Brocade Communications Systems, Inc. F3Q08 (Qtr End 07/26/08) Earnings Call Transcript

Brocade Communications Systems, Inc. (BRCD)

F3Q08 Earnings Call

August 13, 2008 8:00 am ET

Executives

Alex Lenke – Director of Investor Relations

Mike Klayko – Chief Executive Officer

Richard Deranleau – Chief Financial Officer

Analysts

Aaron Rakers - Wachovia Capital Markets, LLC

Samuel Wilson – JMP Securities

Mark Moskowitz – JPMorgan

Paul Mansky – Citigroup

Min Park – Goldman Sachs

Kaushik Roy – Pacific Growth Equities

Tom Curlin - RBC Capital Markets

Jayson Noland - Robert W. Baird & Co., Inc.

Bill Fearnley - FTN Midwest Research

Glenn Hanus - Needham & Company

Brent Bracelin - Pacific Crest Securities

Presentation

Operator

Welcome everyone to Brocade's third quarter fiscal 2008 financial results conference call. (Operator Instructions) Mr. Lenke, you may begin.

Alex Lenke

Joining me today from Brocade are Michael Klayko, CEO, and Richard Deranleau, CFO. Before we begin let me cover some housekeeping items.

Brocade issued a press release today detailing its third quarter fiscal 2008 financial results via PRNewswire and First Call. The Q3 press release is available on our website at www.brcd.com. A copy of the slide 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 made available at approximately 8:00 a.m. Pacific Time today through 8:00 a.m. Pacific Time August 20th. To access the telephone replay, dial 888-286-8010 or 617-801-6888. The pass code is 99608062.

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, guidance and the proposed acquisition of Foundry Networks. These forward-looking statements are only predictions and involve risks and uncertainties such that actual results may vary significantly. These and other risks are set forth in more detail in our Form 10-Q for the fiscal quarter ended April 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 the nonGAAP and GAAP figures is provided in our fiscal Q3 press release, which has been furnished to the SEC on Form 8-K and in the corresponding slide presentation on our website.

Before turning the call over to Mike, I would like to note that this call will focus primarily on Brocade’s operational results for its fiscal Q3 and that further detail regarding the Foundry Networks acquisition will be provided at our upcoming analyst's day on September 17th in San Jose.

With that, I will now turn the call over to Mike.

Mike Klayko

Q3 was an outstanding quarter as Brocade returned to double-digit revenue growth, setting a new company record for quarterly revenue in what is typically a seasonally slower period. Our continued operational execution drove significantly better than expected financial performance in Q3.

We exceeded the Street EPS estimates for the 12th consecutive quarter and achieved sequential margin expansion despite a seasonally mixed shift towards our switch and embedded products. And as Richard will discuss, our cash flow and balance sheet metrics remain robust.

From a product perspective, Q3 saw continued strong performance of our new DCX backbone, record revenues in our switch business, and the third consecutive record revenue quarter of our embedded switches for the bladed server market. An increase in professional services helped drive record revenue in our services business as customers increasingly turned to Brocade as the trusted expert in the evolution of their data center networks.

In addition, several new products that helped drive our organic growth in Q3 are expected to continue to deliver growth for the company over time. For example, our industry leading DCX backbone, in only its second full quarter of shipment, continues to exceed our expectations. In particular, we are very pleased to see increased DCX acceptance this quarter from our customers whose networks are based on traditional MEG data technology. We firmly expect that the DCX backbone will continue to ramp as customers realize its performance, density and power efficiency advantages.

Our record switch business was driven by a combination of strong worldwide demand for our 4gig products and the initial acceptance of our new, 8gig switch family. These new switches were introduced by all of our major OEMs in our Q3, and once again set new benchmarks in the industry for performance, density and power efficiency. We anticipate an expanded market adoption of these industry leading switches in their first full quarter of shipment in our Q4 and continuing into 2009.

In Q3 we also began shipping our new 8gig HBA products into key strategic accounts. The initial customer feedback has been very positive with early trials clearly highlighting our performance and integrated feature set advantages. We anticipate that this customer feedback will help drive growth in our new HBA business in 2009 as strategic OEM qualifications are completed later this year.

These are just a few examples of the continuing product cycle that we believe has further widened our competitive advantage in our core markets, and it has helped to bolster our confidence for increasing momentum as we enter into complementary market segments.

