Cisco Systems' CEO Discusses F3Q13 Results - Earnings Call Transcript

Seeking Alpha

Cisco Systems, Inc. (CSCO)

F3Q13 Earnings Conference Call

May 15, 2013 4:30 pm ET

Executives

Melissa Selcher – Senior Director, Analyst and Investor Relations

John T. Chambers – Chairman and Chief Executive Officer

Frank Calderoni – Executive Vice President and Chief Financial Officer

Gary Moore – President and Chief Operating Officer

Robert Lloyd – President, Development and Sales

Analysts

Ittai Kidron – Oppenheimer

Mark Sue – RBC Capital Markets

Simona Kiritsov Jankowski – Goldman, Sachs & Co.

Jess L. Lubert – Wells Fargo Securities, LLC

Tal Liani – Bank of America Merrill Lynch

Brian Marshall – ISI Group

Ben Reitzes – Barclays Capital

Brent Bracelin – Pacific Crest Securities, Inc.

Brian Modoff – Deutsche Bank Research

Ehud Gelblum – Morgan Stanley

Amitabh Passi – UBS

Brian White – Topeka Capital Markets

Presentation

Operator

Welcome to Cisco Systems’ Third Quarter and Fiscal Year 2013 Financial Results Conference Call. At the request of Cisco Systems, today’s call is being recorded. If you have any objections, you may disconnect.

Now, I’ll like to introduce Melissa Selcher, Senior Director, Analyst and Investor Relations. Ma’am, you may begin.

Melissa Selcher

Thank you. Good afternoon, everyone, and welcome to our 93rd quarterly conference call. This is Melissa Selcher and I am joined by John Chambers, our Chairman and Chief Executive Officer; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, President of Development and Sales; and Gary Moore, President and Chief Operating Officer. I would like to remind you that we have a corresponding webcast with slides on our website in the Investor Relations section.

Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements and other financial information can also be found on the Investor Relations website. Click on the Financial Reporting section of the website to access these documents.

Throughout this call, we will be referencing both GAAP and non-GAAP financial results. The matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that we discuss in detail on our documents filed with the SEC, specifically the most recent reports on Form 10-Q and 10-K and any applicable amendments, which we identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

Unauthorized recording of this conference call is not permitted. All comparisons throughout this call will be on a year-over-year basis unless stated otherwise. I will now turn it over to John for his commentary on the quarter.

John T. Chambers

Mel, thank you, very much. We are pleased to announce another very solid record quarter. We delivered our ninth consecutive quarter of record revenue. We also delivered record non-GAAP operating income and record non-GAAP net income. Our solid results in Q3 are the proof points of the effectiveness of our vision, strategy, differentiated value proposition and continued execution even with a challenging global macro backdrop.

Specifically, in the opening comments, I would like to focus on the following five key takeaways from Q3. First, we are executing very well and continue to consistently deliver to hit or exceed expectations. In addition to driving both top line and bottom line growth, gross margins continue to be stable and operating margins are strong. Bottom line, we again did what we said we would do.

Second, we are well positioned in the major technology global growth markets in the industry. Our cloud data center revenue growth was up 77%, wireless was up 27%, and SP Wi-Fi up well over a 100%, and SP Video was up 30%. We’re continuing to deliver game changing innovations like UCS, Unified Access, Videoscape Unity, the Internet of Everything and Self Optimizing networks to drive the technology transitions and transform markets.

Third, we saw continued improvements from a total geographic perspective with total product year-over-year order growth of 4% following two quarters of flat growth. Also, for the first time in six quarters, we delivered positive growth across all four customer segments; those segments being Enterprise, Commercial, SP and Public Sector.

The most important takeaway, however, for me in the quarter was the performance in the U.S. and emerging countries. In the U.S. our commercial business was up 13%, U.S. enterprise was up 10%, U.S. service provider was up 10% and U.S. public sector up 5% in terms of orders.

Emerging countries also saw a strong double-digit growth of 13% year-over-year. And remember in Q2, the last quarter, we reported the growth in emerging countries, which is 6%. While we like the trend, we are managing the business to account for a continued slow steady recovery on a global basis.

Fourth, we generated $3.1 billion in operating cash flow and returned to our shareholders $1.8 billion in share buyback and dividends. And fifth, we articulated our strategy in value proposition to deliver a new model for IT, where customers are embracing our unique ability to drive an open systems approach to greater networking automation, optimization and programmability. With the role the network plays at the center of every transition, we believe we are uniquely positioned to help our customers manage through and capitalize on the opportunities ahead and in so doing, meet our goal of becoming the number one IT Company.

In every quarter, there are always areas of our business that outperform and some that underperform. We continue to demonstrate again in this quarter the consistent strength of our portfolio approach, our discipline, our innovation and our execution.

