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Brocade Communications Systems (NASDAQ:BRCD)

Q3 2012 Earnings Call

August 16, 2012 5:30 pm ET

Executives

Robert Eggers

Michael A. Klayko - Former Chief Executive Officer, Director and Chairman Of Corporate Development Committee

Daniel W. Fairfax - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

Jason Nolet

David B. Stevens - Former Chief Technology Officer

Analysts

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Keith F. Bachman - BMO Capital Markets U.S.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Brian T. Modoff - Deutsche Bank AG, Research Division

Erik Suppiger - JMP Securities LLC, Research Division

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Amitabh Passi - UBS Investment Bank, Research Division

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Matthew S. Robison - Wunderlich Securities Inc., Research Division

Kent Schofield - Goldman Sachs Group Inc., Research Division

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Stephen Patel - ISI Group Inc., Research Division

Scott Schmitz - Morgan Stanley, Research Division

John Slack - Caris & Company, Inc., Research Division

Operator

Good day, ladies and gentlemen. Thank you for standing by. And welcome to the Brocade's Third Quarter 2012 Earnings Conference Call. As a reminder, this conference call is being recorded. And now, I would like to turn the program over to our speaker, Rob Eggers, Vice President of the Investor Relations with Brocade. Sir, please go ahead.

Robert Eggers

Thank you, Siobhan. Good afternoon, and welcome to Brocade's Q3 earnings call. By now you should've seen our press release and prepared comments, which are available on our website, brcd.com. The press release is also distributed by MarketWire and furnished to the SEC.

Before we take your questions, investors should note our comments today may include forward-looking statements regarding Brocade's financial results, plans, market opportunities and business outlook, which are only predictions and involve risks and uncertainties such that actual results may vary significantly. These and other risks are set forth in more detail in our form 10-K for the fiscal year ended October 29, 2011, and in our form 10-Q for the quarter ended April 28, 2012. These forward-looking statements reflect beliefs, assumptions, outlook, estimates and predictions as of today, and Brocade expressly assumes no obligation to update any such forward-looking statements. In addition, this presentation may include various third-party estimates regarding the total available market for SAN and Ethernet, as well as other measures, which do not necessarily reflect the view of Brocade. Further, Brocade does not guarantee the accuracy or reliability of any such information or forecast.

This presentation includes non-GAAP financial measures. The most directly comparable GAAP information and a reconciliation between the non-GAAP and GAAP figures are provided in our Q3 2012 press release, which has been furnished to the SEC on Form 8-K, and in our slide presentation and prepared comments on our website, brcd.com.

Here to take your questions are Mike Klayko, Brocade's CEO; Dan Fairfax, CFO; John McHugh, CMO; and Dave Stevens, CTO and VP of Corporate Developments; and Jason Nolet, VP Data Center and Networking.

I will now turn the call over to CEO, Mike Klayko. Mike?

Michael A. Klayko

Thanks, Rob. Good afternoon and thank you for joining us today. Fiscal Q3 was a great quarter for Brocade. We had tremendous differentiation in our product line and fantastic execution across our organization. We were able to overcome many of the issues that others are experiencing in this challenging environment. As a result, our financial performance exceeded our expected outlook for revenue, non-GAAP operating margin and earnings per share.

Revenue in the third quarter of 2012 increased by more than 10% from the prior year to $555 million, including healthy growth in both our Storage and Ethernet businesses. Storage revenue grew 16% year-over-year, driven by the strong ramp of our 16-gig products, which now accounts for nearly 30% of our total SAN revenue.

Ethernet product revenue in Q3 was the second highest in the company's history, with improved revenue from our Federal segment and our growth in the Enterprise customer segment, led by our new ICX products for the campus LAN.

We're also very pleased to report that our non-GAAP earnings per share in the third quarter were $0.14, increasing nearly 60% from the prior year and representing our fourth consecutive quarter of year-over-year EPS growth of 20% or more.

On the balance sheet, our improvements were extraordinary. With strong cash flows, we continue to pay down our debt and expect to exit the fiscal year in a net cash position 1 year earlier than previously communicated. Further, leveraging our cash generated from operations, we repurchased $45 million or roughly 8.7 million shares during the quarter. Over the past 12 months, we bought back 60 million shares, representing nearly 12% of the shares outstanding as of Q3 2011.

For the fourth quarter, we continue to see healthy demand across our product portfolio and remain highly focused on our profitability. But Dan will give you more specific details on our fourth quarter guidance in a moment. I can tell you that we're projecting that our full year revenues will grow by 3% to 4% and our EPS will increase by 26% to 28% from fiscal 2011.

