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Edited Transcript of GIMO earnings conference call or presentation 27-Apr-17 9:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Gigamon Inc Earnings Call

Milpitas May 1, 2017 (Thomson StreetEvents) -- Edited Transcript of Gigamon Inc earnings conference call or presentation Thursday, April 27, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jennifer Gianola

* Paul A. Hooper

Gigamon Inc. - CEO and Director

* Rex S. Jackson

Gigamon Inc. - CFO and Principal Accounting Officer

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Conference Call Participants

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* Alexander B. Henderson

Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology

* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* Erik Loren Suppiger

JMP Securities LLC, Research Division - MD and Senior Research Analyst

* Jason Noah Ader

William Blair & Company L.L.C., Research Division - Partner, Co-Group Head of Technology, Media, and Communications

* Kulbinder S. Garcha

Crédit Suisse AG, Research Division - MD

* Patrick M. Newton

Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst

* Simon Matthew Leopold

Raymond James & Associates, Inc., Research Division - Research Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Gigamon's First Quarter 2017 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Jennifer Gianola, Head of Investor Relations. Please go ahead, ma'am.

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Jennifer Gianola, [2]

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Thank you, operator. This is Jennifer Gianola, Head of Investor Relations at Gigamon, and I'm pleased to welcome you to Gigamon's conference call to discuss its first quarter 2017 earnings results. With me on the call today is Paul Hooper and Rex Jackson.

After the market closed today, Gigamon issued a press release through PR Newswire. The release is also available on the company website at gigamon.com. This call is being webcast live on the Investor Relations page of the Gigamon website and will be available for a period of 1 year.

During the course of today's presentation, our executives will make forward-looking statements within the meaning of the federal securities laws. Forward-looking statements generally relate to future events or future financial or operating performance. Forward-looking statements in this presentation include, but are not limited to, statements related to our business and financial performance and expectations and guidance for future periods, our expectations regarding our product and go-to-market initiatives and the related benefits and our expectations regarding the market and our customers.

Our expectations and beliefs regarding these matters may not materialize, and actual results in future periods are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks include those set forth in the press release that we issued earlier today as well as those more fully described in our filings with the SEC, including our annual report on Form 10-K.

The forward-looking statements in this presentation are based on information available to us as of the date hereof, and we disclaim any obligation to update any forward-looking statements except as required by law.

Please note that other than revenue, or as otherwise specifically stated, the financial measures to be discussed on this call will be on a non-GAAP basis. The non-GAAP financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. A discussion of why we present non-GAAP financial measures and a reconciliation of the non-GAAP financial measures discussed in this call to the most directly comparable GAAP financial measures are included in our earnings press release that's available on our website.

On this call, we will give guidance for the second quarter of fiscal year 2017 on a non-GAAP basis. We do not make available the reconciliation of non-GAAP guidance measures to corresponding GAAP measures on a forward-looking basis due to the high variability and low visibility with respect to the changes, which are excluded from these non-GAAP measures.

I will now turn the call over to Paul Hooper, Gigamon's CEO.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [3]

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Thank you, Jennifer, and thank you all for joining our call this afternoon. We continue to make progress as we execute on the 3 initiatives that I laid out last quarter: capturing and developing customers, focusing on specific vertical markets and delivering innovative technology. While executing on these activities, we have delivered revenue and gross margin at the top of our guidance range, expenses lower than planned and EPS ahead of our Q1 guidance. While we're pleased with these results, there is still work ahead in order to return to stronger growth.

I'll start by examining the progress and activities around the 3 initiatives, with the first one being our focus to capture new and develop existing customers. While we're all excited about the interest in our recently introduced products, which I'll discuss later on the call, the evaluations involving our visibility solutions for Amazon Web Services continue to gain traction.

As a reminder, we launched our AWS software solution last November that enables our customers to gain visibility into data in motion, both entering or leaving the public cloud, but also and more importantly, traversing east to west across applications hosted in the cloud. This solution complements our existing portfolio, and in combination, offers a solution for the increasingly important world of hybrid cloud deployments, an architecture comprised of both on-premise and cloud-based infrastructure.

One of the largest investment companies in the world and a new customer for us is comprehensively evaluating our AWS visibility solution to support their move to a hybrid architecture. One of our ecosystem partners, RSA, originated this opportunity, highlighting the results of ongoing investment to extend the depth and breadth of our relationships with marking, leading, security and management vendors.

We also partnered with RSA on an opportunity with one of the world's largest HR providers and a Fortune 500 company. This customer that protects significant volume of highly confidential information has completed a thorough evolution of our visibility solution for hybrid deployments, both in the AWS cloud and in their on-premise data centers. The evaluation was successful and is expected to result in a large visibility deployment order with us in their data center ahead of their move to AWS. This is also a new prospect for Gigamon and one that demonstrates the power of our AWS solution as a demand generator for both physical as well as virtual visibility solutions.

In addition to enterprise evaluations, we are focusing our AWS solution efforts on the federal government. This summer, we plan to launch a solution for the specific segment of Amazon Web Services that serves the federal government, GovCloud. We continue to see strong interest in our AWS solution by several agencies and government departments with our federal team currently engaged with one of the largest agencies as they seek a visibility solution to enable their move to the world of the public cloud.