To provide some additional details from a financial perspective, Frank if you’ll go next on this, I’ll come back and then talk about what we’re seeing in more detail from a product perspective and geographic and some interesting trends. You’ll come back Frank, if it’s okay and do the guidance. I’ll provide some summary comments and then we’ll do what we enjoy most which is the Q&A.

So Frank, over to you.

Frank Calderoni

Thank you, John. So we had a solid quarter despite difficult macroeconomic environment. Our strategy is working; we are growing profits faster than revenue and increasing shareholder value remains our top priority. We have stronger operational discipline and a more focused portfolio. Our total revenue growth was 5% and non-GAAP EPS was $0.51 per share. We grew profits faster than revenue six straight quarters as measured through earnings per share.

In this quarter, we completed the divestiture of Linksys, continued our NDS integration, announced two more acquisitions in software and cloud, and closed two others in network software and security all in line with delivering top-line growth, profitability and balancing our portfolio. In terms of our business momentum, we saw product revenue growth of 5% with total product book-to-bill of approximately 1%. Our services revenue grew 7% driven by our strategy of solutions led selling. There are a couple of reasons for the slow growth this quarter.

First, Q3 FY12 was a very strong quarter for services with 13% revenue growth including revenue recognition of several large multi-year deals that were in Asia-Pacific. Second, our services revenue growth is lower following slower product order growth over the last few quarters. As we discussed at our Financial Analyst Conference, our model for services revenue growth is 9% to 11% CAGR over the next three years to five years.

As I mentioned, we announced two acquisitions during the quarter including Ubiquisys, a leading provider of intelligent 3G and LTE small-cell technologies and SolveDirect, which provides cloud delivered services, managed integration software and services. Both of these acquisitions as well as our divestiture meet our business objective to increase growth and innovation while positioning us to provide the optimum return for our shareholders.

We continue to make solid progress with our operational excellence initiatives on both growth and operating margins. We saw very good leverage in our profitability model this quarter with strong non-GAAP operating margins of 28.2%, which was at the high end of our long-term financial model.

In Q3, our total non-GAAP gross margin was 63.0% compared to 62.3% last quarter and 63.1% a year ago. Our non-GAAP product gross margin was 62.1% compared to 60.9% last quarter and 62% a year ago. We continue to see consistency and stability in our product gross margin. We also saw good gross margin stability across our individual product areas. Our non-GAAP service gross margin was 66.5% compared to 67.6% last quarter and 61.1% in Q3 FY12.

We continue to manage our overall business as a portfolio, both in terms of top line growth as well as profitability. So an example was, this quarter, we concentrated our set top box sales in the most profitable business opportunities and we chose not to participate in non-strategic and non-profitable deals. We plan to continue this discipline as we move forward. We saw stability and consistency in total gross margins by geography with the Americas at 62.6%; EMEA at 65.3%; and APJC at 61.1% as well as from a product area perspective.

Our non-GAAP operating expenses were $4.3 billion or 34.8% as a percentage of revenue and that compares to 34.5% in Q3 of FY12. Our head count investments of 675 are specifically related to our acquisitions as well as investments in our engineering as well as our services business. We expect our strategic investments in these areas to drive profitable growth over the long term.

Our non-GAAP tax provision rate was 21% which was consistent with our expectations. And our non-GAAP net income was $2.7 billion representing an increase of 5% year-on-year. As a percentage of revenue, non-GAAP net income was 22.3%. And as I mentioned earlier, our non-GAAP earnings per share on a fully diluted basis was $0.51 and this is versus $0.48 in the third quarter of fiscal year 2012 which was a 6% increase.

Our GAAP net income was $2.5 billion, representing an increase of 14%, as compared to $2.2 billion in the third quarter of fiscal year 2012. Our GAAP earnings per share on a fully diluted basis was $0.46 versus $0.40 in the same quarter of fiscal year 2012, which represents a 15% year-on-year increase. We are committed to our capital allocation strategy as we demonstrated by the announcement this quarter of a $0.17 per share quarterly dividend and this was an increase of $0.03 per share or 21%.

Our consistent execution and strong financial position enables us to provide a greater dividend yield level to our shareholders. During the quarter, we returned $1.8 billion to our shareholders which included $860 million through our share repurchase as well as $905 million through our quarterly dividends. Our total cash, cash equivalents and the investments were $47.4 billion, that’s including $7.9 billion available in the U.S. at the end of the quarter. And our cash flow from operations, as John mentioned earlier, was $3.1 billion and this was up 4%.

In terms of our key balance sheet metrics, DSO or days sales outstanding was 37 days reflecting a greater proportion of shipments in April than early in the quarter. And we continued strong and consistent collection throughout the quarter. Our non-GAAP inventory turns were a very strong 11.9%. Overall, our long-term financial strategy is performing as expected and we continue to deliver innovative solutions to our customers. We have the right discipline, focus and rigor and we’re going to continue to make strategic investments and emphasize our commitment to shareholder returns.

John, I will turn it back over to you.