Further, I firmly believe that the strength of our product line has never been better and our results show that great products can trump a difficult macro environment. We will continue to make investments in strategic areas such as Ethernet fabrics, storage area networking, software-defined networking and 100-gigabit Ethernet, and look forward to showing you where our portfolio can go from here.

As you may know, we'll be hosting our Analyst and Technology Day at our campus in San Jose, California on September 12. At that time, we'll take you through our long-term financial model, our capital structure plans and our market opportunity assessment. We will also be discussing in depth our product and technology roadmap that we -- that will continue to drive our strategic direction going forward.

I am very proud of our organization and our ability to drive both revenue growth and profitability improvements. As you know, we made a number of enhancements to our team last quarter, and I'm pleased to say that we are already seeing the benefit of these changes with continued progress in our channel and improvement in our ability to drive sales and stronger focus overall.

Finally, as many of you have already read in our subsequent press release today, I announced my intention to resign from Brocade once a successor has been identified by the Board and transitioned into the CEO role. Decisions like these are never easy and it is -- it will be difficult to say goodbye. Brocade has a great, great team of talented and dedicated professionals and is in a great position, both financially and in terms of our innovation portfolio. I'm therefore comfortable that this is a good time for me to move on.

I am proud of the great strides Brocade has made in the networking industry thus far. I am confident that this company will continue to be a strong leader as we capture the many exciting growth opportunities before us. The board has formed a search committee and will retain an executive-recruiting firm to identify the best candidate to lead the next phase of Brocade's growth. I can't give you a time frame for the process, but the Board is focused on identifying and retaining a new candidate as soon as possible. You can find additional detail about this announcement in both the press release to be issued -- that we issued and in the 8-K that's been filed.

I'm now going to turn the call over to Dan Fairfax for a brief summary of our third quarter results and guidance for the fourth quarter. Dan?

Daniel W. Fairfax

All right. Thank you, Mike. As you've already seen in our prepared remarks, we had a great quarter as revenue grew 10% year-over-year and exceeded our expectations. Our overall non-GAAP gross margin was 63.7% in the quarter and the resulting non-GAAP operating margin was 19.5%. We generated cash flow from operations of $113 million and repaid $40 million of our term loan and repurchased $45 million of stock during the quarter. So far in Q4, we have incrementally repurchased $30 million of our shares and we look forward to pay down the remaining term loan balance this quarter and be net cash positive as we exit FY '12.

We provided Q4 guidance in our prepared remarks, and I would like to take a minute now to give a little more color around our assumptions. Looking forward to Q4, we considered a number of factors, including the following in setting our outlook: the current macro environment and the economy continue to show uncertainty, especially within the Eurozone countries. Overall, we see IT spending growing but individual customer segments we sell to, such as Federal and Service Provider, may experience more uncertainty than others.

In Q4, we are expecting total revenue between $555 million and $575 million and non-GAAP EPS of $0.13 to $0.14. We continue to see encouraging demand trends for our storage products and expect Q4 storage revenue to grow sequentially and be up approximately 7% to 10% year-over-year. We expect our Q4 Ethernet revenue to be flat to slightly higher quarter-over-quarter. We expect non-GAAP operating expenses to be approximately $250 million in Q4. And finally, based on our Q4 outlook, we expect to grow revenue this year by 3% to 4% and non-GAAP EPS this year by 26% to 28%.

And with that, I will turn the call back over to the operator to begin the question-and-answer session. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And we will take our first question from Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

And I guess first question for Mike. What was the driver behind the decision here?

Michael A. Klayko

Which decision?

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

The decision to step down.

Michael A. Klayko

Well, I mean I've been doing this for a long time. It's -- this is a -- we're in a great position as you heard financially, product-wise, channels, organization. In fact, if you come to Tech Day in the Analyst Day, you're going to see even the further strength of the product portfolio. So I think anytime you're going to move on in an organization, you move on at a time of strength, not a time of weakness. And I think we're very strong and we'll continue to be strong for a very long period of time.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Will you still have any involvement with the company going forward?

Michael A. Klayko

Well I'm going to stay on as the CEO until we find a new CEO. And then there's different philosophies about that and I believe that once you decide to make a transition, you make a complete transition. So I will actually step off the board once I've stepped down as being a CEO.

Jayson Noland - Robert W. Baird & Co. Incorporated, Research Division

Okay. I wanted to ask one last question on Federal. A big July and flat to up into October, which is not typical of seasonality. We've heard from the channel some comments on pull forward out of fear of sequestration. Is that what happened there or maybe just some comments on the seasonality in Federal.

