we go through the summer versus kind of what Aaron was trying to get back to earlier in terms of just some sort of competitive or OEM dynamic.

Richard Deranleau

I think from a competitive situation, as Tom said it’s a competitive, very competitive space. Having said that we believe that we have an advantage in the market because of our product cycle and our ability to deliver on things like services. From a, AMEA is generally weaker in the summer. That’s pretty seasonal. So what we’re looking at right now is essentially saying, hey we think we’re going to slightly down or flat typical seasonal norms, and if you peel the onion back a little bit, its because we have an upside from a very strong product cycle position but from an economic point of view, its more challenging right now. You add the two together and you kind of get us back to what is normal.

Mark Moskowitz – JP Morgan

As far as the Directors given that you do have visibility there, has there been any change in the decision making cycle in the last month or so?

Mike Klayko

I don’t know if I would call it a change, I’d actually think some of the discussions we’re having fit nicely into, as customers are all struggling with I’ll call it the cost equation, they’re trying to figure out how to eliminate costs in their environments and actually this hits the sweet spot because it allows them to consolidate and re-architect and so what’s its done is, its actually had a few more high level conversations happen within organization about timing. And so we’ve had, as I mentioned earlier on the call, the DCX ramp has even exceeded our own expectations and a lot of it is because of all the characteristics this product brings to the market right now because it really focuses on the sweet spot which is around consolidation and cost.

Tom Buiocchi

Interestingly enough, the DCX may have kind of accelerated the ROI modeling from some customers because of its consolidation capabilities and its performance. So the initial ramp exceeded what we initially thought it was going to be and the product is perfect for the time because it does deliver on ROI. It’s very compelling.

Mark Moskowitz – JP Morgan

Richard could you give us a sense in terms of where you are with the move to [Foxcon], how much longer before you get the full extraction of the marginal leverage there?

Richard Deranleau

It’s a little bit complex for a number of reasons, but what I would say at this point is that we’re fairly well consolidated in terms of overall movement into our Foxcon supply chain.

Mark Moskowitz – JP Morgan

On the cash flow, clearly some pretty impressive metrics you’ve put forth two quarters in a row, can you give us a little more color just in terms of how of this is because of the McDATA acquisition being completely behind you, maybe some changes in your overall global infrastructure regarding the back office?

Richard Deranleau

Yes, I think we’ve done a really good job of closing the book on McDATA acquisition. Now what you’ve got is your kind of back to where we were pre acquisition in terms of gross margin, in terms of DSO, in terms of all the main metrics that we had pre acquisition. But because the revenue level is so much higher and our operating profits are back to what they were percentage wise, the profits are substantially greater than they were and most of that is dropping right to the bottom line because we’ve got really tight working capital management and that frankly is the answer. It’s a well-tuned business model.

Operator

Your next question comes from the line of Jayson Noland – Robert W. Baird & Company

Jayson Noland – Robert W. Baird & Company

Could you talk a little bit more about your FCOE adaptor win and expectations for I guess pace of adoption of FCOE?

Mike Klayko

I’m not going to talk about the win because I’ll let my partner talk about the win from that standpoint. But we just wanted to make a statement we’re clearly in the market. It’s an ’09 type of revenue statement. You can debate the timing whether it’s mid ’09, late ’09, that type of timing statement. But we’re clearly in the market with very competitive products. One of the interesting things is we go through this as you take a look at how FCOE fits within our current data center fabric; it’s another different type of product that fits nicely in our DCX and our data center fabric line of products. And it’s also with our conversion and Ethernet products and so forth; you’ve got a total solution we can bring to the customers. When customers look at that, then they start evaluating, FCOE right now in the early stages, it’s more expensive then current fiber channels. And so although we’ll be in the market as everybody is so cost-conscious right now, we’re just being very measured on how much revenue we plan in that product set, because cost is a very important element at this point in time. So we’ll be there. We have products. We’re going to have wins; you’ll see them get announced by our partners. But we also are being very thoughtful in terms of how much revenue we think we’re going to get.