John T. Chambers

Thank you very much, Frank, a nice job. I will now provide some additional detail on the performance and trends we are seeing in our business and in the market. I’ll first walk through our product portfolio in terms of year-over-year revenue growth, followed by discussing geographic and customer segments in terms of orders.

First in networking, we continue to drive industry leading innovations across our core switching, routing and wireless businesses. With continued challenges in Europe and global public sector, we did see switching revenues decrease 2% this quarter. But in the data center, we saw continued strength in our Nexus switching product line with double-digit growth of approximately 12% year-over-year. And in the campus, we saw good customer adoption and growth on our fully converged wired and wireless Catalyst 3850 platform.

We see demand for faster speed ports driving switching upgrades, cycles and in Q3 shipped a record number of 10 gig ports growing 35% year-over-year. We do see budget shifting from wireline to wireless benefiting our wireless business, which delivered another strong quarter of record revenue growth, up 27% year-over-year.

While our competitors have stumbled in this market, we experienced strong growth across the board. SP Wi-Fi growth continued to be extremely strong with triple-digit growth and our recently refreshed wireless LAN portfolio grew at 17%. Our Meraki integration continues to go well and we continue to take share in this market.

Our NGN routing strategy remains solid with our architectural approach and strength in mobility providing differentiated long-term value. In this quarter, total revenue for NGN routing was flat year-over-year. Strong momentum in our ASR 5000 family in SP mobility with record revenues up 60% at the edge. And at the edge from a fixed perspective, our ASR 9000 revenues were up over 40% and this was offset by declines in our core CRS platform.

We do see SP CapEx spending continuing to be challenged, but we believe we are gaining more than our fair share with the alignment of our product portfolio, architectural approach and innovation capabilities with the priorities matching our capabilities to the priorities of our customers. During the quarter, we provide additional detail on our strategy to deliver a new model for IT, helping our customers move beyond the hype of software defined networks or SDN to a much more complete solution for networks programmability and orchestration.

We now have over 50 customers in beta with our Cisco ONE API agents and controller and announced our leadership in the open daylight project, a community led, open, industry-supported framework to create a transparent approach to SDN. Customers are telling us that they strongly prefer the breadth and openness of Cisco’s approach and ability to build upon existing network investments and run across hybrid environments as only Cisco can deliver. We feel very confident in our leadership position in this market.

Moving on to data center and the could, our data center traction is truly impressive with growth of 77% and continued market share gains. As we execute on our unified data center strategy, we are seeing our UCS plus Nexus business now on a combined run rate of approximately $5.5 billion annually, growing over 35% year-over-year.

Integrated solutions such as FlexPod with NetApps and Vblock through VCE are driving significant demand for UCS and the UCS is becoming a preferred and strategic platform across all segments and geographies around the world. Our leadership in the data center, wired and wireless networking and our architectural approach is enabling us to be the trusted partner for many customers as they optimize their business for a world of many clouds.

Moving onto video, total SP video grew 30% driven largely by NDS. The NDS integration continues to go well and Videoscape Unity is seeing continued traction. This quarter, we announced two new European service providers for Videoscape and received the Future of Video Award for Innovation.

Moving onto collaboration, we continue to improve on our collaboration execution. While revenue was down 1% when we normalize for underlying server revenue which is now reported in the data center making a more accurate comparison to what we’ve seen in prior years the business was up 2%. Rowan, we like what we’re seeing there and really excited about our plans for the next one year to two years here.

We saw continued strength in conferencing, up 11% due to momentum and enterprise, offset by softness in TelePresence which was down 6%. Collaboration unit announced and delivered tight integration across TelePresence and WebEx further simplifying and aligning its focus of growing a larger mix of software, which is now approximately half of the total business of our collaboration group.

Moving onto security, we saw a decline of 4% with weakness in content security, balanced in part by [relative] stability and network security. The continued shift of security business to term based software licensing does have a short-term impact on year-over-year revenue growth. Order growth for enterprise licensing agreements, identity service engine, and cloud web security continued to outpace overall business.

Finally, our services business continues to be a crucial component of our strategy to become the number one IT Company. Together with our partners, we are winning large multiyear service deals as our customers ask us to partner with them to meet their business goals. We see near-term opportunities that leverage our solid $180 billion customer install base and longer-term opportunities around new consumption models and markets.

In summary, we continue to focus on market transitions and customer priorities to drive our innovation and focus. We see new business and consumption models coming into the market with increased pace. And we are very focused on how we remain cognizant of the risk, capitalize on the opportunities, and adapt a change faster than our peers to support our customers as their business opportunities and requirements also evolve at this pace.

I will now move on to provide some color on our geographic and customer segments. The following geographic and customer segment growth rates are in terms of year-over-year product orders unless specifically stated otherwise. In Q3, Cisco’s total product orders returned to growth up 4% year-over-year.