Michael A. Klayko

Actually, we had commented in the past that our Federal business, we put new leadership in, we put a focus in on different agencies and different programs. Our product set that we've brought to market is winning in that marketplace. And so we actually think the trend that we have is going to continue.

Daniel W. Fairfax

Yes, we don't think it's been pulled in.

Michael A. Klayko

No, I don't. No, these are not transactions that were pulled in.

Daniel W. Fairfax

Yes, maybe make just one last comment on that. So we normally do talk about the seasonality we see in the Federal business. First half of the year, we're fiscal year light and then back half, strong. We're just seeing that trend materialize right now.

Operator

Our next question comes from Keith Bachman with Bank of Montréal.

Keith F. Bachman - BMO Capital Markets U.S.

I was just wondering if you could comment on the SAN storage business. And specifically this year, you'll end up somewhere around 9% to 10% year-over-year growth. And that's certainly much higher than if you added up the collective storage vendors, EMC, NetApp, Hitachi, et cetera, part of that share gains, but what's the sustainable you think SAN storage growth since your growth this year seems to be far exceeding what the market would suggest?

Jason Nolet

Okay. Keith, this is Jason. I think the first point is the one you just made and that is share gains, right. In the first calendar quarter of this year, we took 6 points of share, driving us up to about 71% of market share. So that's certainly responsible for part of it. But the other part of it is, candidly, the strength of the product portfolio, right. We've been talking I think on a number of these calls about the 2-year lead that we have on the technology side with the generation we refer to as 16-gigabit Fibre Channel, but there's more to it than just the speed bump. And we continue to enjoy that leadership position, right. We're seeing great uptick on the director-class products. We're seeing great uptick on the switch products. We are perfectly on track to see the transition to 16 gig consistent with what we've seen with previous speed transitions. So I think it's the technology and product leadership that keeps us out in front and we got a good lead there.

Keith F. Bachman - BMO Capital Markets U.S.

So can you keep growing as you look at FY '13 you think as a positive number next year?

Michael A. Klayko

Keith, this is Mike. When you look back over the past 15 years that we've been in this business and look at the install base that's out there right now, it's well over $10 billion of install base, and that -- those products that are in are -- we're the trusted person that's in that account right now. We have been there with these accounts for a long period of time, and they're going to need the new speed as they move to cloud architectures or in a -- more virtualized environments. So there is an enormous install base that we can mine without even taking share but actually turning our own base. And so I think this trend line is going to remain for a while.

Operator

Our next question is from Paul Mansky with Cantor Fitzgerald.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

I want to echo Keith's sentiment and good luck, Mike, in your first next endeavor. We'll certainly miss hearing from you here on the call. Related to that, Mike, I think you have been wearing a couple of different hats here for last quarter or so, the second one being Ian Whiting's former position. Can you update us on where we are relative to back filling that position?

Michael A. Klayko

Yes, the new sales guy, I really like him a lot. And so I'm going to -- I will tell you that, that transition is that the leadership team that are in each of those either geography leadership or functional groups are very strong. And so we're in good stead there. And I think we'll have a transition about the same time that I transition, so all that will happen at once. But I'm going to continue in that role also as we move forward. There's no reason to change it at this point in time. It works real well. We have a great cadence going. So I don't think we're going to miss a beat there.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

And then I didn't hear any mention with respect to that potential sale-leaseback that I think we talked about on the call last quarter. Where are we in that process, thought process or execution?

Daniel W. Fairfax

Yes. Paul, this is Dan. So as we kind of indicated on the call, we're looking at all of our assets in terms of management. And we've gone out and done the market checks now, consolidated our basic pieces that it would be an appropriate time for us to monetize the campus and we're moving ahead on that project.

Paul H. Mansky - Cantor Fitzgerald & Co., Research Division

Okay, great. And then, as I look at your geographic mix and then certainly the vertical mix, U.S. is basically flat sequentially. International looks like it drove both for the growth, while at the same time, Service Provider was flat -- flattish on the Ethernet side, big growth in Federal obviously. So Enterprise being kind of a plug there. Can you maybe talk through some of the dynamics you're seeing in the Ethernet side of the house between the U.S. and International on the Enterprise side specifically?

Daniel W. Fairfax

Well yes, this is Dan again. Certainly, as we looked sequentially, we saw a nice recovery in the Ethernet side of the business, driven heavily by Federal. But all territories really responded well. We're running and we continue to fine-tune our, what is called our playbook there in terms of how we're using the channel, where we go direct and the market segmentation pretty effectively. As Mike mentioned, our sales leadership is quite strong now in each of the territories, and we're seeing fairly balanced results. But I guess as we put the backdrop of the macroeconomic environment in front of us, we would expect North America just to perform better as Europe kind of still struggles along here with its own issues. And I think you'd expect to see that going forward. And we'll -- again as a comment I made earlier, we would expect to see kind of the normal seasonality we've seen in the Fed. So we'll expect a strong Q3, a strong Q4 and then we'll probably be back into the cycle where our business will drop down again as spending just kind of dries up a little bit on the government side.

