Brocade Communications Systems F1Q06 (Qtr Ending Jan 28, 2006) Earnings Conference Call Transcript (BRCD)

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Brocade Communications Systems Inc. (NASDAQ:BRCD)
Q1 2006 Earnings Conference Call
February 16th 2006, 5:00 PM. Executives March 1, 0000 ET

Analysts

Laura Conigliaro, Goldman Sachs

Aaron Rakers, A.G. Edwards

Tom Curlin, RBC Capital Markets

Paul Mansky, Citigroup

Henry Naah, Lehman brothers

Mark Kelleher, Canaccord Adams

Brent Bracelin, Pacific Crest Securities

Mark Moskowitz, JP Morgan

Shebly Seyrafi, Kaufman Brothers

Kaushik Roy, Susquehanna

Operator

Good afternoon my name is Cassidy and I will your conference facilitator. I would like to welcome everyone to Brocade’s First Quarter Fiscal 2006 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remark there will be a question and answer period. Operator Instructions. Ms. Stacy, you may begin.

Shirley Stacy, Director of Investor Relations

Thank you. Good afternoon everyone, I’m Shirley Stacy, Brocade Director of Investor Relations. Joining me today are Michael Klayko, Brocade CEO, Richard Deranleau, Brocade Interim CFO and Don Jaworski, Vice President of Marketing.

Before we begin, let me cover some housekeeping items. Brocade issued a press release detailing our first quarter financial results today over PRNewswire and FirstCall. This press release is available on our website at www.brocade.com. This conference call is being audio webcast and will be archived on our website for approximately 12 months. A telephone replay will be available today by 6 pm Eastern Standard Time through the end of day on Thursday, February 23rd. To access the telephone replay dial 800-642-1687 or for international dialers 706-645-9291, and the passcode is 4925754.

As a reminder the information in the press release discussed today will include forward-looking statements including without limitations, statements about Brocade’s financial results, business outlook and guidance. These forward-looking statements are only prediction and involve certain risk and uncertainties such that actual results may vary significantly. These are the risks that are set forth in more detail in our Form 10-K for the fiscal year ended October 29, 2005. Forward-looking statements reflect “believe”, “estimates”, and “predictions” as of today. And Brocade especially assumes no obligation to update any such forward-looking statement.

Financial information that we review on today’s conference call is presented on a non-GAAP basis. The most directly comparable GAAP information and the reconciliation between non-GAAP and GAAP is provided in our Q1 ’06 press release, which isn’t furnished to the SEC on Form 8-K and in the corresponding Q1 ’06 slide presentation posted on our website at www.brocade.com.

In addition, presented and discussed sell-through information which provide the measure of OEM and channel partner sales to end-users. Brocade does not report revenue based upon OEM sell-through information and this measurement is not intended to be viewed as a substitute for reported GAAP revenue. Sell-through is a measure of demand but it’s not a GAAP measurement of revenue and therefore is not subject to the same level with internal controls as reported GAAP revenue.

Please note that certain reclassifications have been made to prior year balances in order to confirm to the current year presentation. With that I’ll turn the call over to Mike.

Michael Klayko, Chief Executive Officer

Thanks Shirley. Good afternoon everyone and thank you for joining us. Today I’ll briefly discuss our results for the first quarter, review our SAN connectivity performance and trends and update you on our new Tapestry and service initiatives. Following my remarks Richard will provide more detail on our Q1 financial results and outlook for Q2.

Our results for the first quarter of fiscal 2006 were outstanding and exceeded our expectation in what is our seasonally strongest quarter. Q1 revenue was a record $170.1 million and increase of 17% sequentially and 5% year-over-year, and substantially better than our previous revenue guidance of $156 million to $161 million. Strong end-user demand overall to a better than expected sales generating higher non-GAAP gross margin at 60.2% and increased non-GAAP operating margin to 17.3%, which demonstrate the leverage in our business model.

Q1 non-GAAP diluted EPS was $0.10 as compared to $0.07 in Q4 ’05 and $0.10 in Q1 ’05. This exceeds our non-GAAP EPS guidance of $0.05. Our product sell-through for the quarter was also a record at approximately a 173.6 million. Our performance this quarter is a result of many factors, both external and internal to Brocade. In addition, to benefiting from growth of the storage market we were also seeing the results from the investments we made 18 months ago develop the most robust product portfolio in the industry, which is resonating with end-users customers across all geographies and OEM partners.

Let me spend a few minutes describing our performance in our SilkWorm SAN connectivity business. The quarter was led once again by a record quarter and directors. We also saw growth from our embedded and fabric switches. We continue to be the only SAN infrastructure provider with an end-to-end 4-Gig offering and the only provider of a common operating system across all our switching products.

This is a combination that is very appealing to our partners and customers alike. 4-Gig products represented 72% of our Q1 product sales, up from 50% last quarter and we expect 4-Gig to approach 90% of our business in Q2. Clearly the market is moved rapidly to 4-Gig technology and our product cycle has afforded us advantages and opportunities.

With 4-Gig HBAs now in the market and 4-Gig storage arrays beginning to roll out, we expect the preference for 4-Gig proven technology to continue to grow. I continue to be very pleased with our execution in the enterprise category. In Q1, directors had excellent revenue growth both sequentially and year-over-year representing a record quarter both in terms of revenue and systems shipped.