To continue our move towards the frictionless evaluation of our software solutions, we released an AWS Quick Start capability that allows customers to deploy and evaluate our cloud visibility software with no intervention on our part. This new capability show one of the largest and most diversified software companies in the world undertaking an evaluation of our fabric management platform in combination with our AWS software solution. The interest and momentum in evaluations around our AWS offering has exceeded our expectations, and we remain pragmatic in the assumption that it takes time to convert a proof of concept into a booking.

Our win last quarter with Chicago Mercantile Exchange exceeded our expectation in the pace of closure of the deal, and we expect a number of the active evaluations to convert in the months ahead. We added 84 new customers in the quarter, representing a diverse range of companies from around the globe. The following handful of customers that represent over 600,000 in average first-time bookings showcases the ongoing demand for pervasive visibility to address the needs of tomorrow's security architecture.

One of the most technologically advanced military organizations in the world adopted our GigaVUE family of products to establish a modern, flexible and proactive security infrastructure. A member of the NASDAQ Financial-100 deployed our visibility platform to enable their network consolidation project as they were looking to increase the effectiveness of their existing security implementation.

A premier U.S. health care provider adopted our platform to establish visibility into East-West traffic within their data center to improve their security posture and address reliability challenges that were directly affecting the organization's performance and bottom line.

A world-renowned Asia economic planning agency implemented our visibility platform to establish pervasive security across their IT infrastructure.

A well-known financial services company adopted our in-line solution to enable the deployment of real-time perimeter threat protection while also reducing operational expense and carbon footprint. And one of the most pioneering government agencies in the Middle East implemented a nationwide visibility platform to allow their security team to have pervasive reach across the national infrastructure.

Capturing and developing customers is our first imperative. We have and will continue to invest significant time and attention in our go-to-market efficiency and execution. As I mentioned on the prior earnings call, we have sufficient capacity in our sales structure to scale our business given existing sales employees and new hires that are approaching 9-month tenure.

Furthermore, during the back half of 2016 and in Q1 of 2017, we focused our demands generation engine on creating qualified appointments for our field teams. While an appointment is not the guaranteed order with the latter really occurring in the same quarter, we do have proven success in converting appointments to bookings. And through our increased focus, we saw a 100% year-over-year increase in the number of qualified appointments this quarter.

Although we are pleased with our progress to date, there is still more work ahead as we continue to improve our go-to-market results, particularly in the North American enterprise market. Accordingly, I've executed to 2 changes to ensure we have the right leadership and vision to continue driving this important initiative.

First, we've appointed Kim DeCarlis as our new CMO. Kim, most recently CMO of Imperva, joined us this week and brings us strong background in security and management with a specific flair to demand generation and field enablement.

And second, I have decided to bring in a new leader for our worldwide sales organization. And while we undertake a diligent search for a strong individual, Helmut Wilke, our current sales leader, will remain with the company to ensure a smooth transition.

Turning to the second initiative, vertical markets. We have made good progress in mapping out unique and strong differentiators for our solution and products in our target enterprise verticals: finance, health care and technology. These verticals are now the core of our direct and indirect sales playbooks that enable the sales motion from initial engagement with a prospect through to a booking.

While the North American enterprise market needs particular attention as we recover our momentum, the service provider business delivers strong quarter due primarily to the continued rollout of our Subscriber Aware Visibility solution within one of the largest North American carriers as well as a number of expansion in service providers around the globe.

The North American carrier that has embraced our complete and comprehensive visibility solution now has lifetime purchases of $100 million and continues to gain both financial and operational advantage from the Gigamon deployment. We believe our relationship with this service provider continues to have a good runway ahead. And although the revenue from this market is classically lumpy and challenging to predict, the fact that one mobile service provider has seen healthy returns from such a large-scale investment in our visibility solution highlights the potential for us in this vertical.

Examining the third initiative, the delivery of innovative technology. While our offering for the public cloud continues to generate increasing interest around the globe, we also realized that a number of visibility deployments and architectures demand extremely high performance and density. To address these requirements and offer our most performance-demanding customers new levels of scale, we announced our top of line GigaVUE-HC3 this month that delivers market-leading and shaping performance. The HC3 offers up to 2.5x more processing and connectivity per rack unit from the HC2 with the pricing providing a very attractive incentive for customers to consider our flagship product.

Over 30 chassis have been quoted to customers since we took the unique step of adding the HC3 to the price list ahead of its launch due to a number of RFPs that require this level of performance. This addition to the portfolio complements our best-selling HC2 chassis and rounds out the HC family that is now comprised of the HC1 for small enterprise or branches, the HC2 that addresses the needs of mid to large enterprise and the HC3 that serves processing and -- serves high processing and connectivity requirements.

We do not expect the HC3 to cannibalize the HC2 as they're targeted at different markets. The HC2 is purpose-built for the 10-gig and 40-gig world and offers a balanced combination of compute and connectivity, whereas the HC3 is built around the new 25-gig and 100-gig network standard and is designed to scale to the exacting requirements of terabit class performance. We expect the HC2 to be the workhorse of the business complemented by the larger HC3 and the lower-end HC1.