David B. Stevens

Paul, this is Dave. I would just -- independent of the macroeconomic environment, which I think Dan has just talked about, just to give you a little bit of color on what's going in the Enterprise business in general, is I think we're actually making great progress in a number of different fronts within the Enterprise business across, really, all geographies. We've got a much stronger product portfolio than we had even several quarters ago. Dan mentioned the launch of the ICX products, which happened in Q2. Those are ramping really nicely into Q3, really running beyond our expectations there. We've also included new blades for chassis, higher 10-gig densities. We'll unveil some other platforms at the Tech Day in September 12, which we won't talk about now. But really across that product portfolio, the engineering team is really developing a very strong value proposition there. And then on the channel front, we continue to grow the channel program and engage the channel partners. They see the value with the product portfolio and also the channel program is there. So it's a great program. They make good revenue from it. They see the value in the sales motion into the customers. We're making the -- as you know, over the last couple of years, we've been tuning the sales organization. That's starting to bear some fruit, so we're starting to see some traction efficiency across the sales front. And I think that's just -- that whole set of things is really running ahead of and exceeding the expectations that we set forth internally and then you're just seeing that pop up in different places, both the Federal space and I think you'll see it across other geographies as well with the macroeconomic conditions change there. Just in general, I think we're in a much stronger spot in the Enterprise business.

Operator

Our next question comes from Brian Modoff with Deutsche Bank.

Brian T. Modoff - Deutsche Bank AG, Research Division

Yes, kind of coming along on that Enterprise switching side, do you see the campus switching upgrade cycle driven by things like BYOD as a market catalyst to help drive campus switching refresh cycle? Do you see that as helping that business for you?

David B. Stevens

It's really -- this is Dave again. It's a lot of different things that it's upgrading the Voice-over-IP, it's video streaming, it's BYOD cycles, it's schools having to upgrade wireless infrastructure, right. It's just -- it's new and modern applications that candidly break the infrastructure that was put in place 4 or 5 years ago. So we are seeing an upgrade cycle happen there. And I think in general, people view the campus infrastructure as kind of the on-ramp into cloud services if you're implementing that or into internal data center applications. And so there is a refresh cycle going on really across that portfolio.

Operator

Our next question is from Erik Suppiger with JMP Securities.

Erik Suppiger - JMP Securities LLC, Research Division

A few questions. First off, just to be clear, it sounds as though you do anticipate Fed to be up sequentially in the October quarter. Is that correct?

Daniel W. Fairfax

Yes, I think our view is that we're doing quite well there. Anthony Robbins and his team have really diversified our business. Still concentrated in some of our traditional markets, but we would expect to see continued strength.

Erik Suppiger - JMP Securities LLC, Research Division

Okay. On the VDX, can you -- it sounds like you've got a good customer base at this point. Can you give us any sense for how material the contribution from VDX is at this point?

Jason Nolet

Yes, this is Jason. So I think I can answer that in a couple ways. One is we're starting to see customers that are starting to approach the limits of the scalability of the current offering. So in production deployments, they've got 24 switches, all ports active and are looking forward to the next wave of scalability that we're going to actually announce at Technology Day, that's been referred to here. So we are seeing customers and I think I commented on this last time where we saw a lot of pilot projects, we saw a lot of greenfield projects, new applications. But now we're seeing scaled-out production deployments, and obviously happy to see that. We've also got a couple of customers who have kind of breached the $1 million mark in terms of purchases. And that's terrific to see as well. So I think we are now starting to see the rollout of all those pilots that have been taking place over to last 3 or 4 quarters or so.

Erik Suppiger - JMP Securities LLC, Research Division

Okay, and then lastly, any comments on the competitive landscape specific to Cisco? They've been making various organizational and structural changes in the sales organization. What kind of focus do you see from them on their fiber channel products?

Jason Nolet

Yes, I would say -- I don't want to comment on Cisco's strategy here necessarily, but I guess I think we continue to feel very bullish about where we stand in that marketplace. And we don't think that they have become any more competitive recently than they've been in the last year or so. So just kind of status quo for us in terms of the leadership position we have.

Operator

Our next question is from Mark Miskowitz with JPMorgan.