Our performance in Q3, when considered alongside the solid results of many of our enterprise partners, also indicates that the fundamental market trends and customer demand drivers remain intact. Our product road map and solutions addressed customer demands for high performance, [alter] reliable networking in a next generation data center. Customers are also relying on us for better virtualization deployments, new data management strategies, data center efficiencies and green initiatives.

Increasingly, customers are reaching the conclusion that our data center fabric strategy is the most relevant and pragmatic approach in the industry to solve their evolving data center management and networking needs. These consistent, fundamental market drivers, along with our broad and growing product advantages, give us growing confidence in the health of our target markets and in our ability to compete and win in both the short and long term.

With that, I’d like to turn the call over to Richard for more detail on our Q3 results and outlook going forward. Then I will return for a few concluding remarks.

Richard Deranleau

We are very pleased with our third fiscal quarter, where we delivered excellent results in what is typically a seasonally weaker quarter. Let’s look at our Q3 financial results in detail beginning with the income statement.

Q3 revenues were $365.7 million, up 3% sequentially and up 12% year-over-year. We are very pleased with this performance given that our fiscal Q3 is a seasonally weaker quarter and historically flat to down 3% sequentially from our fiscal Q2. The record revenues in Q3 were driven by strong performance in our core infrastructure products, especially switches, our embedded switches for bladed servers, and also in our Services business.

On a geographic basis, we saw particular strength in North America. In Q3 our international revenue percentage, normalizing for those large OEMs who take delivery of internationally destined product within the U.S., was approximately 60%, down from the 62% in Q2.

Moving on to our Business segment, in our core data center infrastructure business, our data center infrastructure revenues were up 1% quarter-over-quarter and up 4% year-over-year. Our DCX backbone continues to be a significant contributor, representing over 30% of our overall director sales in Q3, and we had a solid demand for the 48K director. Total director revenues were down quarter-over-quarter as is seasonally expected for our Q3, but were up 3% year-over-year.

Switch revenue was up 12% quarter-over-quarter and up 5% year-over-year. We have seen a rebound in our Switch business, helped by the introduction and initial ramp of our 8gig switches.

In our Services business, we had record revenues, which were up a healthy 8% quarter-over-quarter and 43% year-over-year. The revenue growth was driven primarily by an increase in our Professional Services business, which is important strategically but which also carries a lower gross margin than our support and maintenance offerings. On a non-GAAP basis, overall Service gross margins were 37.5%, at the low end of our Services target model of 38% to 45%, due to the higher mix of Professional Services.

The impact of the purchase accounting adjustment related to the acquisition on McData in Q3 was a $1.9 million reduction.

In our Files business, revenues from our FME product were not material in the quarter, but early deployments have been well received by new customers. Overall, revenue in our Files business was down quarter-over-quarter and down year-over-year.

In our Server Connectivity business, in our embedded switch product line, we had our third consecutive record quarter with revenues up 12% quarter-over-quarter and 39% year-over-year. We are on track and began revenue shipments of our new 8-gig HBAs via channel partners this quarter. We expect to see more significant revenue contributions from our new HBA products in fiscal year ’09 as our OEM partners complete their qualification testing.

On a non-GAAP basis, gross margin for Q3 was 61.9%, higher than our previously expected range of 59% to 60% and above our long-term target model range of 57% to 60%. The upside in gross margins was driven by higher revenues and an improvement in our product cost structure. In Q3 the pricing environment remained stable and sequential like-for-like ASP percentage declines were again in the low single digits.

Q3 non-GAAP operating expenses were $143.7 million, slightly above the higher end of our prior outlook of $138 million to $142 million, driven primarily by the variable costs from the higher revenue levels. Non-GAAP operating margin for Q3 was 22.6%, exceeding our prior outlook of 19% to 20% and at the high end of our long-term model of 18% to 22% of revenues.

Our effective non-GAAP tax rate in Q3 was 32.3%, slightly above our expected rate of 30% to 31%. Our effective GAAP tax rate in Q3 was 61.1%. The difference between GAAP and nonGAAP net income are reconciled in today’s press release and in today’s webcast slides.

Moving on to our operating results, on an earnings per share basis, Q3 non-GAAP diluted EPS was $0.16, above our guidance of $0.13 to $0.14, driven primarily by the higher revenues. NonGAAP EPS also reflected a benefit of approximately $0.007 cents from a onetime foreign exchange gain of approximately $4.1 million.

Reporting on a GAAP diluted basis, Q3 EPS was $0.05.