In addition to having the industry’s highest performance in highest-port-count director customers and partners are responding to the strength of our road map in our ability to continually deliver high quality solutions.

Our strength in directors this quarter was widespread, across partners and geographies. We now had shipped over 10,000 directors worldwide which represents a formidable install base in which they add new technologies and capabilities through Blade and software upgrades.

Our record quarter was fueled by a large number of deals, many of which with the expense of our competitors. Few Q1 customer wins include Porsche, IBM Global Services, China Mobile, Telstra Reach, Shinhan Bank, Yokogawa Electric Corporation.

Q1 revenue per switches declined moderately year-over-year from Q1 ’05 that had good growth from the prior quarter Q4 ’05 reflecting strength across our, 4-Gig ports-on-demand switches. These switches allow us to cover a wide range of very competitive price and configuration points for customers and partners with a minimum number of skews.

In the embedded space we saw outstanding growth for embedded SAN switches across all top server OEMs with very strong growth sequentially and year-over-year. During the quarter, we announced a new 4-Gig switch module for IBM BladeCenter and recently participated in the launch of Blade.org along with IBM, Intel and others. It’s form the faster collaborative innovation around new BladeCenter systems and solutions.

We maintain our enthusiasm for the Blade computing market and for the role of storage network as a key enabler for new Bladed computing solutions. We currently have a total of six server OEMs for Bladed server modules and expect additional design wins in the future.

Let me update you on an important aspect of our supply chain and product delivery operations. A few quarters ago, I gave a brief update on Restriction of Hazardous Substances or ROHS. That directed by the European Union that mandate the reduction of six hazardous substances for all manufacturers of electronic and electrical equipment sold in Europe.

Given our strong mix of European sales, ROHS compliance is critical to enable continued supply to the European community. Today I am pleased to tell you that in January, we began shipping ROHS compliance products if you are well ahead of the mandated July 1, 2006 deadline. This is a significant accomplishment and critical requirement because any supplier that is not ROHS compliance before the deadline will face difficulties in selling our products in Europe.

We’ve been very proactive on this subject and have executed well on this initiative. I’d like to now discuss the progress we’ve made with our new Tapestry product family and with our services initiatives. Tapestry WAFS is a Wide Area File Services solution for branch and remote offices. Evaluations and initial appointments are going very well. We have a number of deployments across all geographies including one of the first large competitive swap up in this new growth area.

Our strong product integration with Microsoft from both the technical and field sales prospective is a key differentiator in the market and to customers. As we mentioned in last quarter’s call most customers are rolling out WAFS solutions in small early deployment phases prior to broad implementations. So while we continue to gain customer win we’re currently behind expectations on our internal WAFS plan.

Our continued optimism for the growth potential, a branch office optimization stems from the clarity of a customer problem and a continued feedback we’ve received from end-users. We will continue to hold our skills in understanding of the market dynamics for this opportunity.

During the quarter we also announced an extension of our agreement with Nortel to develop software for Nortel’s branch office solution that provide cost effective management and protection of data in remote offices. Tapestry DMM or Data Migration Manager is our unique data migration product, that simplifies the migration of data across heterogeneous storage devices on a firm. We announced Tapestry DMM in November and already beginning to see very positive customer interest with substantial quantitative benefits in both time save and easy of use.

Customers had procured the solution as a traditional product or as a data migration service from Brocade. As we have provided the flexibility to deliver it either way. This last week Tapestry DMM received the “Product of the Year Award” from Storage Magazine, and Storagesearch.com for its innovation and addressing a significant customer data challenge.

As we mentioned in our last quarterly call many enterprise data migrations overwhelmed their plan time and cost budgets. And we believe that its simpler, faster solution for data migration will find strong customer demand. We are actively working with the services organization of one of our major OEMs and expect to announce an agreement regarding their delivery of Tapestry DMM services soon. Tapestry ARM or Application Resource Manager is an innovative solution that allows operating systems, applications and data to be quickly assigned to servers from a storage network. It’s much faster and much more flexible way of deploying applications on servers and is an excellent example of how shared storage network can help the server and application side of the IT organization, not just the storage professionals.

Quite frankly, it simplifies the operations and reduces the complexity of data centers. With recently added several new customers to our Tapestry ARM early access program and continue to get excellent feedback regarding time saving and operational flexibility. We are integrating additional features and functionality that our early access customers are requesting and expect to have broader deployments later in the first half. Also we will be rolling our Tapestry ARM through face-to-face and online seminars throughout the U.S. in Q2.

I am also excited to share the momentum and progress from our services initiatives. Fueled by increasing customer demand our worldwide services bookings grew over a 100% sequentially, and is tracking to our expectations. Professional service engagements grew rapidly with the strongest emphasis on proactive onsite engineering and data migration services utilizing our Tapestry DMM tool to enable fast deterministic migrations.