Jayson Noland – Robert W. Baird & Company

If we look out three to five years, is FCOE take going to be similar to something like [I-SCUSI] or is it a little more compelling in your view?

Mike Klayko

Well that’s the real interesting debate going on in the industry at this point in time. You can look at technologies that have been around for a long period of time and they’re still being deployed. I think the application and the infrastructure are going to go ahead and dictate what protocol. But from our standpoint we’re going to be providing all these different technologies and the reason we feel that, feel so strongly about our business model going forward is we are in the center of all these data centers today. We do have all the infrastructure and as customers want to deploy new technologies I think they’re going to turn to us because we’re proven and we’ve been inside of the largest mainframe accounts, the largest enterprises, with proven technology and this is just an extension because its just fiber channel over a different physical layer.

Jayson Noland – Robert W. Baird & Company

It sounds like your HBA traction is pretty good and I believe you said significant revenue contribution in fiscal ’09, we were talking about 10% of revenue in a few years, is that still the goal or could it be something sooner then that?

Richard Deranleau

From my perspective getting 10% of revenues at this point for any of our businesses gets to be a challenge because the revenue growth is accelerating. So we’re going to be going through our ’09 planning process and coming out with more guidance at Analyst Day, but from our perspective given the traction that we are getting with our Tier 1 OEMs, given the interest at the end user level, and I think Mike has said this before, we intend to be a serious player in the market and once you do that those start coming down to being significant revenues from our perspective.

Operator

Your next question comes from the line of Keith Bachman – BMO Capital Markets

Keith Bachman – BMO Capital Markets

I want to go back to the services this quarter, I just want to try to get a little bit of color on where the upside in the service is, was it because of the increased headcount that you had or was it in a certain specific area and related to that looking at the next couple of quarters, how do you think about metrics of services growth versus the product side?

Tom Buiocchi

One of the big aspects is that with the introduction of DCX there have been a lot more conversations about how new data centers or even existing data centers are going to be re-architected. And we’re a lot more involved in those conversations, with [strive] some significant projects for us on the services and consulting side. In addition to that, as data centers get larger and our service and support staff gets larger we get more involved in support contracts of a significant nature as well. So those are two drivers.

Richard Deranleau

Yes, just a couple of pieces of color is that we, from a services perspective, we have more projects to more customers, on a support level we’re writing more support contracts and we had a particularly strong quarter in terms of renewals.

Keith Bachman – BMO Capital Markets

And so does that suggest that you would anticipate the strength of services for the next couple of quarters, if those are the drivers, it sounds like sustainable drivers as we look out over the next couple of quarters, are they not?

Richard Deranleau

Yes, I think we’re pretty pleased. Now if you look at our percent of revenue on services is approximately 17% this quarter so that’s right in range of where we had kind of wanted it to be. So these are sustainable. I’m not sure that we’re counting on as much incremental strength in Q3. I think its going to be more balanced between product and services. I think what this quarter shows us is that we are definitely have a lot to offer in the services business and our level of expertise we can bring to the end users.

Keith Bachman – BMO Capital Markets

It sounds like you’re pushing out the FAN activities somewhat, before you talked about realigning the sales force to try to capture incremental sales, if you could just give us a little more color on the FAN side, that would be great.

Tom Buiocchi

We have focused the sales forces in terms of both channel sales and direct sales for our FAN products and I think the comment we made today was that our new product, the FME product, which started shipping very late in Q2 and was not material in Q2, is getting some good customer feedback but we have a new product cycle there as well. And that is in a segment where we haven’t been as successful in the past and we have to build some credibility there.

Keith Bachman – BMO Capital Markets

Could you just talk about the government vertical, was that a help, neutral or hurt this quarter?

Richard Deranleau

Yes I would say it was pretty much just in line. It wasn’t a help, it wasn’t a hurt.

Operator

Your next question comes from the line of David Cahill – RBC Capital Markets

David Cahill – RBC Capital Markets

My impression is that the SBS was actually a pretty sizable little company with probably 200 engineers and about $30 million in business last year, so I would assume that it’s a least $8 to $10 million quarterly run rate, can you help me understand the contribution in the April and July quarters, probably more specifically why April was immaterial and is $8 to $10 million about right for assumed forward run rate for July and beyond contribution from that?