Looking at the numbers from a geographic perspective, the Americas region grew 7%. As we said earlier, we saw very strong balance across enterprise, commercial, service provider and even public sector. U.S. public sector grew 5% in the quarter with state, local and education growing 13% and U.S. Federal declining 3%. As we have said before, we believe this balanced approach to growth is a positive signal for the U.S. economy going forward.

The Asia-Pacific, Japan and China region grew orders 1%. We have over the last several years seen tremendous growth in Japan. And last year, fiscal year 2012, there was growth year-over-year of 30%. This has created some tough comparisons. We also continue to see challenges in China, largely Cisco specific, relating to the business environment. We do believe we are making progress, although we expect these challenges in China to last for several more quarters.

Our Europe, Middle East, Africa and Russia region continues to show improvement flat in Q3 following a decline of 6% in Q2. We still see pressure in the southern part of Europe with declines in the mid-teens but we did see growth in three of the four other regions. So you’re beginning to see Europe bottom out with the exception of the South, a great job by Chris and team in Europe.

We were especially pleased with the progress we made in Q3 in the emerging countries with growth of 13%. As a reminder, emerging countries grew 6% in Q2. We are also pleased with the balance across emerging countries with India growing 29%, Russia growing 16%, Brazil up 14%, China up 8%, and Mexico up 4%. The remaining emerging market around the world which is approximately 50% of our total business from emerging countries was also very solid with growth of 13% as well.

Now moving on to the customer market view, again from an orders perspective, we saw growth in every segment. Enterprise grew 3%, commercial grew 3% from an orders perspective, our service provider grew 8% and global public sector grew 1%.

Frank, let me now turn it back over to you for guidance.

Frank Calderoni

Thanks, John. Let me now provide a few comments on our outlook or the guidance for the fourth quarter. Let me remind you again that our comments include forward-looking statements. You should review our recent SEC filings and identify important risk factors and also understand that actual results could materially differ from those contained in the forward-looking statements and then actual results could be above or below guidance.

The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP. For Q4 FY13 while we like the trends, we are managing the business to account for a continued slow steady recovery. With that in mind, we expect revenue growth to be in the range of 4% to 7% on a year-over-year basis.

This guidance factors in the divestiture of our Linksys product line, which contributed approximately 1% of total revenue in Q4 FY12. For the fourth quarter, we anticipate non-GAAP gross margin to be approximately in the range of 61% to 62%. Our non-GAAP operating margin in Q4 is expected to be in the range of 27.5% to 28.5%. Our non-GAAP tax provision rate is expected to be approximately 21% in the fourth quarter.

Our Q4 FY13 non-GAAP earnings per share is expected to range from $0.50 to $0.52 per share and we anticipate that our GAAP earnings in Q4 will be $0.07 to $0.10 per share lower than our non-GAAP EPS.

Other than those quantified items noted previously, there are no other significant differences between GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant. As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Thank you, and John, back to you.

John T. Chambers

Frank thanks very much. In summary, for nearly 30 years, we’ve focused on moving the world to [IP], first in communications and now in IT. We build a portfolio of assets that deliver value for customers and shareholders with a discipline and financial strength to make long-term bets on innovation.

There is no doubt that the pace of change in our industry is only increasing. Let me be very clear, change has always been good for Cisco. We use these times of change to get closer to our customers, transform our business and drive new opportunities and at the same time break away from our competition.

Many companies are articulating strategies to expand in the networking and reshape this market. Over the last 20 plus years at Cisco, I’ve seen these challenges every few years. For example, I remember back in the 90s when we were a router company. Some believed that the new switching startups would topple our business. However, after the hype settled, it was clear that Cisco was the leader and we did it by listening to our customers and delivering products that help them transform their businesses.

With this strategy, we established our leadership position and increased our relevance to these customers, and we have used this playbook again and again and again throughout our history to become an almost $50 billion company. I’m extremely confident with the hand Cisco has to play and yet we have never taken it for granted.

We take competition seriously and make no mistake about it, we love to compete, it keeps us focused. History is littered with company’s large and small, upstarts and established that bet against Cisco and failed. I have no doubt we can see this again. We have always believed that the Internet will revolutionize the way we work, live, learn and play.

This has never been true than it is today, think about it, with cloud, mobility all coming together to deliver the internet of everything, and unprecedented new ways of opportunities for many players in our industry and our goal is to lead this transition. While we have to earn our leadership position every day, I believe we have the right cards, the right people and if played right, we can emerge as the number one IT Company in the world.

Mel, let’s now open it up for questions.

Melissa Selcher

Thank you, John. We will now open the floor to Q&A. I’m first going to clarify one number during that was mentioned by Frank. Our Q3 FY12 non-GAAP service gross margin was 67.1%, not 61.1%.

A reminder as we go into Q&A, we still request that sell side analysts to please ask only one question. Operator, please open the floor to questions.

Question-and-Answer Session

Operator

Thank you. Our first question comes from Ittai Kidron with Oppenheimer. Your line is open.