We are in active beta field drives for our recently introduced in-line SSL encryption/decryption solution, an offering that is a functional extension to our popular in-line bypass capability that was initially offered at 1 and 10-gigabit space, which are more than adequate to the vast majority of enterprises. We extended this solution to the world of 40-gig networks to enable us to capture higher-speed deployments occurring as part of data center transformation initiatives.

The world of SSL decryption is becoming significantly more complex with the latest encryption standards demanding that any inspection or protection of information flowing into or out of an enterprise be executed in-line. While our in-line SSL solution is expected to be generally available later this quarter, we've seen strong interest and early bookings with a good example being a growing European e-commerce site, a new customer for us, that was looking for full visibility solution with integrated SSL decryption to protect the server infrastructure from encrypted malware, a growing issue for the industry in general.

We are very pleased with the early progress of our in-line SSL solution and are bullish about its potential in the near and medium term. While we recognize that this expansion of our capabilities takes us into an established market with incumbent vendors, we believe our early results demonstrate the Gigamon approach is compelling. With significantly lower complexity, requiring only a single decryption/encryption process to protect an enterprise rather than a sequence of latency-inducing and operationally destabilizing actions and increased efficiency with a fully integrated solution in comparison to current solutions in the market, we are optimistic about the product's potential.

Before handing over to Rex to cover our results in more detail and provide guidance for the second quarter, I'm pleased to announce that Art Coviello joined our Board of Directors this week. Art brings over 2 decades of experience leading RSA as they grew to over $1 billion in revenue and became one of the most recognized and influential pioneers in the cyber security industry. I look forward to working with Art as we continue to lead this exciting market as pervasive visibility becomes the architecture of choice in modern data centers, whether on-premise, hybrid or cloud. Rex?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [4]

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Thank you, Paul. As a reminder, unless otherwise noted, the financial results we're discussing today are non-GAAP and excludes stock-based compensation and related payroll taxes. We reconcile our results to GAAP in both our earnings release and in the supplemental financial presentation we posted on our Investor Relations website today.

As Paul stated, we met or exceeded our Q1 guidance. Revenue was $69.6 million, at the high end of our guidance range, up 4% from last year and seasonally down 18% sequentially. Recall that Q1 of 2016 was a 14-week quarter with the extra week yielding approximately $1.6 million of incremental service revenue and approximately $2.2 million of additional operating expenses.

Product revenue was $44 million, down 1% from last year and down 26% sequentially. Our largest customer, a U.S. service provider, represented 18% of total revenue in the quarter, hitting a lifetime value of approximately $100 million. We estimated $3 million to $4 million of revenue from this customer in our guidance given in January. As Paul mentioned, this customer's requirements are difficult to forecast. Their requirements expanded significantly late in the quarter, backfilling the softness in our North American enterprise business.

Recurring service revenue was $25.6 million, up 13% from last year and unchanged sequentially. Deferred service revenue was down 2% sequentially but up 23% year-on-year to $95.7 million, reflecting growth in the second half of last year and significant service renewal.

The Americas contributed 82% of revenue; EMEA, 12%; and APAC, 5%. Compared to last year's Q1, revenue in the Americas was up 3% and EMEA was up 22%. APAC was down 19%.

First quarter revenue by vertical was 54% enterprise, 32% service provider and 14% federal. Year-on-year, enterprise was down 5% and federal was down 11%. Service provider grew, however, by 33% based on the strong showing by our largest customer and higher contributions from other customers. Sequentially, enterprise was down significantly, specifically in North America, but we expect enterprise to recover well both in dollars and as a percentage of revenue in Q2.

We continue to benefit from strong repeat customer purchase activity. 89% of our Q1 bookings came from repeat customers. To make our top 25 customer list now requires a minimum of $7.2 million lifetime spend, a 31% increase from a year ago. Our top 25's average purchase this quarter was $1.2 million, better than Q4 but lower than 2016 average of $1.35 million and driven in meaningful part by our biggest service provider customer. Top 25 customer participation remains strong with 22 of 25 contributing to Q1.

On the new customer front, we added 84 this quarter, bringing our cumulative customer count to 2,420, up 18% from a year ago. The distribution of the new customers was 68 enterprise, 8 federal and 8 service provider. And the average purchase was $91,000, consistent with last quarter.

Overall, customer participation was also solid at 620 active customers. This total was below our seasonally higher Q4 total of 747 but higher than Qs 1 through 3 of last year.

Gross margin is up slightly year-on-year to 81.9%, at the high end of our expectations with the better mix and improved inventory management.

Q1 operating expenses were $50.3 million, down slightly sequentially as further hiring in Q1 and our annual sales kickoff meeting expenses offset substantially lower commissions versus Q4's typically higher year-end rate. OpEx was up 17% year-on-year, driven by a 39% increase in headcount as we have invested heavily in our business, particularly in R&D and sales and marketing. Expenses were approximately $1.7 million, below the midpoint of our guidance range due primarily to lower commission and bonus accruals and below-forecasted hiring.

Operationally, we added 59 employees during the quarter, approximately 1/2 of those in sales, ending with 743 employees worldwide.

Our DSO was 74 days, down 7 days from Q4 as we collected certain onetime longer payment term receivables from one of our largest customer.