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

My first question is for Mike. Mike, I just wanted to get a little more color from you, if possible. Just given that since you took over the sales function, you have some pretty good sales velocity in both business units here. And, Ian, I know tried to undertake 3 different rhythms [ph] I think in the sales force. So what changed so quickly? If you can you just kind of give us some line of sight there and how sustainable are those changes in terms of the end result?

Michael A. Klayko

Well, I think I'm not going to say there's a thousand things. You just do a few things well and I think you can get results. And having been involved in running sales organizations for a long period of time, we just focused on a few things, and they are bearing fruit. We've got great leaders out in the field too. We actually made a lot of changes, not just at the top of the organization but throughout the organization. And then frankly, we haven't made dramatic changes to our strategy. We put a strategy in place, now we just continue to execute to it and it's bearing fruit. So a lot of it is focused execution on the strategy put in place and you don't -- you kind of take all the other things and just push them to the side that aren't important. And that's how you execute well in the sales structure. And so it gives me a lot of confidence going forward that's not going to change now.

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

Okay, but was there anything around incentives or channel protection? Or just the -- how you [indiscernible]? No?

Michael A. Klayko

No, nothing like that. It's just focus, focus, focus.

David B. Stevens

Product portfolio helps.

Michael A. Klayko

Yes, product portfolio helps a lot too. And we had a great product portfolio too as Dave is mentioning. We purpose-built some products for the channel like in the ICX, which are just being very, very well accepted in that space. The DCX product line and the whole SAN portfolio, well accepted in that space, some great wins at -- in Federal accounts and very big marquee accounts. Big accounts buy more, and so we're in some very, very large accounts right now. So all the different segments we're focused -- that we are focused on are beginning to bear fruit.

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

Okay, and given this incremental momentum, how should we think about it in terms of new to Brocade versus incumbents? And of those customers, as we think about them -- as you scale with those new customers, should we get a better margin leverage towards down the road or is it immediate?

Michael A. Klayko

Well, I don't know about new to Brocade. I know that the SAN storage, the SAN storage in terms of margin opportunity going forward. And the reason we're so pleased with how VDX is doing and moving forward is that as a margin profile, it looks more like a SAN product than it does an Ethernet product. And we're going to go through a lot of this at the Analyst Day. We're going to give you our views on what the portfolios look like going forward. So maybe we ought to keep a little bit of powder dry for that. But I will tell you that as we morph going forward and the reason we're so excited about the Ethernet fabric and the continuation of that portfolio, just makes our margin portfolio -- our margin profile look better.

Mark A Moskowitz - JP Morgan Chase & Co, Research Division

Okay. And if I could sneak one more in. Dave, just kind of curious if you can weigh in a little more on SDN. It's clearly a top of mind for a lot of investors right now and just kind of give maybe the 2-minute overview in terms of how you see Brocade more or less navigating this type of emerging technology.

David B. Stevens

Yes. I mean I'll make a couple comments there and then I'll ask Jason to also -- he owns the data center portfolio today. But I think the SDN scenario that we've been very interested in, we started our initial SDN work actually with the Nicera team maybe 2.5 or 3 years ago. And I think the way that I view it at a macro level is I think if you look at networking technology today, it's very, very complex. One of the things that customers want to do is they want to take complexity out of the network infrastructure, make it more reliable, make it better for virtual machines, make it easier to manage. And it results sort of goodness that comes out of that. So the way that we look at it is fabrics are a way to take complexity out of the physical infrastructure, to take sort of the deep hierarchical network that we built in data centers over the last 20 years and to radically simplify those with a flat, fast fabric architecture. And then SDN is really just simply the ability to add an infrastructure layer in the control and management plane on top of that physical infrastructure. And so the 2 of those technologies go very, very well together. And one of the things that I think we'll talk about a lot at Technology Day is specifically how those 2 technologies fit together, what we're doing on top of the fabrics with SDN, with VMware and VXLAN and Nicera and all the other players there. But we're very, very bullish and positive on the technology.

Jason Nolet

Yes, this is Jason. Just to add to that, I think we're now getting a lot of credit for thought leadership in this space because we've been doing it, as Dave mentioned, for a couple years now. And having shipped OpenFlow support on our high-end MLX router at 100 gigabit speeds, line rate, hardware-assisted in kind of a hybrid mode so it fits naturally and seamlessly with existing porting techniques, is one of the proof points as to why we're taking a leadership role here. So we're having a lot of very, very interesting conversations with very high-end customers. I spent half a day yesterday with one of the largest banks in the world talking about our thoughts on SDN, our strategy, our position, use cases and really I think driving a lot of credibility and gravity around Brocade as the leader in this space. So we're pretty excited about it and we're taking it pretty seriously.