Ittai Kidron – Oppenheimer

Thank you and congratulations on great numbers and very optimistic guidance. John, as we went through the last three weeks and listened to every one of your competitors, things didn’t seem as rosy as you see them. Now clearly you are taking business away and you’re executing to higher level than others.

But what is it that you’re seeing on the enterprise side in the U.S.? You’ve highlighted that vertical specifically in the past as very critical for the continued recovery process. How are you seeing purchasing decisions being executed over there? Are you seeing some delays and also if you can revisit your perspective on Fed is there a bottom for that pit?

John T. Chambers

So in sequence, first, thank you very much for the compliment on behalf of us all here at Cisco. In terms of what is changing the market, our architectural approach tying together our products to solve our customer’s top proprieties quicker than anyone else is regaining traction. That’s especially true in enterprise where brands, team focuses on selling to the business customer in conjunction with the CIO and meeting the CEO’s top priorities.

In terms of the momentum there, the pipeline looks good. Pipeline actually increased Rob again faster than the actual growth this quarter and is well over $2 billion for Brian’s group alone. The number of large deals, Ittai, are actually increasing. However, you are seeing a little bit slower rate in bringing the deals home, which is a nice way of saying, you got to have more opportunities and it might come in pieces versus before.

In terms of commercial, where you really look at what Alison has done, leading our Group, that’s 13% growth year-over-year, and it’s probably an even more accurate indicator of economic potential in the U.S. looking out a couple of quarters, and we’ve seen this trend interestingly enough, improve steadily in both enterprise and commercial for four quarters in a row. Alison grew at 13%, but again she sells solutions not routers or switches or data center or UCS type solutions.

Service provider was very strong. Michael’s team did very well there, 8% core growth, 2% from NDS, making 10% growth and you’re seeing our relevance to the large players, the AT&T, the Verizons, the Time Warners, the Comcast continue to be very solid and really make a difference.

So, I like the trends in the U.S. The state and local business, as you all know, almost two, two and half years ago was the start of the decline that unfortunately we experienced first and shared with the market and fast forward two years later, you’re starting to see it lead the upturn. The Federal business will be a market share change. It’s who is able to really make a difference to this market, but if you look, we experienced a slowdown a couple of quarters ago in federal and now you’re at a minus 3%, but I think you will see some of the FX make this a difficult growth market.

So, we’re focused on building relationships and maintaining value. So, I guess the key takeaway and Rob, we saw this last night at a dinner with one of the large boards of big global multinational bank and the day before with a global search provider and they bring their whole boards to Cisco now as we focus on business transformation.

Our ability to bring innovation to them. Our ability to take the CEOs top five goals and make a difference in their ability to achieve all the top five goals in ways that others are not, and I think what you’re beginning to see Ittai is a transition for us moving from a communications company selling boxes five or 10 years ago to being a solutions company selling IT to our customers.

So if I were to summarize, I think the U.S. was the example of what we want to do in the future and I think it is also a positive trend and probably what you’re going to see in the second half of the year from economic growth.

Melissa Selcher

Okay. Thanks, Ittai. Next question operator?

Operator

Thank you. Your next question comes from Mark Sue with RBC Capital Markets.

John T. Chambers

Hey, Mark.

Mark Sue – RBC Capital Markets

Hi, John, how are you? If I think about one of the reasons why the multiple in text box and in ComTech in particular why they have been compressing, it’s been the lack of pricing power and the declining gross margins. There were deals in the past, such as China, where you took a margin hit, since they were strategic, now you’re saying – now you’re doing the opposite which is walking away from set-top deals, which are not, are we now at a point of structural changes for the industry.

You’re going from selling boxes to selling solutions so that rational pricing can prevail and are we now at a point where these things give you confidence that your need on gross margins can actually improve further from here?

John T. Chambers

So in reverse sequence, the gross margins we like the 61%, 62% range and I’d encourage people not to get above that. But we clearly have done there a huge amount of work across the whole Company on focus on gross margins and the direction. If you sell solutions and IT solutions to the CEOs top priorities, you have earned a major premium. If you’re dealing with a standalone switch or a standalone server and competing purely on a reverse option RFP type of response the margins are very low. But I think what it does speak much what you’re alluding to, our ability to maintain and to add value to our customers as it’s on very strong ground even in the data center where most people thought we could ‘not compete’ and could not get good margins on market share and we were obviously very successful in all three. So, I think it’s a combination; I would not encourage you to move the models around in terms of your gross margins on that.

We’re doing a better job of getting software in, a better job of getting value for our ASICs. Frank, you want to add something else?

Frank Calderoni

Yeah, Mark, as we talked about, I mean the whole thing we look at gross margin and overall profitability as the portfolio play, not only to the current, but also the long period of time, and we want to make sure that we have the flexibility to make trade-offs. So, as we talked about today set-top box is an area, we’re making some trade-offs. There’s other parts of the portfolio we’ll continue to make trade-offs. In the range of gross margin as I talked about back in December, looking at 61 to 62 over the long-term and there could be some things that could factor it in on the positive side, as we continue to kind of look at investments in the software area.