I am very pleased to report the reassigned service agreements this quarter with EMC in one of our top distributors Tech Data. These are the first examples of the partner friendly services approach that we described in our earlier calls whereby our strategy is to package and deliver many of our services through our major OEM and reseller partners. We fully expect to have additional partners join our program. Services remain an important investment area for the company. The need and demand for our areas of expertise and experience are significant and are being validated by our services performance. Our early results are encouraging and we planned to continue building our team and delivery capabilities.

Before handing the call over to Richard, I’d like to give you a brief update on our progress with the SEC. During the quarter we began active settlement discussions with the staff of the SEC regarding the Company’s restatements related to stock-option accounting. As a result of these discussions, in Q1 we booked a $5 million provision for an estimated settlement expense. This settlement amount is our best estimate after time and is subject to change as our discussions with the staff of the SEC continue.

I’ll now turn the call over to Richard for a review of our Q1 financial results and then I’ll be back with some concluding remarks and Q&A.

Richard Deranleau, Interim Chief Financial Officer, Principal Accounting Officer, VP of Accounting, Treasurer and Corporate Controller

Thank you Mike. I’ll now turn to a review of our Q1 results beginning with our income statement. Q1 revenues were $170.1 million in our seasonally strongest quarter. This represents an increase of 17% sequentially from the $145.5 million in Q4 ’05 and 5% year-over-year from the $161.6 million reported in Q1 ’05. Q1 port growth was up 17% from Q4, bringing total cumulative port shipped to over 6.4 million. Q1 sell-through was approximately 173.6 million, an increase of 8% sequentially from sell-through of approximately 160.8 million in Q4 of ’05. And then increase of 7% year-over-year from sell-through of approximately 161.9 million in Q1 ’05.

Non-GAAP diluted EPS was $0.10, this compares to non-GAAP diluted EPS of $0.07 in Q4 ’05. And non-GAAP diluted EPS of $0.10 in Q1 ’05. Reporting on a GAAP basis, Q1 ’06 EPS was $0.05, this compares to breakeven GAAP EPS in Q4 ’05 and GAAP EPS of $0.10 in Q1 ’05. Our effective non-GAAP tax rate in Q1 was 25.3%. Non-GAAP net income for Q1 excludes charges of approximately 5.6 million in net stock-based compensation expense. 0.6 million for amortization of deferred stock compensation expense related to prior acquisitions. 4 million in cost associated with the completed internal review in ongoing SEC investigation. $5 million in reserves for the estimated settlement with the SEC, and 1.9 million associated tax effects of non-GAAP adjustments.

In Q1 ’06 the impact of FAS 123(NYSE:R) was 5.3 million and is included in the 5.6 million in net stock-based compensation expenses just mentioned. The difference between the two is a variable charge of 0.3 million for serving stock awards.

Non-GAAP gross margins for Q1 ’06 was approximately – was 60.2% above our guidance of 55% to 56% in our target model of 55% to 58%, this compares to non-GAAP gross margins of 55.3% in Q4 ’05 and 58.8% in Q1’05.

The increase in gross margins from Q4 to Q1, primarily reflect the impact of higher overall sales volume and a more favorable product mix and pricing environment. Which reflects our leadership in 4-Gig end-to-end solutions sparing directors, switches and embedded blades. Q1 ASP declines were in the single-digit, slightly better than the prior quarter, again reflecting a more favorable pricing environment.

Q1 non-GAAP operating expenses excluding the items referred to previously were 73 million. These expenses were inline with our Q1 target of 73 million to 75 million. Q1 non-GAAP operating expenses increased approximately 6 million from the Q4 ’05 operating expenses of 67.1 million. Recall, Q4 operating expenses included some one time savings. Q4 non-GAAP expenses excluding one-time savings were approximately 71 million.

Non-GAAP operating margin for Q1 ’06 was 17.3% this compares to Q4 ’05 non-GAAP operating margin of 9.2% and Q1 ’05 non-GAAP operating margin of 19.1%. The improvement in non-GAAP operating margins over Q4 ’05 goes to demonstrate the leverage we had in our business model.

Now let’s turn to the balance sheet, cash flow from operations in Q1’ 06 was a healthy 20 or 32 million, compared to 39.4 million in Q4 ’05. Cash flow from operations benefited from strong profitability and lower DSOs despite a traditionally lower cash flow quarter. Our cash and investments balance at the end of Q1 ’05, which includes restricted investments was 789.1 million. As a reminder the restricted short-term investments represent funds satisfy for the retirement of our outstanding 2% convertible note in August of this year.

Net cash excluding the convertible debt was 510.2 million up from net cash of 485.5 million last quarter. On our Q4 ’05 earnings call we indicated that the company had a 93 million stock buyback authorization, and with actively repurchase our stock. Subsequently we decided that due to the potential the late filing of our fiscal 2005 Form 10-K it would be prudent sustain from repurchasing our shares. However now that all of our filings are current we expect to be in the market.

Day sales outstanding and accounts receivable was an outstanding 41 days in Q1 ’06 compared with 44 days in Q4 ’05. DSOs were once again below our target range of 50 to 60 days primarily due to continued improvements in shipment linearity and strong collections by the Company. Our on-hand inventory was 8.2 million in Q1 ’06 compared to a 11 million in Q4 ’05 inline with our range of 8 million to 10 million as projected last quarter.