With high end of range of revenue and gross margin and operating expenses below range, EPS came in well above our estimated $0.12 per share though substantially below Q1 of 2016's $0.22 on comparable revenue and margin due to our substantial year-over-year increase in operating investment.

Our balance sheet and cash flow remained healthy with cash plus short-term investments up sequentially $7 million to $265 million.

Looking forward to Q2, as Paul mentioned, we remain focused on the go-to-market elements of our business and on driving sales efficiency towards the stronger second half. Given the relative softness in North American enterprise, we are again giving measured guidance. Accordingly for Q2, we expect revenue to be $69 million to $73 million, below last year's Q2 revenue of $75.1 million. We expect gross margin to remain 81% to 82%.

We're forecasting second quarter operating expenses of $54.5 million to $55.5 million, reflecting a full quarter of additional expenses for Q1 hiring, higher expected variable compensation, timing of marketing spend and the addition of the new facility adjacent to our headquarters. With the 33% non-GAAP tax provision and approximately 41.5 million diluted share count, we expect non-GAAP earnings per share of $0.02 to $0.07.

Though our operating margin will again be substantially below the 23% we posted for 2016, we are committed to our long-term model of 25% to 28%, and therefore, are slowing OpEx increases until we see the expected improvement in our top line in the second half of this year. We plan to update our financial results at our second quarter 2017 conference call currently scheduled for Thursday, July 27, 2017.

With that, I'll turn it back over to Paul.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [5]

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Thanks, Rex. We've made good progress during Q1 as we prosecute the 3 core initiatives I laid out in our prior earnings call: capturing and developing customers, investing in vertical markets and delivering innovative technology. More work is required, and we remain committed to returning to at or above market growth rates by the end of the year.

Our confidence remains high for 3 reasons. First, our focus on go-to-market elements of the business is showing results. And we expect our sales efficiency metrics to recover as our marketing regains momentum under Kim's leadership, our demand generation initiatives deliver results and the 2016 new hires in sales reach their 9 and 12-month productivity milestones. Second, the expansion of our portfolio into the world of in-line SSL, cloud-based visibility and market-leading performance visibility nodes is showing early signs of good traction. And third and probably the most significant, visibility into data in motion is an increasingly strategic consideration by large enterprises around the globe. We are seeing several large RFPs for visibility solutions are engaged in many medium and long-term planning discussions with Fortune 100 customers regarding their visibility needs into the future.

As a case in point, according to Gartner's Adaptive Security Architecture presented at the recent Data Center Conference in December, continuous visibility is at the core of security. Gigamon is the world's leading visibility company, and we believe our solution is essential in the design of a detection, response, prevention and prediction security framework for modern on-premise, hybrid and cloud infrastructure. The market increasingly understands the need and value of visibility. As the proven and recognized market leader, we are the front and center to capture this wave of investment.

With that, I'll ask Bethany to open the call up for questions. Bethany?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we will take our first question from Alex Henderson of Needham.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [2]

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So I guess the first question I'd ask you here is, can you talk a little bit about linearity in the quarter relative to the non-service provider piece? Did you see evidence that your enterprise business was starting to snap back in March? Or is this something that you really have seen a little or no improvement on that piece of it? What gives you such confidence that you're going to get that enterprise piece kicking back in? And does the service provider deal diminish your opportunity for that customer as there is an absorption period over the next couple of quarters?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [3]

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Alex, good questions. So the linearity in the quarter was reasonably normal compared to the recent quarters. However, the amount of interest that we're seeing in the portfolio, I've kind of laid it out in the prepared remarks regarding the cloud, but also in the new products, is definitely starting to pick up steam. And so we're seeing a good activity level around the enterprise space and good diligence by our sales leadership to kind of stay focused and stay in control of the forecast that they provided to us to help in the consideration of guidance for Q2. So I'm remaining cautiously optimistic regarding the enterprise, the speed of the enterprise recovery, but there certainly are early signs out there. Regarding the service provider deal, your point is well made. It was larger than we contemplated. And as we all know, that vertical is very lumpy. But the likelihood of us picking up a similarly sized transaction in the second quarter is clearly a lot smaller. But we do still expect that account to be an ongoing and an active purchase. So we have just started on a 100-gig initiative with them. In fact, this was the first real order of substance around 100 gig. We are starting to get more in detailed conversations with them regarding the NFV architecture. So this service provider, in its own right, still is a very active and ongoing customer with a good runway ahead.

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [4]

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And obviously, we also have a meaningfully improved pipeline from an enterprise perspective as we look into Q2. So I wouldn't say it was -- yes, go ahead.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [5]

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So is the timing of the HC3 launch having any impact on the timing of the -- pulling down these orders?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [6]

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You mean that service provider order?

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [7]

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No, no. In general, your HC3 launch, is that having an impact on your enterprise timing of bringing in customers?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [8]

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So I mentioned on the call that we've got 30 of them already in the pipeline with the product that's still not even GA. And so that's an indication of some of the early signs and early momentum. And as Rex said, that's given us more opportunity to build the pipeline, particularly in the enterprise space going into Q2.

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Operator [9]

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(Operator Instructions) And we will take our next question from Kulbinder Garcha of Crédit Suisse.