And there’s things that could also kind of be more challenging on the lower side. So, there’s always going to be that balance that we’re going to work to in the portfolio and we want to stay reasonable with that kind of range over that longer period of time, and the overall focus for us is bottom line profitability.

John T. Chambers

Okay. Thank you, Mark.

Frank Calderoni

Thank you, Mark.

Melissa Selcher

Thanks Mark. Next question please?

Operator

Thank you. Our next question comes from Simona Jankowski with Goldman Sachs.

John T. Chambers

Hello Simona.

Simona Kiritsov Jankowski – Goldman, Sachs & Co.

Hi, John, thank you so much. I just wanted to ask you specifically on the service provider vertical, which for you was quite strong and this was a quarter, when we saw a lot of misses related to the service provider vertical and also the carrier spending numbers came in a bit lower for the quarter in some of the largest North America carriers. And so, just wanted to get your perspective there, how much of this is specific to Cisco’s execution and share gains or the fact that maybe the linearity in the quarter changed, where it got stronger toward the end, and just if you can paint that picture looking out through the rest of the year as well?

John T. Chambers

Sure. The linearity during the quarter for our orders was pretty typical what we see all Q3s, not even a variation of 1% in the first month versus the second month, versus the third month of our typical performance. I think it does speak to our value to our customers and service providers and I think it does speak to service providers are beginning to bet that they’ve got to have strategic partners long-term, something that others would not say was going to occur five years ago. So, we’re winning the share of wallet spend. The North American spend, especially in the U.S. is probably stronger than you saw in other parts of the world. We saw Europe challenged in terms of service provider spend and then we saw some great numbers from Asia-Pacific in prior years, NTT as an example out of Japan where we maintain our share spend, but just the spending is tighter. It’s a nice way of saying, Simona, I think the carrier spend is low double digits, and there might be some relief in the second half of the year, but we’re focused on value to the customers and share of wallet spend and I think that was the primary reason we were successful.

Melissa Selcher

Great, thanks Simona. Next question please.

Operator

Thank you. Next question comes from Jess Lubert with Wells Fargo Securities.

Jess L. Lubert – Wells Fargo Securities, LLC

Hi, guys and congratulations on a nice quarter in a tough environment. Question is on…

John T. Chambers

Somebody says that’s nice. We’re about to get this. This is tough question.

Jess L. Lubert – Wells Fargo Securities, LLC

So the question is on the guidance, it seems like order trends are improving across the board, yet if I do my math correctly, it seems like you’re guiding for just 1% sequential growth during the July quarter, which has historically been a seasonally strong quarter for the Company. So, I’d like to understand some of the key factors that you’re still most concerned about from a vertical or geographic basis and what’s driving you to take what appears to be a fairly conservative approach to your Q4 outlook?

John T. Chambers

Frank, I’ll take part of it and then you kind of backstop me. First is the sequentials on revenue are usually dramatically different than the sequentials on bookings. Bookings Q3 to Q4 is almost always in double-digits, the orders come in late in the quarter. This is the quarter we build backlog and we fully intend to build a very solid backlog going into Q1 and Q2 of next year and that’s how we’ve always run it.

That’s how the sales incentive plans are positioned. In terms of the order rate, if you think about it, we are projecting 4% to 6% just a quarter ago, you take Linksys out which would be down a point and we now have set 4% to 7% that’s equivalent to 5% to 8%, if Linksys were still in the numbers. It’s pretty aggressive numbers in terms of revenue and it does speak to our ability to forecast.

We appear to be gaining share and feel good about the momentum. But the global economy there still challenges, I would like to see more out of Asia. We would like to see a little bit more stability in Southern Europe. We think these are pretty aggressive outline of our goals for this quarter. So again I would not assume that the sequential 1% in revenue is indicative of our growth and clearly when the order growth returned to positive at 4% that was a good start. Frank?

Frank Calderoni

Hey John, I think that kind of covers a good amount. We’ve been – clearly if you look at the orders for the last couple of quarters it’s been pretty flat, kind of showing some growth this past quarter. So we have been improving the momentum. We are seeing some momentum improve as we captioned into the guidance in Q4. But with the backdrop of the environment and the slow and steady recovery we want to make sure that we continue to kind of see that play out. Hopefully what we are counting on here is to be able as you said to build some backlog, which is important especially at the end of the fiscal year kind of going into the beginning of the next year.

And so we factored all that in and we feel that this is a balanced guidance both top line and bottom line. So as John said, if you look at the top line at 4% to 7% without Linksys is pretty much 5% to 8%. And then if you look at the bottom line, we’re also growing profits at a pretty reasonable rate in the range of about from an EPS perspective of 6% to 10% on the low and the high. So I think that’s a fairly good set of guidance that we are providing for the quarter.