Capital expenditures for the fourth quarter were 8.2 million, which is consistent with our target range of 6 million to 8 million. And finally, deferred revenue increased to 51 million in Q1 ’06 compared to 45.5 million in Q4 ’05. The increase is primarily due to continued growth in service bookings, a portion of which is deferred and recognized over the life of the service contract.

Now for our outlook, while you compare your models and estimates there are some factors to consider, Q2 is historically sequentially down from a seasonally strong Q1. The seasonal pattern corresponds to a seasonally slower growth period from most of our major OEM partners and is most pronounced in the enterprise portion of the market. Our competitive position and product momentum across our entire product family is strong and we remain confident in our ability to execute.

Our end-to-end 4-Gig lead is affording us many opportunities and we expect the environment to remain competitive, particularly as our competitors begin to come to market with their 4-Gig platforms. We expect ASP declines to be in the mid single-digit.
When we take a look at all of these factors, our outlook for Q2 is as follows, we expect our reported revenue in Q2 to be in a range of 157 million to 162 million which is above the current consensus FirstCall analyst estimate for Q2 of 154.5 million. We expect Q2 gross margins to be in the 56% to 57% range reflecting the impact of lower sales volumes in Q1 and then increase in switch and services in the product mix. For Q2, we expect total non-GAAP operating expenses to be in a range of 75 million to 77 million.

As Mike indicated earlier, we are beginning to see the benefits of our new initiative in both Tapestry and in services. We plan to continue to increase Tapestry development investments and to build out our service team and delivery capability. We expect other income, other expense net to be approximately 4.5 million in Q2. We expect our non-GAAP effective tax rate to be in a range of 24% to 26%, we expect diluted shares outstanding to be in a range of 270 million to 274 million. Before addressing EPS guidance I would like to remind you the following with respect to FAS 123(R).

In Q1 ’06 we adopted FAS 123(R), which requires us to include expenses related to stock compensation based on their fair value. We are providing non-GAAP EPS estimates without option expenses for comparability purposes. We have adopted FAS 123(R) prospectively and as such we are not restating prior period financial results. We expect the impact of FAS 123(R) related to fixed stock options to be approximately 4.5 million to 5.5 million per quarter in fiscal 2006. In addition we account for certain stock awards on a variable accounting basis. The changes in stock price will impact the amount of compensation expense.

We expect Q2 GAAP EPS of $0.02 to $0.03. Excluding stock compensation and other one-time item we expect Q2 ’06 non-GAAP EPS of $0.05. We expect capital investments to be in the 6 to 8 million range. We expect day sales outstanding will be near the low end of the 50 to 60 day range. As I indicated earlier DSOs have been below this range two quarters in a row, we will continue to monitor DSOs and to the extent we become confident in our ability to maintain a lower level, we will revise this target. We expect the inventory levels to be in a 8 million to 10 million range now that our contract manufacture transition is complete. And we expect to remain cash flow positive and expect to generate an average range of 20 million to 30 million in operating cash flow per quarter throughout the year.

Before I comment on our outlook for fiscal 2006, I want to reiterate our commitment to our long-term financial model targets, which includes a gross margin range of 55% to 58% non-GAAP operating expense range of 38% to 40% and non-GAAP operating margin range up 15% to 20%. While we do not expect to operate in our target models in fiscal 2006 we do anticipate making progress throughout fiscal 2006 and expect non-GAAP operating margins to be in a range of a 11% to 12% by the fourth quarter.

For fiscal year 2006, we expect to achieve 660 million to 672 million in revenue, which is above the current consensus FirstCall analyst estimate for fiscal 2006 of 650.4 million. Our expectations for gross margins in fiscal 2006 is a range of 50% to 57%, this range is slightly higher than the previous range of 54% to 56%, which was provided on our Q4 earnings call and reflect the positive effects of more directors and software revenue in our product mix excuse me, our expectation for gross margin in fiscal 2006 is a range of 55% to 57%. With that I will now turn it back to Mike.

Michael Klayko, Chief Executive Officer

Thanks Richard. Before we open the call for questions, I would like to recap the highlights from our Q1 results. First, we’re executing to our plan, we had an outstanding quarter and are executing very well in our core business. We are especially pleased with our results in the enterprise segment. Second we are driving for growth; our results this quarter demonstrate the leverage in our model from top-line growth. Our investments in Tapestry solutions and service offerings are showing promise, with strong differentiation and customer interest. We will continue to drive new initiatives and rapidly expand our offerings in these areas. And third, Brocade is becoming more than fiber channel switching, storage networking and SAN switches are our core business and the fundamental building blocks that we are enabling and it enables us to expand into adjacent markets.

Our belief in strategy is that the benefits of shared storage have an increasingly important role in driving next generation, cost efficiencies with servers, applications and storage with them and across data centers. Brocade will continue to be a leader providing innovative offerings in the areas of switching, software, services and solutions that allow customers to extend the value from their investment in shared storage and derive even greater benefits.

In closing, I would like to invite everyone to our upcoming Analyst Meeting in San Francisco on March 15. We are looking forward to sharing our plans and thoughts with you in a very interactive form. With that operator, please open the call for questions.