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Kulbinder S. Garcha, Crédit Suisse AG, Research Division - MD [10]

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I guess for Paul, in terms of -- it sounds like with the transition in sales leadership as well, there's lots of moving parts in terms of even returning to an accelerated revenue growth in the second half of the year while getting you close to market rate maybe as we exit this year. Can you speak about what's changing in Gigamon to actually make sure that happens? There's obviously weakness in Q1 and that was obviously North American weakness. And then we've had the service provider lumpiness that probably impacted Q2. I get that. I was trying to think about the confidence visibility you have about returning to growth. Or could that even be pushed out? Because I'm assuming you had sales that would come in and there will be a different round of promotions, incentives and that kind of thing. Could this actually take a realistic 6 to 9 months, do you think?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [11]

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Kulbinder, I said at the end of the prepared remarks, I think, I was -- I did specifically talk about the fact that we remain committed and firm believers that we will exit this calendar -- this fiscal year at or above market growth rate. So we remain committed to that. Yes, there is -- from the outside, that looked like a significant amount in change but there is also a significant amount that is stable. We have a demand generation engine that we're working on activity for the last 9 months. And that, as I say, has generated double the number of appointments this quarter than we saw in the year-ago period. We've had the number of the R&D projects that we're just talking about now have been in flight projects for the last 12 months. We've had a lot of brand development activities that still continue to roll. We have a number of initiatives around our marketing space that you're going to see rolling out over the course of the next few weeks here. And I could carry on with a range of initiatives that have still -- still have significant legs inside of the company. And they're not short-term initiatives and they're starting to generate returns. Certainly the change in sales leadership could be disruptive, but Helmut will be remaining on to ensure that we go through a smooth and progressive migration to the new leader. And Kim's arrival is very timely insofar as she's now picked up a team that's got the pace and the cadence behind it and she's now going to inspire greater focus around the demand and the brand activities. So I remain confident that we are looking at exiting this year at or above market rates. That's what we predicted and suggested at the end of the last call.

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Operator [12]

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And we will take our next question from Jason Ader of William Blair.

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Jason Noah Ader, William Blair & Company L.L.C., Research Division - Partner, Co-Group Head of Technology, Media, and Communications [13]

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On the go-to-market side, Paul, what are some of the changes you're planning to implement? Because one of the points of feedback we heard from security of ours is that they love your product but they're having trouble selling it because it lengthens the sales cycles that they have for various security tools.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [14]

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So we've got a -- I saw that report, Jason. And that we've got a number of initiatives with the largest security vendors to help streamline that selling process, not least of which is to get customer use cases and testimonials out in front of the question because that ultimately -- another customer having been down the same path to make a significant difference to the speed and pace of a further transaction. So we're working with security vendors. We are coming together, as I say, with strong use cases. And we're focusing primarily on a subset of the vendors that we've got because there are nearly 60-plus that work with us and we're spending more time with a few. And if you -- going back to my prepared remarks, I spoke about RSA is just one example of a couple that are being really great traction with us and are bringing us in on a number of their transactions. So once they get past the initial introduction and education, a number of the security vendors see value and see a significant opportunity in bringing us into transactions.

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Jason Noah Ader, William Blair & Company L.L.C., Research Division - Partner, Co-Group Head of Technology, Media, and Communications [15]

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Okay. And as you reflect on the last several quarters and kind of what went wrong, especially this quarter, I mean, the enterprise side, it looks like it missed by something like $7 million. So that's pretty big miss, certainly well below what you expected. What do you think the -- in your view, what do you think the real problem has been -- or problems have been in the enterprise side?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [16]

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I think there's a few. Certainly, there are some macro changes in the enterprise world. People are thinking about security in a different way to the way they thought about it a year ago. And security is not something that is no longer required. It's something that requires a much more thoughtful architecture and implementation. Rather than just in somewhat of a tactical deployment mode, they're moving to much more of a strategic and a thoughtful way of rolling it out. So that's the first transition that, I believe, has occurred over the course of the last 12 months. The second one is the cloud is gaining more relevancy inside of large enterprises, which is part of the reason why I believe we've seen such a faster-than-expected uptake in proof of concept around AWS solution. Now we haven't seen many of them translate yet into revenue, but we have strong hope that a number will given the volume of them, which far -- as I say, far exceeds that, that we thought was going be the case at this point in the process. The second thing is some micro changes. I think our marketing has missed in certain areas in maintaining a pace and a cadence with demand-generating activities. And that's one of the reasons why Kim joined us, to be able to get to a much more common beat and rolling thunder with regards to our story and our message for The Street regarding the value proposition of the Visibility Fabric.