Now turning to our cash flow and balance sheet, our cash and investment balance at the end of the quarter was $764 million. Net of convertible debt, the balance was $595 million, slightly down from last quarter. Cash flow from operations in the third quarter was $71.7 million, significantly above our expected range of $50 to $60 million, reflecting the strong cash generation power of the company’s business model.

In Q3 we used approximately $38 million to repurchase approximately 4.7 million shares of Brocade common stock. Stock repurchases during Q3 were executed under our corporate 10b51 automatic stock purchase plan. To date, we have purchased a total of 50.5 million shares of Brocade stock for a total of approximately $386 million.

During Q3 we suspended our share buyback program due to the impending Foundry acquisition. At the end of Q3 we had approximately $414 million remaining available under our total stock buyback authorizations, but plan to prioritize our use of cash for debt repayments following the expected close of the acquisition.

Now turning to our outlook for Q4, here are some assumptions for you to consider. While our continued assumption is that the macroeconomic environment will continue to be challenging until the beginning of calendar year 2009, we expect that IT spending on our core business will continue to show the same level of strength we have experienced in the first three quarters of our fiscal 2008.

Our best visibility continues to be 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 continue carefully managing our expenses and head count growth. While our core markets remain very competitive, we believe that our new product introductions and our installed base advantage keeps us in a uniquely strong, competitive position. DCX continues to make a significant impact, and the initial ramp of our new 8gig switch family looks promising. From a pricing perspective, we expect quarterly ASP declines to remain in the low single digits.

Typically, Q4 is a stronger seasonal quarter. However, in the current macroeconomic environment, we are expecting Q4 revenue midpoint to be up 4% sequentially and up 11% year-over-year. Historically we would expect Q4 to have a higher mix of directors versus switches than in Q3, which would put slight sequential upward pressure on our gross margins in Q4.

Now, taking all of these factors into consideration, our outlook is as follows: We expect our revenue in Q4 to be in a range of $375 million to $385 million, a percentage range of up 2.5% to 5.3% sequentially and an increase of 10.3% to 13.2% year-over-year. We expect non-GAAP Q4 gross margin to be between 61% and 61.5% above our targeted long term model range of 57% to 60%.

For Q4 we expect total non-GAAP operating expenses to be in a range of $146 million to $149 million. While we expect to be disciplined in our spending, we plan to make additional investments in strategic R&D and marketing and sales programs in order to maintain our product cycle momentum and our strong position within the market. At the same time, we plan to manage non-strategic spending very carefully.

We expect our Q4 non-GAAP operating margin to be in a range of 20% to 22% which is within our long term target model. We expect non-GAAP other income-other expense net in Q4 to be approximately $2 to $3 million.

Regarding our tax rate, we expect our Q4 and annual non-GAAP tax rate will be approximately 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 the 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 392 to 396 million shares, including the diluted impact of the McData convertible debt. Based on these factors, we expect Q4 '08 nonGAAP diluted EPS in a range of $0.15 to $0.16. We expect Q4 ’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 Q4 will consist primarily of the same items as in Q3. 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 Q4 to be in the $12 million to $16 million range, plus expenditures for the new campus in a range of $20 to $25 million. We expect DSOs in Q4 to remain within our target range of 40 to 50 days and on hand inventory to be in a range of 15 to 20 million. We expect to generate cash from operations in Q4 of approximately $60 to $80 million.

In summary, in Q3 ’08 we had an excellent quarter financially, bucking typical seasonal trends and regaining the double-digit, year-on-year growth that we expect our core businesses to deliver. We executed well across all of our business fundamentals, including a strong rebound in our switch business, and continued growth in our embedded and service businesses. We retained and extended our strong market advantage with additional new products in our current product cycle.

We continued to make the necessary investments to maintain and improve our market position, while continuing to deliver on the improved business model targets that we outlined at our September, 2007 analyst's day. Going forward, we will continue to balance the need for strategic investments against the ongoing discipline in our operational spending, and we remain committed to continue optimizing our growth initiatives, our business model and return to shareholders.

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

Mike Klayko

We had an excellent Q3. We are executing very well on both strategic and the operational aspects of our business. Our customers and partners increasingly support our strategy, and our products and services are clearly aligned with theirs.

Let me put our Q3 performance into a more, long-term strategic context, specifically with respect to our announced acquisition of Foundry Networks. We clearly understand that in order to meet our long-term objectives, we must be able to generate healthy organic growth and margins in our respective core businesses.