Question-and-Answer Session

Operator

Thank you. Operator Instruction. Your first question comes from Laura Conigliaro with Goldman Sachs.

Q - Min Park

This is Min Park on behalf of Laura just a couple of questions, last quarter you provided several target metrics and remain quite firm when question on why you shouldn’t be strong in number this quarter, then you ultimately blew them off, this is more of a case if you guys being always conservative in your target or how is this visibility dimish?

A - Richard Deranleau

Well, let me take that one Mike, first of all our outlook for Q2 is up from our outlook last quarter. But Q1 was seasonally stronger than we expected, so our Q4 outlook – for Q2 is up a much higher base. You can mind that our Q2 revenue guidance of 157 to 162 million is about the same revenue guidance that we provided initially for Q1, our seasonally strongest quarter. Q1 was a very strong quarter and exceeded our expectation, however Q2 as historically been our seasonally weakest quarter, it is also a seasonally weak quarter for some of our major OEMs. Also keep in mind that as our enterprise business increases we are more affected by seasonality than we have been in the past, in addition we expect the environment to be competitive particularly as our – as other vendors come to the market with 4-Gig solution.

Q - Min Park

Okay, given that you guys going to be bought a leading and, allowing indictor for the storage market, what is your performance there about the industries growth for the next quarter?

A - Michael Klayko

I think you’ve seen a lot of report chart from different vendors right now, in those – it appears to be a lot of wind in the sales right now from service providers, right, today.

Q - Min Park

Okay and lastly, one last question, to what extent is the softness of some of your fabric switch is? Really a function of QLogics increased presence in the space and their partnership with Cisco?

A - Tom Buiocchi

Hi Min, this is Tom, how are you?

Q - Min Park

Okay.

A - Tom Buiocchi

I’m not sure, what we’ve seen in the fabric switch state is that we have a very strong product line or up sequentially and when we saw this quarter, it was essentially a mix ship for us from switches to directors, its unclear as exactly what happened in the switch market until everyone reports, and we’re going to, I’ll be triangulate that, I know its great, but our switches sales are stronger, up sequentially. We’ve got a very competitive product line there and I think as we execute we’ll continue to see growth there.

Q - Min Park

Great, thank you.

A - Tom Buiocchi

Thanks, and next question?

Operator

Your next question comes from Aaron Rakers with A.G. Edwards.

Q - Aaron Rakers

Yeah, thanks guys, congratulation for best quarter. I guess may be just a follow-up on the prior question, and may be you could help us understand what you saw from a linearity perspective throughout the quarter, and may be walk us through, the trends following December into January, and what you’ve seen thus far into the current quarter? And I got a follow-on if I can.

A - Richard Deranleau

This is Richard now, I’ll attack the linearity question, very good linearity for the quarter very balanced, this followed on from Q4 which had improved linearity, and that has continued for us through the end of the quarter. So we’re really quite pleased and we would like to continue to see that trend in linearity.

Q - Aaron Rakers

And was there any – may be I miss this, was there any guidance in regards to sell-through expectations in the quarter – in the current quarter from you guys?

A - Michael Klayko

Sell-through and sell-in, we started this a few quarters ago, but right now there is no material different. So, we just reported it as – this quarter just, there is no difference any more.

Q - Aaron Rakers

And then final question, may be you could help me understand, you talked about your growing install base as a director products and talking about the ability to go back into that install base and sell essentially blades going forward, how do I think about that in terms of implications for your gross margin, can we possibly see you guys have a stronger gross margin possibly towards a 60% range looking into the next fiscal year?

A - Richard Deranleau

So, I think the – certainly the blade up is an opportunity for, but we are not sure about the lifecycle it takes to do that, and from a gross margin perspective we give them the guidance, and I think we’re comfortable with that guidance.

A - Tom Buiocchi

Hi Aaron, this is Tom I think it represents an after-market install base opportunity to sell up, the more of top-line thing and the gross margin thing.

Q - Aaron Rakers

Fair enough. Thanks guys.

Operator

Thank you. Your next question comes from Tom Curlin with RBC Capital Markets. Mr. Curlin, your line is open.

Q - Tom Curlin

Hey, good afternoon, sorry about that.

A - Shirley Stacy

Hey Tom.

A - Michael Klayko

Hi, Tom.

Q - Tom Curlin

Hey, those are good numbers, congratulations.

A - Michael Klayko

Thank you.

Q - Tom Curlin

And high consecutive guidance, it’s refreshing actually, so that’s good stuff. On the Tapestry initiative especially on the server side, how do you – how do you bring some OEMs into the fold on that, right, I mean that, how do you convince them, that’s not a conflict if you will with, their own software initiatives or that they – that you can enhance if you will what they are doing on that front?

A - Tom Buiocchi

Hey Tom, this is Tom here. There is a combination of things that goes on right, one is that they continue to evaluate the technology and go through their various product groups to understand the positioning within their current stack and their offering. And I think the more time they spend with our products to understand that they are actually complementary to what they are offering and can add value. But in parallel with that, let’s take a look at the multi-protocol router, we need to go out and educate customers in the marketplace about the unique added value of these products. So it’s a process, it typically takes a couple of quarters as it do with the multi protocol router, and we go through their process were all the major OEMs right now while we educate the market.