John T. Chambers

Thank you, Jess.

Melissa Selcher

Thanks Jess. Next question please.

Operator

Thank you. Next question comes from Tal Liani with Bank of America Merrill Lynch.

Tal Liani – Bank of America Merrill Lynch

Thanks guys.

John T. Chambers

Hi Tal.

Tal Liani – Bank of America Merrill Lynch

I’m trying to understand the gross margin. I know we discussed it, but I’m trying to understand the gross margin and kind of put maybe two questions in one. The routing business grew 10% sequentially, if I do the math right. It’s about flat year-over-year. The switching was down both year-over-year and on a sequential basis. The margins, every quarter, you guide below and you beat the margin – the gross margin number, and the question is when you take a two year view, the last two year view where margins kind of were under pressure you’re back now to margins that – above what we saw two years ago or one year ago. So, is this the new sustainable margin of 63? What are the puts and takes of – I know you just said 61 to 62, but what are the puts and takes in the margins that drove it up to 63 in the quarter that your largest and most profitable business is down sequentially and year-over-year?

John T. Chambers

We have, Tal, as we’ve talked about even back in December. We’ve headwinds and tailwinds that we look at against that 61 to 62, if I want to be balanced looking at over long-term. Clearly, this past quarter very pleased with the 62% margin, I think we had many things working in our favor from across the portfolio as I mentioned.

I think this is one of those quarters where and I’ve looked through a lot of the detail, we had great execution across the board, that doesn’t necessarily happen every quarter, and so we’ve got to make sure things come up from time-to-time gets factored and secondly, the other thing from a headwind perspective that we continue to come through from quarter-to-quarter, if you look back over the last several quarters or even the last two years, from a quarterly standpoint, we’ve had some, where it’s been higher, some where it’s been lower, and the variation depends on the mix.

Mix from the standpoint of UCS and how fast that’s growing, and then also from a – something that’s the video perspective of the two drivers. So mix comes into play from time to time, as well as various other things from an execution standpoint within the portfolio. So looking at that and spending the time that we have across the business and making sure that we balance that, I feel very comfortable that 61 to 62 is a reasonable range with the ability to maybe go a little higher and a little lower depending upon how those things balance out.

Frank Calderoni

Thank you, Tal.

Melissa Selcher

Next question please.

Operator

Thank you. The next question comes from Brian Marshall with ISI group.

Brian Marshall – ISI Group

Thanks guys. All right. Hi John thanks. Quick question on gross margins as well, and I guess, maybe the margin execution in the quarter was pretty phenomenal, but maintaining the 61 to 62 longer term, I guess that would suggest that, there may be some – little bit of clouds in the horizon. I guess, one of the things that we would be concerned about is potentially Cisco’s ability to capture any margin shifts that may emerge with the transition to SDN, I mean clearly, most software defined networking developments right now are in a proof of concept base, but over the couple of years, that’ll start to reach volume production and so love to hear about your ability to capture margin in that kind of a realm. Thanks.

John T. Chambers

So I’ll talk a little bit about the margin piece, and Rob, I’m going to ask you to comment specifically about SDN, especially in the data center, where clearly we’re doing extremely well on our numbers. The margins, I don’t think it’s going to be a software gain. It’s going to be an architectural gain, where software, silicon, ASICs, hardware, a world of all clouds play architecturally together and as we articulate that well to our customers, our customers are getting it and we’re starting to win our big large deals, because we have the best product architectures in routing and switching.

We have the best, using the customers’ words, SDN strategy and it leverages their existing installed base, and what you are seeing is many of our new investments that Frank is investing in very heavily for us have very little revenue effect for the first year. They are largely going to be expenses this next year and those are the recurring revenues in software as well. But if we were facing abnormal pressure from a new competitor that has a dramatically different business model that was being successful you would have seen different numbers in the data center and you would have seen different numbers in terms of our growth versus our peers.

This is what I said earlier. We have a number of challenges coming at us. In the end it will be in our opinion, architectural play, where software play a key component but it will be an architecture where our plays will I think win in the end and we’ve done this – I don’t know I have lost track now, Rob, how many times. But we are already on to our next challenge beyond SDN without taking it for granted. Your thoughts Rob a little about the data center.

Robert W. Lloyd

Yes. John, I think you already pointed out that in the data center switching area we actually grew 12%, a very big portfolio and we’ve got some market leadership there. It’s important to note that we just introduced the Nexus $6,000 which is based on Cisco’s ASICs and silicon. And I think the real answer to the question that was just asked is we continue to see absolute evidence in the marketplace that as eventually controllers and agents and overlays evolve, it’s great hardware, it’s Cisco silicon and ASICs that are going to drive the scale that underlies the promise of SDN and Cisco’s software with Cisco ASICs and silicon is really the formula. So we see that alive and well right now, which is why we’re doing so well and I feel very comfortable of the future that formula will continue to scale.