Operator

The next question is from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

My question is on Enterprise, which grew 21% quarter-over-quarter. Could you discuss maybe some of the trends behind this rise? And looking ahead, how should we think about the Enterprise business for the October quarter?

Daniel W. Fairfax

Yes, so in terms of -- this is Dan. So in terms of Enterprise growth, we saw -- well, I guess I'd still say, a nice recovery. We were disappointed clearly with our Q1 and Q2 results, but nice growth in that business and really across all of the segments that we sell into. Federal was particularly strong, and again, we made comments earlier on the call. We would expect to see a continuation of the Federal spending typically in the positions and the visibility we have in the sales cycles there as well. And then as we look further forward, as our channel efforts continue to mature, we're going to expect to see growth in the business, the product portfolio. Dave made some comments, there has been refresh. These products are very attractive to the market, easier for the channel partners to sell them than some would say, the traditional products out there. And we feel very good about the positioning. We look at some of the other segments, Service Provider, we expect to see again just because of the -- some of the difficulties they have with their own businesses, a little choppiness, but we feel very, very good about how our routers are positioned in the market. Again, we've made some comments about the technology that we're going to be discussing next month and we'd invite everyone to come. We've got some exciting things on the router front as well to discuss with you.

Mark Sue - RBC Capital Markets, LLC, Research Division

And just as a quick follow-up, you mentioned 650 VDX customers and VDX revenue was about $8 million last quarter. Could you maybe just discuss VDX revenue this quarter?

Michael A. Klayko

Yes, we didn't break out the VDX revenue this quarter. We just gave a sample last quarter. We're going to update that whole Ethernet fabric segment when we get together at Analyst Day. But we did not break it out this quarter. It continues to be solid, I'll just leave it at that.

Operator

Your next question is from Amitabh Passi with UBS financial service.

Amitabh Passi - UBS Investment Bank, Research Division

Dan, first question for you. Just trying understand the gross margin guidance. Looks like revenues are going to be up, mix flattish to this quarter, maybe slightly better, yet you're guiding margins down somewhat. Just wanted to get some color there.

Daniel W. Fairfax

Yes, so really, the key to our gross margin guidance is around the mix of Ethernet to SAN products. And rather than any kind of -- anything underneath that in terms of the specific product mix, just really at a more macro level there.

Amitabh Passi - UBS Investment Bank, Research Division

Okay, and then I'd be curious to hear how your quarter progressed even in terms of linearity or just the trends you're seeing geographically. There still seems to be a lot of caution out there, yet you delivered a pretty strong quarter. So just wanted to get some sense of the linearity and just maybe what you're seeing across your various geographies.

Daniel W. Fairfax

Yes, I think really for us, the DSO numbers that we talked about in the -- in our prepared remarks really tell the story. But we've had 3 or 4 quarters now of better than our historical DSO rates that were below 40 days. So linearity has been very good for us. And again, we suffer, as do many of our peers in the marketplace, there's some larger deals getting stalled out when we thought they'd be closing but I don't think there's anything unusual there. Our business, though, has been very, very solid from a linearity standpoint.

Amitabh Passi - UBS Investment Bank, Research Division

Excellent and just a final one for me, your debt paydown schedule looking forward, should we presume that $40 million, $50 million per quarter is probably the rate at which you'll continue to pay down debt or do you sort of throttle back now that you've made significant progress?

Daniel W. Fairfax

Well, we've -- so we did make some comments about the term loan. We think it would be appropriate to retire the term loan in the fourth quarter. There's $30 million left outstanding on that. And we're really left with kind of the 2 towers in our bond portfolio. And our intent would be to come to Analyst Day next month with a really complete discussion around what we're thinking in terms of capital structure and the use of cash.

Operator

Our next question is from Aaron Rakers with Stifel, Nicolaus.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

When I look at the guidance that you guys have given, I think in the context and the commentary, you had said that you would expect 7% to 10% growth in the Storage business. When I look at that historically, it looks like that's going to imply kind of low single-digit sequential growth. If I were to look at that historically, it seems like that's a bit below what I would typically think of sequentially. If my math is right, is there something underneath that or is that just a healthy dose of conservatism given the macro backdrop? I'd love to understand why that might be sub-seasonal.

Daniel W. Fairfax

Yes, so I think we try to appropriately guide, neither conservative nor too liberal. But if we look at how the year shaped up, well, performance in the early part of the year was very, very strong. We saw a strong Q2. And as we look at the back end of the year and again some of the tealeaves we're reading in terms of the macroeconomic environment, we think the guide is appropriate at kind of the levels you talked about. It'll be a great year for us clearly on the Storage business and we'd expect with the kind of product sets and the additional 16-gig devices that we're continuing to rollout, that as we look into '13, the business will be quite strong. But this is kind of our near-term guidance and we think it's appropriate.