Our Q3 performance and Foundry’s recent Q2 results are strong indicators that we are both on the right track to drive that ongoing, organic growth. And when you add this healthy core growth to our stated expectations regarding the acquisition and integration of Foundry, such as first, several potential sources of revenue leverage; second, the anticipated cost synergies; third, broad product and technology advantages; and finally, a more comprehensive and strategic position in a much larger market, well, you can understand why we are very excited about the future.

We will spend more time on the various aspects of the Foundry acquisition and on our preliminary expectations for 2009 at our analyst's day in San Jose on September 17th. We hope to see you there, and thank you again for joining us today.

Now we would 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 Aaron Rakers – Wachovia Capital Markets, LLC.

Aaron Rakers – Wachovia Capital Markets, LLC

Can you help us understand what the contribution was from the SCS acquisition during the quarter? Just to kind of understand the organic growth?

Richard Deranleau

The impact from Q2 to Q3, the incremental was a little over $3 million. So when you look at the organic growth implications, that would have still put us well over $360 million and still in double-digit growth range.

Aaron Rakers – Wachovia Capital Markets, LLC

And then a follow-up to that, one of the comments mentioned was that the mainframe, maybe the McData install base is starting to turn over a little bit. You know, maybe you can help us understand what that install base looks like, maybe where you’re at in terms of seeing that as being a driver. Is that something that continues over the next several quarters? And then I do have one final question after that.

Mike Klayko

I think it continues over the next several years not quarters because customers are at various stages in implementation in their infrastructure. And there’s, as you know, in some of the largest accounts in the world, McData had a very large install base. And so as those customers re-architect and they start to deploy the DCF architecture that we’ve laid out, you’ll see that they now have a very logical plan with our DCX product set as well as our expanded line of switch products sets to transition at their pace. And we think it’s going to be there for quite a while.

Aaron Rakers – Wachovia Capital Markets, LLC

And final question from me on the gross margin front, very positive given the mix shift even in the quarter. Can you talk a little bit about product costs and specifically maybe also dovetail into, you know, the opportunities that still may exist as you’re supporting a couple of different director class platforms, when you might see, you know, opportunities to consolidate that into one platform over the next couple quarters?

Richard Deranleau

The improvements, we’re really taking a look at product costs and some of the components which are major parts of our product. For example, the optics, we’ve had some benefits there. And also the leverage in our supply chain, when you start getting to these levels of revenue. In terms of moving to the one platform, you know, really DCX and 48K away from the legacy McData directors, a lot of that benefit, frankly, has been realized. So we’re now getting up to the point of pretty high gross margins for a hardware company.

And so that, you know, when we look at the guidance going forward, we’re pretty comfortable this next quarter operating above our range, but I wouldn’t look for, you know, massive improvements above where we are because we’re at pretty good levels.

Operator

Your next question comes from Samuel Wilson – JMP Securities.

Samuel Wilson – JMP Securities

Can you talk a little bit about the strength in the U.S.? Verticals, anything with verticals that did better or worse and specifically how the financial vertical performed for you during the quarter? And second, can you give sort of the first reactions now that you’ve – you know, the Foundry deal's been publicly announced and available in the marketplace for the last few weeks, sort of reactions from the OEMs, reactions from major customers about the pending acquisition?

Mike Klayko

From Foundry acquisition, feedback I’ve received so far in talking to the end user customer set has been overwhelmingly positive. The feedback from our OEM partners is extremely positive because they understand what we’re doing and why we’re doing it, and we’ve been very good at communicating the messaging and what our – how this fits within our strategy. And so nothing negative at all from anyone that I’ve received comments directly from.

Richard Deranleau

Yes, just a little bit of color. North America was quite strong for us. North America had a good quarter. It was pretty broad based across all our verticals. Financials was really quite strong, which we really hadn’t anticipated. But bottom line is all the verticals were strong. Financials was stronger than anticipated, and North America had a real good quarter.

Operator

Your next question comes from Mark Moskowitz – JPMorgan.

Mark Moskowitz – JPMorgan

Richard or Mike, can you talk a little about the customer profile in terms of the buying patterns right now? What do you see in terms of the appetite from your newer McData customers in terms of the DCX versus legacy Brocade? Is there any way to kind of contextualize the sustainability as some of these positive commentaries you’re providing on the demand environment?