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Operator [17]

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And we will take our next question from Erik Suppiger of JMP.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD and Senior Research Analyst [18]

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Yes. So first off, can you just discuss a little bit around what we might expect in the second half of the year in terms of ramping back to a normal market growth rate? Would you expect a larger step-up from Q2 to Q3 or a larger step-up from Q3 to Q4? And then secondly, your new customer adds in the quarter were flat with the year-ago quarter. Do you think that we will start to see that pick up? We saw a nice result in Q4. Will we see that number start growing year-over-year as you get the HC1 out in the market?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [19]

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So Erik, this is Rex on your first part of your question, and then I'll have -- I'll toss it back to Paul for the second part. If you look at the comments that Paul made earlier regarding what would Q2 look like if you put the T-Mobile order that we thought would be probably incremental $7 million, $8 million. We thought it would be in Q2 when we gave guidance in the last call. The glide path comment that we made "You have a very different looking Q2 and so the step-up to Q3 wouldn't be quite as serious." what that means, of course, is that the underlying business, other than the large order, is still there and we think healthy. So we look at consensus today and think that, that is still a very reasonable outcome for us for 2017, maybe a little higher gross margin, a little lower operating expenses. But the revenue looks very achievable, and that's the goal that we're driving to.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [20]

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And then turning to the second part of your question there, Erik, regarding the new customer velocity in the second half. You're right, the HC1 is certainly one catalyst. There are others. AWS is proving to be an interesting catalyst. A number of new accounts that it's bringing to proof of concept is exceeding where we thought it was going to be. We also had -- not to forget, in Q1, we had our first North American Partner Conference. So we had 600 and something attendees in one room listening to the Gigamon story and listening to the latest products and the latest launches. And I believe that's going to start to show fruit as we go through the course of this year. And we're seeing a number of our new products, SSL being another example that is what is part of the overall Gigamon visibility story. It's also a discrete product and interestingly finding some of our new sales guys that have been with us for a couple of months, a couple of quarters are embracing that as being an interesting opening for new customer opportunities. And so in areas where we've had new sales guys joined, a few months after they joined, you tend to see this spike in either AWS or SSL opportunities because they take these new products into new customers and create new opportunities. So I'm pretty optimistic that we're going to start to see an increasing velocity of new customer adds. But I would just -- for all callers, just a reminder, we are a very conservative counter of a definition of new customer, have been since inception of the company. And so we count very, very carefully. And it's, to some degree, overly conservative. But we decided to stay true to our same counter-mechanism. Hence, the numbers would seem lower that some others may report. But the fact is we're still making, I believe, good progress.

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Operator [21]

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And our next question comes from Patrick Newton of Stifel.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [22]

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I guess 2 clarifications. One is -- I'm sorry if I missed this, but what was the backlog in the quarter? And then you've also spoken to getting back towards industry growth or at or above industry growth. What is your view of the rate of industry growth?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [23]

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So on the backlog, we obviously have reported that at our 10-K, Patrick, but we've not been giving out backlog on a quarterly basis.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [24]

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And as we talk about industry growth rate, we've always used the number somewhere between 20% and 25% as being the industry that's independently reporting. So we're using that as our guiding benchmark. But as kind of Rex pointed out to, I think, the prior question, our focus is still around -- to achieve that objective and consensus is a pretty good indicator of how we're thinking.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [25]

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Great. And then I guess, Paul, you talked a lot about new initiatives, customers, sales breadth and just change you're making in general. But I guess given the results, if we were focus on your current business at your largest customers, specifically in your enterprise segment, can you walk us through what's happening there? And there is some concern that there's a saturation effect with some of those customers that might be negatively impacting growth and if you have any comments on that.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [26]

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Yes. I've heard that comment as well, Patrick. But I -- it's not something that I think is supported by fact. If you look at our largest customers, our top 25 customers, about 1/2 of those are enterprise customers and they have been for many, many years. And this quarter, we had 22 out of 25 of the purchase from us, which is very much in the range around the normal. It's somewhere between 21 and 24 that purchase from us every quarter. And so it's still a very normalized number of our largest customers purchasing from us. We still see -- and we've run a good degree of analytics regarding from a first time purchase what's the repeat purchase multiple, what's the repeat nature of that customer. And we do tend to see, from a first purchase, customers coming back within 9 months for a second purchase. It's not atypical, and it's something that isn't dramatically changing or shifting in our business. So we still have a good degree of business with existing customers as well as the now 84 new customers we added in the quarter.

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [27]

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I guess maybe to ask that differently, instead of 22 out of 25 purchasing from the company, if we were to eliminate your largest customer in the quarter, is there any way to help us understand how the rest of your 24 largest customers fared year-over-year and if they were at, above or below your overall growth rate?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [28]

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Is there any way? I'm sure there is. Hang on for 1 second. The average revenue from the top -- someone help me, top 25 customers...

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [29]

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$1.2 million.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [30]

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Yes, $1.2 million. Thank you. Perfect. $1.2 million. So from the top 25 customers, it is $1.2 million on average in the quarter. And if you look back over the whole of last year, it's floated between at the high end -- at the low end $1 million and at the high end $1.7 million. So it's very much in the same range.

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [31]

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Patrick, (inaudible) ours, but once you back out the large service provider, that will take out 12, and then you just do the math, right?

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Patrick M. Newton, Stifel, Nicolaus & Company, Incorporated, Research Division - VP and Senior Analyst [32]

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Yes, I can back into that. Just one more, if I may. You're talking a lot about the AWS product and the interest. Can you just help us understand the revenue potential from this product and perhaps how this layers into your expectation for accelerated growth in the back half of the year?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [33]

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So when we announced the product in November last year, we set the expectation that we have no real aspirations for any major revenue activity from it in the course of 2017. Anything that comes in is really going to be incremental. What does come in as incremental, just as a reminder for The Street, is going to be subscription based. So it's going to be recognized rapidly. But we don't have -- we don't have much expectation for what it could do, Patrick. But that said, the velocity and interest we're seeing in the proof of concepts and evaluations, it's higher and it's faster than we contemplated. So certainly, it could become an interesting tailwind that kind of lifts us as we go into the fourth quarter. But at the moment, the planning assumes very, very little from it this year. Different next year but certainly not much this year.