Aaron C. Rakers - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then on the 16-gig discussion, you guys I think are running in the mid-70% range for the gross margin in the Storage business. And I think in the past, you've talked about it being more likely target model being in that high 68% to 70% range. With the 16-gig lead, do you think that, that continues into calendar 20013? Or maybe put another way, at what point in time, if we do, do you think we might go back to that normalized if it is 68% to 70% level?

Daniel W. Fairfax

Current course of speed, we've been operating at that level now for a while. We do have some advantage in the market because of the great product set we have out on the street. Some of this may change with the competitive dynamics, but we don't know what our competitors are doing right now in this area. So nothing to say it's not -- it's going to change in the near term.

Operator

Next question is from Matt Robison with Wunderlich Securities.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

I was hoping you could give a little bit of color on regional and maybe product mix on the Service Provider segment. And also, was wondering if the strength in the Federal, if there was incremental activity with civilian agencies or if it was mostly program-related spending that's coming in along the lines of your traditional-type customers?

Michael A. Klayko

Yeah, I'll do some of the Fed stuff. This is Mike. The Fed is -- all programs in government are basically all -- they're all programs. We're winning more. We had -- as we mentioned before, our penetration in the civilian space had been minimal in the past and concentrated very heavily in the military and some of the intelligence agencies. Those are expanding into all groups of the federal government based on the coverage model we've put in place, the leadership and the strength of our product portfolio. So I can't make it's just 1, it's a group. In the Service Provider space, we offer a variety of product sets. But most importantly, one of the things that we've invested and the reason we called it out is that there's a lot of activity in the Service Provider space as they build out Enterprise data centers also and expand some of their offerings into the SDN arena and other areas. And so our -- the reason we focus so heavily on that is not so much looking backwards of what they bought in the past, but looking forward to what they're going to buy. Tremendous interest in SDN, tremendous interest in building up cloud-based architectures. These are all the things that we have strength. And so we have got a great relationship with our current product set, but I think the future is just starting in that space for us when you try to look at the trajectory around SDN, cloud-based architectures and Enterprise data centers. And so we're going to call it out and we'll be able to show how those transition with our product set there. So it's kind of a -- I tried to answer both of your questions there without a lot of color [ph].

Daniel W. Fairfax

Yes. And, Matt, this is Dan. So we haven't been breaking out for the Service Provider in geographic let's call it subsegments or regions there. But in general, what we've seen is we piloted the model with -- for the Tier 1, Tier 2 service providers, a strong selling motion. We've built out in North America and we're cookie-tethering that now into Europe. And we'll decide when we take that into Asia. But we see lots of opportunity from the success we've seen from that model having worked on that for the last 2 or 3 years in the North American environment.

Matthew S. Robison - Wunderlich Securities Inc., Research Division

So should we expect to see a layer of diversity with the VDX and the load balancers starting to catch up with the aggregation routers somewhat? Is that kind of what you're saying, Mike?

Jason Nolet

Yes. This is Jason. Yes, that's right on. We're seeing VDX tick up both in Enterprise and in Service Provider, public cloud operating offerings. And so you're going to see kind of more balance across the entire portfolio and more diversity of what we're selling into the Service Provider space as a result of that.

Operator

Kent Schofield with Goldman Sachs.

Kent Schofield - Goldman Sachs Group Inc., Research Division

It sounds like we're going to get some good margin detail about the go-forward, but I was hoping you could talk a little bit about the better IP gross margins at least compared to the last couple of quarters, especially given the ICX launch, VX mix, channel sales mix, that would be helpful.

Daniel W. Fairfax

Yes, Kent, this is Dan. The key driver in the quarter was really around the volume. So as you can see the volume's up significantly for our Ethernet products and the overhead absorption really improved the margins there. We saw a significant shift based on that. Again, the team as we roll out these new products, VDX is the poster child. But as we put more of our intellectual property into those devices, we harvest back a great deal more profitability both in gross margin and operating margin. And the same is true for some of the new devices we're rolling out for some of the more traditional Ethernet platforms. We've got a very aggressive program at Brocade, IP in those devices. So you'll see, we think, particularly a steady shift in many of the product lines to higher gross margins as we move forward.

Operator

Next question is from Rohit Chopra with Wedbush.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

A couple questions. Just wanted to get a sense of maybe the competitive and pricing environment. As Kent sort of alluded to, Ethernet gross margins ticked up, but yet you sold more through the channel and you had a little bit more international. So I just want to get a sense of what happened also in the competitive and pricing environment. And then also if you could just talk about any potential large deals that you did in the quarter, if there were any, or maybe you can just point to a few.