Mike Klayko

Well, pretty broad question, Mark, and I don’t think I can categorize them in one single fashion. I will make a comment that we did an internal analysis, and we feel that about at any one point in time about two-thirds of our customers are going through some type of consolidation or some type of relocation of a data center. So you have about two-thirds of your customers who are constantly looking at upgrading some of their implementation aspects of their networks.

Whenever that happens, and if you look at the install base from a historical standpoint, there’s just lots of McData out there and Brocade. And as they go forward, they need an architectural blueprint. The DCF architectural blueprint is really resonating very, very well. And because of that we’re now getting designed in and when these customers begin the design-in process, that lasts for a long period of time, you know, measured in years not in quarters. So we’re seeing kind of a broad base, not just an industry base or even a, you know, a geographic base. It’s all around the architectural aspect.

Richard Deranleau

The other thing that I would just add, Mark, is that, you know, when you talk to the field and their conversation with the customers, you know, I think the classic Brocade customers moved pretty rapidly to DCX and you saw that benefit really in our Q2. And I think the classic McData director customers wanted to play with it and see it a little bit longer. And what we saw this quarter was those folks, after having a chance to play with it, are really stepping up and placing the orders.

Mark Moskowitz – JPMorgan

And then the other question is just the uptake in revenue velocity from professional services is pretty obvious here, and I just want to get a sense – how long until we see some mileposts in terms of you folks talking about the push or the pull of professional services, in terms of cementing even greater revenue growth in your core infrastructure business? Are you seeing that yet or what’s the opportunity there?

Richard Deranleau

Well, I think there’s a really big opportunity and Mike’s been pretty vocal about, you know, the strategic reason for being in professional services is ultimately it drives additional hardware business. And honestly, I think we’re kind of at the start of that right now. We’ve got a lot of growth. In this particular quarter it was around professional services as opposed to support and maintenance, and I do think that gives us a real advantage when it comes to selling hardware.

And some of the strength we have has been – it’s been an investment over time, and I think some of that investment is starting to pay off.

Operator

Your next question comes from Paul Mansky – Citigroup.

Paul Mansky – Citigroup

But, you know, as I look at your revenue performance, you know, relative to certainly your primary competitor, it’s very clear there’s some market share gains taking place here.

You know, you talk to Cisco and, you know, they mention – you know, admit being out of position relative to, you know, current demand trends. And presumably that would be more associated with the mainframe cycle and the higher end of the portfolio, and yet you guys upsiding off your fabric switches is clearly the first thing you pointed out today.

So I wanted to kind of try to bridge the dissonance here and so, maybe if you could, kind of point to, you know, the top three things that you think are contributing to your share gain in the market and maybe touch on, you know, sustainability of that share gain.

Mike Klayko

Well, I think there’s a couple. I’ve had an opportunity to ask customers that specific question, why do we win? And they really break it down into four categories.

One is from an innovation standpoint we have constantly been the leading innovator of product technology and data center implementations for quite a period of time. And we’re at least one if not two and sometimes three generations, depending upon the segment, ahead of our competitors. And so from an innovation standpoint, we’re the product leader.

And the second, we continue to be the highest quality product set in the marketplace, and so we get a lot of accolades for being the highest quality product. We’ve separated ourself there.

Third, from a cost standpoint, you know we’re still - from cost performance and implementation, we’re the best price performing product in the marketplace.

Last, from a risk standpoint, the products work very well and they've had a history of working very well. So it’s not just one element. The customers come back and they categorize into four buckets, and they've said there’s nobody in the industry in the market now that can address all four of those as a - like a chair with four legs in balance as well as we do. And for that reason they like the architectural view that we have with data center fabric going forward, and they continue to buy the product set.

Richard Deranleau

Paul, one thing I’d add real quickly is, you know, we were quite proud of the switch performance but if you – our performance is very strong across the board. Clearly the services, but the embedded was kind of off the charts. But also we had a real good director quarter. It’s just this particular quarter’s weak historically, but we are very happy with our director performance. And, you know, I believe we’re going to end up seeing that we gain some share in directors as well.

Paul Mansky – Citigroup

If I could follow up quickly, clearly earlier this year Cisco made a fairly dramatic announcement vis-à-vis their plans to offer the SOE blade on the NEXIS platform which is, you know, at the end of the day a fairly dramatic change in go to market approach, OEMs versus direct. Are you seeing any blow back from the major OEMs as Cisco continues to kind of align themselves more competitively versus, you know, being more of a partner with respect to the storage OEMs?