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Operator [34]

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(Operator Instructions) And we will take our next question from Catharine Trebnick of Dougherty & Company.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [35]

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My question has to do on 2 things. One, the competitive landscape. How did that show on the enterprise? Was that part of the weakness there? Or was that more execution? And just give us more color on that. And the second part of the question is you did describe something with AWS in the government arena. And what -- can you talk a little bit about that product and timing?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [36]

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Got it. Certainly can, Catharine. So competition is certainly out there, and I would suggest over the course of the last 12 months, competition has probably got more focused around this pace. This is an exciting market. It's a fast-growing market and it's a healthy market. And so it's going to be competitive, nature of the business. And we're certainly seeing some competitors become a little bit more aggressive in the space over the course of the last 6 to 9 months and certainly over the last quarter as well. Nothing that we have seen our win rates change from. Nothing that's driven us to be exceptional in discounting, but there are certainly competitors that are out there. And to your question about did they affect the enterprise, potentially, I don't -- I didn't see the win rate change in the enterprise space significantly, meaning it may not have affected our overall result but it may have affected the delay or the timing of some transactions as customers think about competitive alternatives as well as Gigamon. But yet again, our win rates don't fundamentally change. The second question you came out with was the federal AWS solution. It's referred to as GovCloud, and it's a specific implementation of -- or a segment of the AWS cloud that's focused on the federal government. At the moment, we have a number of trials on products going across our federal agencies and departments. And they're looking for platform support into GovCloud, which we are going to ship around summer months here that will be able to address to that market opportunity as we go into the big quarter for federal in Q3.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [37]

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Okay. And just one another back to competitive, was there any impact with Ixia or Brocade? Do you see any change there? In Arista, we've noticed they've been challenged and a little bit more aggressive with their DANZ product. So just a little bit more color on the Ixia, Brocade, if you've seen any possibility of maybe better wins with them, one being acquired or not?

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Paul A. Hooper, Gigamon Inc. - CEO and Director [38]

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So Brocade and Ixia and Arista. So Brocade, we have -- we hardly ever see competitively. I'll go far as to say almost never. Ixia, whilst they are going through their acquisition steps, we've certainly seen a change in their momentum and their interest around this market space and not too surprisingly. And so we've seen a little bit more noise out of Ixia. Arista, we continue to see in some transactions, I wouldn't say any more frequently than we have done probably a year ago, although we still do compete with them in certain transactions.

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Operator [39]

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And we will take another question from Simon Leopold of Raymond James.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [40]

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Quickly you run through the guidance for the next quarter again. I wasn't sure if I wrote this down correctly. I may have a question, if I did, but if you could just walk us through the assumptions on the quarterly guidance again.

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [41]

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Sure. Happy to do that. So revenue range is $69 million to $73 million. Gross margin, consistent with Q1 at 81% to 82%. OpEx, higher than Q1 at $54.5 million to $55.5 million. And happy to give you reasons for that if you want to go into that. And an EPS range of $0.02 to $0.07 on a diluted share count assumption of 41.5 million.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [42]

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Okay. So I did write it down correctly. So yes, I did want to then follow up exactly on that OpEx jump to make sure we understood what was driving what is, I guess, unusually large rise in expenses, especially relative to sales. And while you're doing that, if you could also clarify why the share count is going up a pretty big jump. I'm guessing it's a annual awards or something like that. But if you could just elaborate on those. And then I have a question.

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [43]

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Okay. So the OpEx is moving up Q1 to Q2 primarily due to personnel expenses as you get full 90 days in Q2 of the hiring than you did in Q1. So that's the #1 driver and with that comes additional bonus for the additional people, and we expect a slightly higher bonus accrual in Q2. In order to generate the revenue range that we've given, bookings will need to be higher. So that drives higher commissions as well. We also have in that a building that was taken down -- sorry, leased adjacent to our headquarters here in Santa Clara that brings in about $500,000 to $600,000 additional expense for the quarter. And then there are things like travel that go along when you actually have more people. So it's a combination of things, those being the main ones.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [44]

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And the jump in share count?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [45]

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The jump in share count, Q1 is a place where we have annual grants. Annual refresh grants typically vest in the first quarter, a year later, and do so thereafter on a time base or performance basis. So that's one contributor. The other contributor is ASC 2006. Please don't ask me to give a dissertation on that. But that has the impact -- that has the impact of increasing your share count as well.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [46]

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Great. Now what I wanted to get back to is something that, Paul, we spoke about a couple of months ago, was the idea that the relationship with AWS could serve as a marketing tool. I'm wondering if you've got any metrics or references in terms of your positioning on the menu with AWS as a lead generator for helping you generate hardware appliance sales, if there's some metrics in terms of that kind of progress that you could offer or longer-term thoughts about thinking about the AWS relationship as a marketing tool.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [47]