Daniel W. Fairfax

Yes, from a pricing -- competitive pricing point of view, I can tell you in the data center, it really hasn't changed much, so no new dynamic there. I'd make the same comment in Enterprise space. The pricing environment hasn't changed dramatically. It's been competitive for quite a few quarters in a row. But I don't think it's gotten any more competitive. And we've been positioning ourselves as an attacker in that space. So we haven't had to really do anything special there.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Okay. And then just some large deals, if there were any large deals in the quarter that sort of helped you out, either government or nongovernment.

Michael A. Klayko

Just normal run rate business that we had planned for were a part of it. Every quarter we have some larger deals and so nothing out of the extraordinary.

Rohit N. Chopra - Wedbush Securities Inc., Research Division

Okay. And nothing that was pushed from before that got closed or anything like that?

Michael A. Klayko

No.

Operator

Our next question is from Brian Marshall with ISI Group.

Stephen Patel - ISI Group Inc., Research Division

This is Stephen Patel for Brian. It looks like you're making good progress broadening your base of VCS and VDX customers. Can you talk about whether you see the bigger growth opportunity there coming from going a lot deeper with your larger customers there, or if the opportunity is going to come from bringing fabrics to a lot more -- a lot of smaller customers?

Daniel W. Fairfax

It's a combination of both. We are getting good cross-selling opportunities out of the SAN installed base because they've obviously appreciated fabric architectures for 10 or 15 years and the story around Ethernet fabrics is resonating nicely with them. But, at the same time, there's a lot of emerging cloud providers in particular, some of which we've done joint press releases with and joint marketing with, who are recognizing that for them to kind of have the most cost-effective data center network, one that's automated, one that scales out quickly, they have to think differently than how they've thought in the past at previous companies perhaps. And that's where VCS is resonating. So we're seeing a kind of a good mix between the larger customers who appreciate the experience they've had with fabrics in the past and smaller customers that are thinking differently about how to start their cloud infrastructure projects going forward.

Stephen Patel - ISI Group Inc., Research Division

Okay, great. And then just a follow-up on Ethernet margins, can you give your perspective on your pricing strategy there and how you think about the trade-off between market share and margins?

Michael A. Klayko

Well, we've increased our revenue 26% to 28% we think for the whole year. We've been very focused on growing the profitability of the company. The strength of the product line that we have right now gives us differentiation and also gives us better margin.

Operator

The next question is from Scott Schmitz with Morgan Stanley.

Scott Schmitz - Morgan Stanley, Research Division

Just going back to some of the geo -- the dynamics in some of the geographies. If I look at the Ethernet side, the Americas and EMEA, there was a big improvement and APAC was a little bit weaker or it was down year-over-year. Can you just talk about some of the dynamics and what you expect going forward?

Michael A. Klayko

Yes, I think part of it was we made -- we started first in Americas in making a lot of the investments; second, in Europe follow -- the investments; and then, third in Asia. And I think the investments that we made, the revenue is directly correlated to that and the timing of it. Nothing more than that.

Scott Schmitz - Morgan Stanley, Research Division

Okay, and then going forward. On Europe, it sounds like it's still choppy but you're growing through that a little bit on the Ethernet side. Is that fair?

Michael A. Klayko

Yes, I think the fact that the strength of the product line is actually trumping a little bit at that point in time. But you can't pick up a newspaper that talks about something going bad in some country in Europe. And so -- and you have to be a little bit cautious there. However, we seem to be doing okay. But we still remain cautious based on everything we read.

Operator

Our final question comes from John Slack with Caris & Company.

John Slack - Caris & Company, Inc., Research Division

Great, made it under wire. A question on OpEx. Nice expense discipline this quarter despite the revenue upside, particularly on the sales and marketing line. How should we think about that going forward, the different buckets in there? And are you guys now out of investment mode on the sales and marketing line after several false starts over the past couple of years?

Daniel W. Fairfax

Yes, so we made -- John, a couple comments, if you think back to the beginning of the year, at the last Analyst Day, we really felt like we've been making the right investments in sales and marketing. It was time we start leveraging those and dropping into up margin. So that's what we've been focused on this year. We know we're clearly in transition, but we don't see the need to boost the sales and marketing spend to drive the kind of growth that we think we can get in these markets.

Michael A. Klayko

Okay, this is Mike again. I want to thank everybody for your time and attention today on our Q3 earnings call. We look forward to seeing many if not most of you at our Analyst and Technology Day on September 12. And with that, operator, you can please end the call.

Operator

Ladies and gentlemen, this does conclude today's presentation. We appreciate your participation.

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