Mike Klayko

We’ve had really good relationships and very strong relationships because of the consistency that we’ve had in our strategy with our OEMs, and I don’t see our strategy changing. And because of that, people like the consistency in the relationships we’ve built. I can’t comment on their change in distribution model, what it’s going to – how it’s going to affect them, but I do like our model.

Operator

Your next question comes from Min Park – Goldman Sachs.

Min Park – Goldman Sachs

Thank you very much. With revenues and earnings both coming up higher than expectations, can you just tell us how much of the upside was driven by demand versus market share gains?

Richard Deranleau

Well, I guess it comes down to two things. We believe that the [TAM] actually grew this quarter and we believe that we will have taken share this quarter. And if you wanted to come down to orders of magnitude, I would have expected something, I mean, non-scientific at this point, but something kind of like 50-50 between growth in the TAM and taking share. If that was your question.

Min Park – Goldman Sachs

Yes great. And also this quarter it seems like overall storage seems to have held up pretty this quarter versus - on a relative basis - versus server demand still lagging. Do you think that you might see a delayed impact and softer server volumes impact storage networking over the next few quarters or if there’s enough tail winds from data center consolidation in your product cycles to keep the momentum up as we go through the year?

Richard Deranleau

On the server side, the one area where we are seeing a lot of strength is in our bladed embedded switch, which really goes very well or with the growth in the servers. And I don’t know, I just see that that business is just growing. It’s getting stronger and stronger and stronger. So it may be that you see the towered or rack servers lagging, but we think that that segment of that server market is still going very strong.

Min Park – Goldman Sachs

And just lastly, can you just talk about the areas where you saw the most market share gains this quarter?

Mike Klayko

I think it was pretty much across the board. I think from our perspective - of course, you know, the way the analysts do the reporting it’s on a calendar versus a fiscal basis so there’s always a little bit of massage there - but I think our feeling is at this point as we gained some director share and we’ll have gained some of the modular or the fixed port switches.

Operator

Your next question comes from Kaushik Roy – Pacific Growth Equities.

Kaushik Roy – Pacific Growth Equities

As a follow up to Mansky’s question on Cisco, I mean, it’s obvious they lost a lot of share, but  and probably the lack of 8 gig, you know, hurt them and helped you - but can you comment, are you seeing any shift in terms of OEM behavior that they’re favoring you over Cisco or something like that?

Mike Klayko

I think it’s - from a standpoint, Kaushik, when I talk to end users, they really are resonating with our story and our architecture. And what they’re doing is - I don’t think there’s a concerted effort by any OEM to go one way or the other. They literally want to supply what the customer wants them to supply as part of the overall solution, and I think we, at this point in time and for the foreseeable future, we have the best solution in the marketplace. And it's driving the behavior of putting that best solution forward then.

Kaushik Roy - Pacific Growth Technologies

And on the directors, can you help us understand - I mean, IBM had a zSeries refresh and EMC and Hitachi, they had very strong high-end system sales - so I would have expected directors to be up sequentially. So can you help us understand the dynamic there that directors were actually down?

Richard Deranleau

If you follow the seasonal patterns, it would have been, you know, very tough to have an up quarter in directors. It's just not the way the patterns have been. And we believe that we are participating in the zSeries refresh, but we think that's a longer term - it's not a real quick bang that it happens. I think that happens over time. So we're actually very, very pleased with the performance of directors, particularly around the level, the percentage or penetration rate of the DCX. So I understand your question, but I think that would have been even a more spectacular quarter if we could have gotten up in directors quarter-over-quarter.

Kaushik Roy - Pacific Growth Technologies

So you are expecting directors to be up sequentially next quarter?

Richard Deranleau

Well, this quarter would tend to be a stronger director quarter, so all things being equal we would expect to see directors higher in Q4 than in Q3.

Kaushik Roy - Pacific Growth Technologies

You mentioned North America's strong. Are you seeing Europe slowing down?

Richard Deranleau

I haven't. I just came back from a couple weeks in Europe, Kaushik, and I have not seen the demand in Europe slowing down.

Operator

Your next question comes from Tom Curlin - RBC Capital Markets.

Tom Curlin - RBC Capital Markets

With respect to the revenue guidance and just given the comments about macro which are similar to last quarter, do you feel like you have, you know, the same level of visibility going into this quarter that you did going into, you know, I guess the quarter completed, you know, a quarter where you ended up [printing] some nice upside?