A - Michael Klayko

And Tom, let me add a little bit of color they also – I mean we’ve been doing, we got in the space – the storage space for past 10 years now, but also when you take a look at that, we’ve got probably well over 2 million servers connected more, so right in the middle of the data path a thousands of mission critical applications. So we are exposed to some very interesting challenges in and around the data center from storage-to-servers-to-application and what we’ve been able to do is validate a lot of the main points from a end-users customers validation, we’ve been going that back and we work with our partners and we are actually working in harmony to solve these.

Q - Tom Curlin

And so, I mean do you feel like you’re getting OEM traction in that regard or is does that being sort of a need in the market, type of opportunity, I mean in the channel, media in the particular customer side.

A - Richard Deranleau

Well, it depends on the OEM that, we’re quite comfortable that the products are applicable not only with some OEMs as well as meeting in the channel and the reseller market. So it’s a combination of both depending upon the application on the paying front the customer has, Tom do you have anything.

A - Tom Buiocchi

Yeah just got statements, we have over 20 OEMs and three substitute products now and most of our OEMs are in some stage of evaluation of the top tier product line, so its fairly wide spread evaluation right now Tom.

Q - Tom Curlin

Okay, and then just with respect to the OpEx guidance, I understand that a lot of that is Tapestry related but it, it seems like you, you probably have to maybe commit some dollars to sustaining some of the core products as well. The course which that comes to mind, do you put here like, you factored in everything you need with respect to next Gen core switch opportunity beyond the 48,000 architecture?

A - Richard Deranleau

Yes, I really believe we have, I think our expense can contemplate, contemplate what we need to do in our traditional space.

Q - Tom Curlin

Okay, thank you very much.

A - Richard Deranleau

Thank you.

A - Shirley Stacy

Thanks Tom.

Operator

Thank you. Your next question comes for Paul Mansky from Citigroup.

Q - Paul Mansky

Can you here me?

A - Richard Deranleau

We can Paul go ahead.

Q - Paul Mansky

Right, thank you, very nice quarter.

A - Richard Deranleau

Thanks.

Q - Paul Mansky

Hey, you clearly laid out the basis for your revenue guidance, I wanted to retouch in your comments around the potential for increased competition in 4-Gig, is that a comment on what do you expect to be a shift away from the directors seasonally and exclusively, or we expecting possibly some, some more competition or some more 4-Gig enabled directors in the market this coming quarter?

A - Tom Buiocchi

Paul, this is Tom I’ll start and I think Mike has the last. I think we’re just contemplating the fact that we are the only 4-Gig and then the product line right now, the other competitors have not normally begin shipping in volume in the suite spot, and at some point in time, in the near future they will. So, I think just contemplating the rest of the guys in the game with 4-Gig eventually.

Q - Paul Mansky

Okay and then, secondly if you can maybe provide us a little bit of color around what as -- what’s software and services was as a percentage of the mix in the current quarter, and then may be if you could provide us some context as it relates to the gross margin profile around services?

A - Richard Deranleau

Okay, Paul let me go over that, we don’t breakout the software and services, Paul I think we have given a view that our new services, we’d like to see those a 5% of revenue and we think that’s achievable goal. When you look at services in terms of our gross margin model, we would like to see that in the 35% to 45% range.

Q - Paul Mansky

And how do that, how does that check related to that range this quarter?

A - Michael Klayko

It’s a little early to tell, and you know I think that’s the goal that we want to work on and but we’re not breaking out specific at this point.

Q - Paul Mansky

Okay and then lastly just maybe total headcount actually in the quarter?

A - Richard Deranleau

Sure, total – we exited the quarter at 1208 employees.

Q - Paul Mansky

Great, thank you very much

A - Richard Deranleau

Our next question?

Operator

Thank you, your next question comes from Henry Naah with Lehman brothers.

Q - Henry Naah

Hey guys, nice quarter

A - Richard Deranleau

Thank you

Q - Henry Naah

Couple of question to you if I may, in terms of the headcount, piggy back on Paul’s question here, it looks like yours is up 40, 50 people from last quarter was that predominantly in services?

A - Michael Klayko

Yeah, so, there is, yeah I don’t want to break it out too much but some color on to this we invested heavily in service headcount.

Q - Henry Naah

Okay and then in terms of, you had mentioned the stock buyback which is kind of freeze there for a while can you give us some indication as to where the plan stand and its still 93 million or as there been any change in the size of the plan?

A - Michael Klayko

Well, and you – probably expect our board authorizes the buybacks and they have authorized the initial buyback of 100 million and so that’s sort of where we are.

Q - Henry Naah

Okay, great, thanks guys.

Operator

Thank you. Your next question comes from Mark Kelleher with Canaccord Adams.

Q - Mark Kelleher

Thanks, let me add my congratulations for the great quarter guys.

A - Michael Klayko

Thank you.

Q - Mark Kelleher

I want to – also a follow-up on one of Paul’s questions, when he was asking about the competitive position in the director space of 4-Gig, in what, how important is 4-Gig for the sale of this directors right now in a competitive environment? Is that extremely important, is that where customers are coming to or it just as other features and functions in the 4-Gig is beneficial.