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The answer to the question is yes, we absolutely see that to be the case. I don't have hard metrics at the moment because as I mentioned on the call, the uptake in proof of concept has actually been higher and faster than we expected. And we're still waiting some of these transactions to close. But what we have seen, and I spoke about one of the customers on the call, started out with an AWS proof of concept and it's now going to translate into an order for our physical appliances. And I don't think that's particularly atypical. Put differently -- sorry, too many negatives. So let me rephrase that and say I think that's going to become a little bit more of the norm. A number of our customers -- a number of new customers to us have started out with the conversation around AWS and have pretty quickly segued into a hybrid deployment, in other words buying physical components at the same time. Now by the time we get to this time next quarter or this time in 6 months, we'll have some more close rate details around those AWS deals and be able to plot those that pulled in hardware, those that led hardware and those that hardware followed. But I'm still reasonably convinced that very few of the deals and the proof of concepts that we have in flight today are going to be pure-play AWS. I think the vast majority are going to be hybrid. So there's is going to be an opportunity pull product through with the same time, which is really our expectation and hope of that AWS launch.

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Operator [48]

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And our final question for today comes from Alex Henderson of Needham.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [49]

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Sneaking under the wire for another one. Just wanted to clarify your prior comment about feeling that you can drive to the current consensus estimates. I assume that you're referring to $92 million in 3Q and $103 million in 4Q, which is the consensus on FactSet. Is that an accurate number?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [50]

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That is directionally accurate. We're obviously not giving specific guidance with the number attached to it, but we think the shape of the year that consensus has determined looks appropriate.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [51]

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Second, if you could help us out a little bit with that significant increase in spending. Is that $0.5 million for the building in the G&A line? And then is the bulk of the rest of it in the sales and marketing? Or are you stepping up substantially in R&D? How do we allocate those a little bit? That would be particularly helpful.

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [52]

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Yes. So as I said in the prepared remarks, most of our investments has gone into sales and marketing and R&D. For example, half the headcount a"Digital Dividend" spectrum in Q1 were in sales. So I would shade it heavily towards those 2 operations and I would keep G&A at a much, much lower rate of increase.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [53]

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But the building goes into G&A or no?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [54]

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The building gets allocated. It gets allocated. But it will be allocated mostly in G&A. So I will probably put it in there with a little piece going to sales and marketing. But the lion's share is G&A.

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Alexander B. Henderson, Needham & Company, LLC, Research Division - Senior Analyst of Networking and Security Technology [55]

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The other question I had again on the modeling front. Your guidance and your result in gross margins in 1Q at 81.9-ish kind of level, 82, is down quite a bit from where you were in the back half last year. And I was wondering if you could talk a little bit about what the pings and pongs are on that? And then going back to the question of global competition, there was some chatter about the Big Switch taking some business from your -- taking a customer from you. Can you talk to whether you've lost any business to Big Switch and whether that's something that's altered the competitive landscape in any way and if it's impacting pricing or any of those type of variables?

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Rex S. Jackson, Gigamon Inc. - CFO and Principal Accounting Officer [56]

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So on the gross margin question, and I'll apologize in advance for not recalling the details and specifics, but both Q3 and Q4 of last year, which is what you're referring to, I believe, we got up into the -- another -- a point or 2 of the guidance -- the actual rate of Q1 and the guidance for Q2. There were some onetimers in there, and also, mix is always the factor. But there were some onetimers that we called out and said we did a little better than we normally would because of these. And so I think our model obviously is 80-plus. We had a couple of quarters where were thinking 81 to 82. I think that's a very good operating assumption in the near term. Clearly, if we look further out, as we continue to move a lot more smart licenses at the top of our solution, a good bit more AWS kicks in, I think there will be some northward movement on the gross margin. But I'll keep it at 81 to 82 for now. I think that's a sustainable number.

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Paul A. Hooper, Gigamon Inc. - CEO and Director [57]

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Got it. And the second question was regarding Big Switch and are we losing any transactions. Big Switch has been around for a period of time, but we do still see them as a fast follower. I mean, we have the leading next-generation infrastructure for the visibility world. And as much as they aspire to copy us, we have led with the first one with an SDN solution, the first one with an AWS solution, the first one with high-capacity nodes. And so customers that are exacting and demanding of visibility solutions certainly come our way. We have seen some, what I would call, commodity guys where Big Switch has been a competition in those transactions for us. We've also seen deals where Big Switch may be in the account we've come in and replaced them because scale and performance isn't necessary their strong suit. So we do see an amount there. I wouldn't say -- that's probably -- they're more pleasant than they were purely because of the number of sales guys they've got. But I wouldn't see them from a technology perspective anything more competitive than they were a year ago and actually, in fact, probably less given our in-line capabilities, AWS capabilities and the high performance of the HC3.

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Operator [58]

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And this does conclude today's question-and-answer session. I would like to turn the call back over to Ms. Gianola for any closing additional remarks.

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Jennifer Gianola, [59]

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Okay. Well, thank you very much, everyone, for joining the call today. We look forward to speaking to you again on our next earnings call in July. Thank you.

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Operator [60]

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And ladies and gentlemen, this does conclude today's conference. We thank you all for your participation. You may now disconnect.