Mike Klayko

Yes, it's kind of the same. We have the same tools, Tom, and we continue to use those tools. And I don't think anything's changed from quarter-on-quarter.

Tom Curlin - RBC Capital Markets

Can you talk a little bit, I mean, what can be done with Foundry from a co-development standpoint between now and year end? You mentioned some incremental R&D investment; maybe that's related to other things but is, you know, are there things that can be done ahead of the deal closing to make things move quickly once it's closed?

Mike Klayko

Tom, you know as probably as well as anybody in this industry, you know, there's HSR and there's a whole bunch of other things you have operate within and we're doing that. We're going to share a lot - I believe we're going to be able to share more at the analyst's day. At this point in time, it would just be premature. We're in the process of making sure we have all the Ts and Cs and Is dotted and so forth, and hopefully by the time we get together at analyst's day on September 17th we'll be able to share more details on what we think we can do.

Operator

Your next question comes from Jayson Noland - Robert W. Baird & Co., Inc.

Jayson Noland - Robert W. Baird & Co., Inc.

Richard, thank you for the color on guidance in FQ4, and I guess just for some clarification on the revenue side, what are you assuming in your fabric switch business given the strength in FQ3?

Richard Deranleau

So sequentially it should be up. We don't break out that on the call, but we're expecting a stronger director quarter. Fabric switches will - everything should be basically up sequentially quarter-over-quarter. We're expecting yet another strong quarter, probably, you know, hopefully a record quarter in embedded blades again. Services, I think it'll be a little bit tough to outdo this quarter because that's such a good quarter. And we'll probably see a little bit more in the HBA revenue now that we're out in the channel with the product.

Jayson Noland - Robert W. Baird & Co., Inc.

On the HBA side of the business, why are you winning there? What are your partners telling you? Is it price, is it your position in the switch market, or is it a combination of both?

Mike Klayko

Jayson, that's a good question, and I've - again, I get an opportunity to talk to a lot of customers, and I've had a chance to talk to these folks. They break it down into four or five reasons, which I won't go into all the technical details, but one is they really like the standards-plus approach that we have. It interoperates very well with the Brocade product set, which they’ve deployed. So that's very, very positive.

The second reason they like it is we've really put a focus on virtual environments and so, you know, there's some things around MPIV. And what we've done in the road map with quality of service and performance characteristics, there's no one else can do this at this point in time. So it will be, you know, that's a huge differentiator.

The third thing that came up is, you know, the users we've talked to tend not to really manage HBAs; they just deploy them. And there's a great anticipation and hope that they work real well with all the variables in the market. When they're going to be deploying ours, they know it's going to be fully tested with our whole infrastructure because we're providing a lot of the other pieces, the switch product. And it's going to be managed from a centralized platform that they don't have to have a separate tool so they like that, with our data center fabric manager. They like the fact that it's one company to work with for support, and they have one phone call to make. And they actually have support people trained 24 by 7 on this product set.

And they also like the road map, where the road map comes into play with CEE and FCoE and all the other things around converged network adapters and so forth. Although folks aren't, you know, jumping to the table with these technologies today, they like the fact that there is a proven road map there that they can depend on.

So it's not just - and, by the way, price doesn't come up; it's the whole other aspects. But yet we're very competitive on the price standpoint.

Operator

Your next question comes from Bill Fearnley - FTN Midwest Research.

Bill Fearnley - FTN Midwest Research

Two questions, if I could. The first is a macro issue. What about verticals, particularly with Asia-Pacific? And then any commentary on the government sector here in the third quarter and what you think it might contribute in the fourth quarter? And then I have a follow up, please.

Mike Klayko

Nothing jumps out at me when I look through the numbers around Asia-Pacific market in terms of either geographic preference or industry preference. It's fairly steady state from a quarter-on-quarter view, the last few quarters. And I'll ask Richard in a second if he can add any comments there.

Federal space, again, we don't have a dedicated focus like Foundry and some other countries have in the fed space. And ours is more of a run rate business there, and so we have not seen anything that's an anomaly there.

Richard Deranleau

Yes, Bill, just a couple of things on Asia-Pac. It's difficult to look at verticals because it's almost each one is a unique market, but Japan was a little bit slower. China was still strong. India's strong; the emerging economic powers. So all balanced, it was a little - it was a good quarter for them, but a little bit of softness in the Japanese market.