A - Michael Klayko

Well, I’ll start in it, I’m sure we could spend a lot of time on this and may be Tom will add in. It’s the 4-Gig in the director space by itself is incredibly important but when you combine it with a server through switching, through director, one operating system all 4-Gig and you can deploy throughout your enterprise, it’s a very, very compelling story that our customers are resonating with. So, our partners like if the customers like it and frankly a lot of the customers today are building out and expanding their SANs in their infrastructure, they are building out new data center infrastructures and what they want to do is, they want to build it up with the latest technology and 4-Gig has a, a lot of technology advantages that they are taking advantage of.

A – Tom Buiocchi

Hey Mark just one more comment, 4-Gig HBAs and 4-Gig storage arrays are starting to hit the market now as well. So, you know most customers making high performance data center decisions right now just move right to the latest technology – with any other technology right, to the latest – latest cycle and hold it right now.

Q - Mark Kelleher

Okay. And switching CapEx you, I don’t know if you can give some more color around the SEC investigation, sounds like it maybe winding down, you sort of satisfied from reserves for that, is there some increased visibility that maybe winding down?

A - Michael Klayko

I can’t give you any more color than what I’ve given you either in the press release for that quarter.

Q - Mark Kelleher

Okay, thanks guys.

A - Michael Klayko

You bet.

A - Shirley Stacy

Next question.

Operator

Thank you. Your next question comes from Brent Bracelin with Pacific Crest Securities.

Q - Brent Bracelin

Thanks for taking my question here, I guess trying to really determine the sustainability here of the part momentum you are seeing, first question how much of the upside in the quarter would you attribute to having kind of market advantage on the 4-Gig side. Secondly, what features or other features do you expect will differentiate your platform as you start to see other 4-Gig products in the market. And then lastly does your April guidance begin the assumption that you will see pricing trends start to deteriorate as other comparative products into the market.

A – Tom Buiocchi

Brent this is Tom I will start. So, obviously when you get a product side advantage that creates some momentum and if I have to reiterate what Mike said, its one aspect of it is the 4-Gig speed, the other aspect of it is we are giving customers entry level to enterprise platforms, same operating system total seeing with interoperability which translates into greater confidence when they to go deploy and build stands out right, so its the couple of things, one of which is the speed in the cycle of the technology but another aspects is just the confidence they get from having a – an entire family that’s totally interoperable and consistent across the operating system. So that’s hopefully a part one. Can you remind the part two of your question?

Q - Brent Bracelin

Again this differentiating kind of the platforms as you start to see the competitive 4-Gig products come to market is it just single OS cross both the fabric and the director or what are the other unique differences that you can…

A - Michael Klayko

Let me just touch on a couple right, and Mike I think summed it up in his prepared remarks pretty he will. SAN’s are more than the switches right now, right? Everybody is making purchase decisions on the infrastructure and on the switch and director technology but their – they got other need and they are looking in many ways to have the shared storage network to be a key corner stone that solves all need, so what are you doing with software, what are you doing with virtualization, what are you doing other services, what are you doing with data mobility and so forth. Then we have some technologies inter vision there that helps customers out as well as some service offerings that will help them kind of architect and deploy their solution more reliably as well. So its – a lot of it’s the switch, and a lot of it’s the technology but a lot of is the overall solution what they are trying to do as well.

Q - Brent Bracelin

Sure fair enough. And then just lastly on the assumption built in to kind of the guidance for April, do you expect kind of pricing to give little more investment there.

A - Richard Deranleau

Sure let me take that, so as I said in my remarks the ASP this quarter was down in single-digit which is better than Q4 when it was in the mid single-digit range. And we are anticipating ASP declines in Q2 to be in the mid single-digit more to where they were historically and as thus we book that into our guidance and helps review on your gross margin.

Q - Brent Bracelin

Okay, great thank you

Operator

Thank you your next question comes from Mark Moskowitz with JP Morgan

Q - Mark Moskowitz

Great thank you few questions if I may. I want to get back to this 4-Gig question that a few folks have asked already, so if you can tackle us somewhat differently, obviously you’ve done a great job in terms of bring the full products but if you look at the OEMs they really have not been tying 4-Gig at all the past year even with some product introductions most recently, I was wondering if you give us a sense is the more of that, some of your competitors are still stub in their toes and having some company specific distractions that actually inspired or led to your revenue momentum last couple of quarters, is that right, just start to seeing some more conservative to the outlook will be grateful.

A - Richard Deranleau

So I will make our, it’s a very stub in their toes, I think we’re just executing well, we anticipated this and we, spend a lot of energy and time in developing a complete product set not just one product or point product but a complete products set, and frankly our customers who are building out their enterprises right now and they are making investments for the future, they want to have the best technology and frankly I think we have the best technology in the marketplace.

Q - Mark Moskowitz

Okay, and then as far as the commentary on sell through Richard I want to get a, better understanding from you why there is no difference now between sell-in and sell-through, you folks have talked about that in the past, and I just wonder why there is no distinction now between the outlook?