Richard Deranleau

Again we’re not breaking out any of the details so I couldn’t comment on your numbers other than to say that probably somewhat high. When you look at our April just ended quarter, based on the timing of the transaction, again I would go back to what I said before was, that the revenue was not material nor was the impact on our operating expenses.

David Cahill – RBC Capital Markets

So in the forward numbers, let’s say its $5 million a quarter, is that about, how do we think about that versus I’ll call it the core or the rest of the business, does it imply it was a smaller number than $5 or the core business is maybe just more cautious relative to what was maybe a $7 or $9 million contribution in the forward from SBS.

Richard Deranleau

So again I want to make sure this is pretty clear, going forward into Q3 we’re expecting our core hardware revenue to be seasonally consistent, which means its either going to be flat to slightly down. Within the services business there will be incremental revenue of course from SBS but there’ll be other trade-offs within our revenue and services as well because services can be somewhat lumpy. So if our services organic growth was to be consistent there might be some upside to ours but given the lumpy nature you have to look at it more like a portfolio approach. But I don’t want the impression to be that we’re using SBS to cover up product declines because that’s not what we’re saying.

Operator

Your next question comes from the line of Shebly Seyrafi – Caris & Company

Shebly Seyrafi – Caris & Company

So in the April quarter, for the April quarter, you guided non-GAAP gross margin of 59% to 60%, you came in at 61.1% and you’re basically guiding for a similar product and services mix in the July quarter, so I know switches are going to ramp and they have a lower gross margin, but it seems like I’m just trying to figure out if there’s upside to your gross margin forecast in your opinion?

Richard Deranleau

We’re trying to be balanced in our approach and I guess when you look at our gross margins, the 61.1% is actually a fairly good gross margin and I believe they’re about our highest since the acquisition. But as you look forward into, as we look forward into next quarter, we’re looking at a product shift that is not as favorable to us as we had this quarter and then the second thing is we’re looking for just a little bit more, not huge, but a little bit more impact in terms of pricing given where we are and people trying to stretch their budgets. So that’s really what’s driving our forward-looking gross margins.

Shebly Seyrafi – Caris & Company

Also you’re basically saying that you’re typically up 6% to 8% sequentially in the fiscal Q4 quarter, now last year you were up 4% sequentially, can you talk about why you won’t be repeating what happened last year for example?

Richard Deranleau

That’s a good question and we had to look at really two drivers which are the DCX now which will have been in the market for nearly three quarters and then our 8G switches will be out so we’re looking at it being more product cycle driven. And I think that compares more to think about what was going on in 2006 with the introduction of the 4G.

Shebly Seyrafi – Caris & Company

And I’m surprised you’re not talking up your product revenue a little bit more for the July quarter in light of the recent introduction of your 8G fabric switches on May 13, maybe you can talk about the pace of your switch revenue as you see it going forward.

Richard Deranleau

So what we have said in the script was we had, its kind of like bookends, the Directors are growing very, very fast; record after record. Same with our imbedded switch and the slowness was in our pizza box or the configured ports switch, so in that one we think the 8G is going to be an accelerator for us. As we look into Q4 but between a seasonally slow quarter, Europe being kind of down for the summer as well as the economic headwinds, we’re looking at a slower ramp on the 8G switches to be something contributing in Q4.

Tom Buiocchi

Just to add one other piece of color maybe, we are directly involved in most of the Director deals, much more direct touch and influence. The great majority of our fabric switches goes through an OEM, through their distribution model and typically several points in the channel. So the velocity of the sale cycle, we have a lot more influence on with the Directors side as well.

Shebly Seyrafi – Caris & Company

I think you said in your press release that switch revenue was down year-to-year, can you quantify that?

Richard Deranleau

Yes in broad strokes, year-over-year it’s something on the magnitude of 16%.

Alex Lenke

Ladies and gentlemen, thank you for joining us today and we look forward to seeing you in New York for our Technology Day on June 26^th. Thank you.

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