Bill Fearnley - FTN Midwest Research

And then for a follow up, when you look at the DCX side and when you look at your view into the enterprise, I mean, you've given pretty, you know, pretty positive guidance here in the directors, but are you seeing any decision cycle stretching or cancellations and how do you feel overall about the quality of your director pipeline here? Because we have heard of some, you know, with some of the storage OEMs and certainly when you talk to folks like VMware, they've talked about decision cycle stretching. Are you seeing any of those same things, particularly in the directors space?

Mike Klayko

Well, Bill, my - again, anecdotal information from dealing with customers is projects in flight are landing. They're still landing. You can't, you know, you have to finish the implementation. Other projects right now, it's interesting. I've met with customers that are accelerating the pace because they see the cost-benefit analysis of either a consolidation project, not elongating. But what we have seen is either an acceleration or some customers deciding to, you know, stagger their implementation but not really changing the decision process, maybe just changing some of the implementation processes.

Richard Deranleau

And just one more piece of color, too, is if you look at our pipeline, the thing that's a little bit interesting this quarter that we're in now is it's pretty broad-based. In other quarters there've been some bigger deals that were affecting our funnel, but here the funnel's pretty broad-based and that's kind of interesting given the economic times. But it gives us the confidence to go out and actually raise guidance above where the Street was.

Operator

Your next question comes from Glenn Hanus - Needham & Company.

Glenn Hanus - Needham & Company

Following up on the HBA question, could you give us any more color, you know, either by vertical or type of customer or where you're actually, you know, finding the most ready buyers?

Mike Klayko

Not to sound flip, Glenn, this is Mike, but customers that have deployed Brocade technology. We have not had a lot of pushback from folks. They're actually embracing our strategy, and they're embracing the differentiation. If we just came with a me-too product, I think it would be different, but we've spent a lot of energy and time and engineering resources on differentiation, and because of that they're embracing that. And so it's not limited to any vertical or any particular geographic basis.

Glenn Hanus - Needham & Company

And any color around the Files business, when we might see some pickup there, what the key catalyst might be for some improvements there?

Mike Klayko

Yes, we just got through our FME launch, which is the file management engine. It's got positive feedback. It's fairly early in all the trial programs, but it's been very successful. You know, you can always - the revenue's very modest, and I expect it to be modest into '09 again. So it's more of a - still a longer sales cycle than we'd anticipated early on, Glenn.

Operator

Your final question comes from Brent Bracelin - Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Richard, I had a follow up question on the switch products. Obviously you had a strong rebound there. You did attribute some of the rebound to 4-gig. My question is, was the rebound in 4-gig solely end demand driven or was there some inventory build at the OEMs ahead of the 8-gig transition? What's your best guess here?

Richard Deranleau

Well, without guessing but telling you just the actuals, we do track, you know, OEM inventory, and this quarter  I mean, we're trying to get away from that because it is - it's just always the same. It's been like two weeks of forward-looking inventory forever - but I would tell you that our sell-through was a little bit higher than our sellin.

Brent Bracelin - Pacific Crest Securities

And then as a follow up to that, when do you expect a transition on, you know, from kind of 4gig to kind of 8gig switches? Is that going to be over the course of three quarters, six quarters?

Richard Deranleau

Yes, Brent, I still think this is a long - you know, the product set's pretty nice that we have because it operates both 8 and 4 depending upon the optic configuration, but what we're finding is as customers implement a new architecture, they also implement it with new speeds of technology. And so it's a good future-proofing architecture because a customer can buy a switch set today and if they have an existing 4-gig, they can put it in and as they want it to grow, all they have to do is change out the optics set going forward. And so it's going to be a very similar implementation, we believe, as the director, will be the switch transition also.

Brent Bracelin - Pacific Crest Securities

My last question's really on kind of R&D and G&A. It looks like spending there spiked in the quarter, growing much faster than the revenue increase sequentially. Was there some one-time items tied to acquisition? If not, where are those internal investments going, which would be helpful.

Richard Deranleau

On the R&D side, clearly we're making some investments in the next generation converged network. There's also additional work we're doing, really across each one of our business segments as we continue to invest there.

From a G&A perspective, you know, it's a little bit lumpy depending on - there's nothing really unique going on there. It does tend to be a little bit lumpy. There's a little bit of acquisition cost, but not a lot.

Alex Lenke

And thank you all for joining us today. We'd like to make sure you remember our analyst's day on September 17th. It'll be in San Jose, and we look forward to seeing you. Thank you.

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