A - Richard Deranleau

Okay so, the message we’re really trying to send is that we are kind of focused on end-user demand right, and so when sell-through is equal to your revenue or approximately in our case, you really not going see any real impact or an OEM inventory. So by giving you both sell-through and by giving you reported revenue we can really get a good sense of through end user demand.

Q - Mark Moskowitz

Okay, and then just lastly here I want to get a sense to how your increased FICON capabilities played out in the fourth quarter particularly – just from your bigger customers.

A – Tom Buiocchi

Sure, this is Tom, and traditionally the fourth calendar quarter is a big quarter for FICON and we did very well in the FICON space last quarter. We have a – in the FICON segment high performance and high density port counts are very valuable along with FICON certification obviously, so we have very high performances as 4-Gig in the industries type port count is 256 and when you put that together with a FICON certification it’s a very good answer.

Q - Mark Moskowitz

Thank you

A - Shirley Stacy

Thanks Mark next question

Operator

Thank your, your next question comes from Shebly Seyrafi with Kaufman Brothers.

Q - Shebly Seyrafi

Yes, thank you very much it looks like you had a temporary advantage in the market place having a more fully featured 4-Gig offering than your competition that led for this spike in your gross margin and good results. I am concerned that this may slip a little bit over the next three to six months and as Cisco comes out with their 9513 director with over 500 ports and that’s versus your current offering 48K with 256 ports, might that result in some head wins for you in the next three to six months, I got few more.

A - Michael Klayko

It’s the question how we are doing? We are doing great. I think if you take a look at our products at right now we do have the product in the marketplace, we are competing very well. If you look at it by segment, its not just the director segment and very well in that segment, but it’s a broad -- it’s the whole broad product line that were, that the customers are looking for. And so it’s not – also again in the state, the thing is that we haven’t talked about here is not only it’s the 4-Gig, that’s the best product our front product is the best product in the market. But the other thing that we’ve invested heavily in is tools and education, that let the customers get the best value for their product. So, not only do we buy those products that are, I think that are leading edge, but we also provide tools and education capabilities that they can utilize these things and get the best value out of them. So we hear back from our customers and we train more than 21000 end users last year on how to get the best value and that’s a big differentiator right now and it is a proof point that customers have come back and said, no its not, it is, the products are great. And it’s all the other things that you do to help make me successful in my environment, that makes the difference.

Q - Shebly Seyrafi

Second question, you just had 60% gross margin, the first time in over three years point to my model. Do you think that if things go your way, I know you are not modeling those, but if things go your way this year and it’s possible that your gross margins be around 60% or near 60% for the year?

A - Richard Deranleau

So, from a gross margin point of view, again we had higher volumes in Q1 and we had more favorable product mix. And as I indicated a couple of times we had a more benign ASP environment. We also had some one-time benefit based on our execution of our 4 our 2 to 4-Gig product line better than we anticipated. And our long-term gross margin goals remain consistent in that 55% to 58%.

A - Shirley Stacy

Thanks Shebly, next question

Operator

Thank you, your final question comes from Kaushik Roy with Susquehanna.

Q - Kaushik Roy

Congratulations on great quarter.

A - Richard Deranleau

Thank you.

Q - Kaushik Roy

One clarification and couple of questions. Did you say that EPS guidance for April, non-GAAP excluding ESOs with $0.05.

A - Richard Deranleau

All right, the non-GAAP EPS is $0.05.

Q - Kaushik Roy

And that’s excluding ESOs, correct?

A - Richard Deranleau

I am sorry.

Q - Kaushik Roy

Is that excluding the ESO?

A - Richard Deranleau

That excludes the stock compensation expense.

Q - Kaushik Roy

Okay, and then on pricing you mentioned it was favorable can you give it by segment by director and the switch level?

A - Richard Deranleau

Actually we don’t really break it out that way but we try to provide you some overall color.

Q - Kaushik Roy

So, was it more on the director level or on the switch level?

A - Richard Deranleau

So, again we really don’t break that out and we’ve given you that all the color we can do on that.

Q - Kaushik Roy

All right, so on competition directors are you seeing more competition from Cisco or from McData and then on the mid Entry-Level switches are you seeing more McData or QLogic.

A – Tom Buiocchi

Kaushik this is Tom, in the director state, everybody did all the deals right. So we are there, we are competing head to head and we are doing very well in competing head to head with the competition and in the switch base its hard to tell right now we don’t know until everybody reports exactly what happen there it’s a little more shielded from us because we are not involved in this field directly with many of those situation so it tough to tell there.

Q - Kaushik Roy

Okay thanks.

A - Shirley Stacy

Thanks.

A - Michael Klayko

Shirley.

Shirley Stacy, Director of Investor Relations

Okay, thank you everybody for joining us, appreciate your time today I wanted to just conclude with some concluding comments. We look forward to speaking with you again in some upcoming conferences we are attending the Goldman Sachs Technology Symposium on February 28. Morgan Stanley Semiconductor & Systems Conference on March 7th. And the Citigroup Small and Mid-Cap Conference on March 16th. As always our presentation and breakouts are audio webcast on our website. One final note an update version of slide set from today’s conference call is on our website and it will be available at 3 o’clock today. It will include the slide set from our outlook for Q2 and for fiscal 2006. And with that thank you very much and have a good day.

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