Brian Marshall – ISI Group

How do you do?

Melissa Selcher

Thanks, Brian.

John T. Chambers

Thanks Brian.

Melissa Selcher

Next question please.

Operator

Thank you. Our next question comes from Ben Reitzes with Barclays. Your line is open.

Ben Reitzes – Barclays Capital

Hey thanks a lot. John and Frank how are you doing? I wanted to ask about cash and yield. The night before Good Friday, you snuck in a 21% dividend increase on us. I was wondering if you could just elaborate a little more about your long-term plans for dividend growth and how you balance that with buybacks, it looks like you have still a lot of balance sheet optimization potentially ahead of you and you could get even more aggressive, if you elected do so. So, just how you are thinking about that after this performance and what you just delivered?

John T. Chambers

So, I’ll take the easy part of it and just thank you all for the feedback. We listen pretty carefully to our large shareholders and the buy and sell-side analysts on what you want us to do those with dividend and buyback. In this quarter, it was well ahead of our 50% free cash flow that we committed to and don’t think we won’t listen to you in the future. We absolutely will very much in line with how we accomplish our goals together. That’s the easy part of it. Frank, let me give it you and put the meet behind it.

Frank Calderoni

So Ben, nothing really changes with the capital allocation strategy that we laid out back in the summer of last year. I think what we’ve been able to do since then is really continue to execute against that and that is to say that on an annual basis that we will return a minimum of 50% of free cash flow through the dividend and the buyback.

Clearly, what we’ve done in the last year, it clearly is empathizing much more heavily towards the dividend with the increase that you just referred to. I think that’s an indication of where we are probably going to go. I mean we’re going to continue to look at both as ways of contributing cash, with I think listening to many of the shareholders or more of the shareholders emphasizing the dividend and also conversations with our Board that’s clearly where we have put more of the focus and we will probably in the future.

But balancing that a minimum of 50% on an annual basis, and we’re actually as you can also see, I think we’re doing a fairly decent job of managing the U.S. cash with that as a backdrop to give us that flexibility with the numbers right now close to $8 billion is the highest it’s been in a long time from U.S. cash position. And that’s primarily to be able to have that flexibility to be able to continue down this path of this capital allocation strategy.

Melissa Selcher

Thanks Ben. Next question please.

Operator

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

John T. Chambers

Hi, Brent.

Brent Bracelin – Pacific Crest Securities, Inc.

Hey how are you. Thank you for taking my questions here. I wanted to go back to the concept of what’s changed in the environment over the last three months. I clearly appreciate your focus on the solutions cell, three consecutive quarters of 5% growth now, but your book-to-bill that was below 1, the last two quarters is now approximately 1, you’re clearly seeing a recovery in U.S. order trends across all major segments, so I guess my question here is, how much of an improvement do you see across overall industry versus how much of the momentum that Cisco is generating here is driven by share gains and the hand that you have specifically?

John T. Chambers

I think our movement from being a communications company and networking company to an IT company has a huge impact on this. The communications companies candidly have had a pretty tough run this fiscal year, and if you watch what we’ve done and we aren’t completely there and probably never will be, but our ability to be viewed as more as an IT partner to our customers has changed dramatically.

We watch the numbers in the U.S. enterprise and it’s been a very remarkable balance from 15%, all the way down to 0%, then 5%, then 9%, then 10% and Alison’s numbers from 22% down to 4% or 5% base and then to 9% last quarter and up to 13% this quarter, that is solution selling and that is share gains in large part, in moving more to what we want to do, and combining services Gary, into the overall approach.

The emerging markets, there’s been a major push in the last four months about just understanding the key government leaders requirements there and how we meet their requirements and driving it through and that is I think even better execution, Rob in terms of what we’ve done in emerging markets. It’ll be bumpy and it always is in emerging markets but I like what our play is doing there.

When you’re asking about Europe we’re modeling Southern Europe to stay tough, decrease is probably in the mid-teens on that. But we like what we see in Central Europe, Canada at corridor Germany, Eastern Europe, Russia. U.K. has leveled out and that’s a nice job there. But I would say in these situations is probably a partially and economic slow recover and I think the right word is slow but steady and partially our execution on the model. Gary, would you add anything to that?

Gary B. Moore

I think our ability to execute the visibility we have into the business and to make adjustments. I mean even going back to the gross margin question, the discipline that we have, continued value engineering some of the things we’re doing there, but the visibility that Chuck and the sales team has and discounting those kinds of things not only helped us win and close deals more quickly but it helps us with the margins.

John T. Chambers

Just to note on this, I know there are a lot of Cisco people who listen to this, you know what we’re going to do right after the call, first congratulations and then we’re going to say you have to move faster, we’ve got to execute better. We’ve got to get better coordination across our functional groups and if we’re going to break away at the level we want we’ve got to take it up to another level as we go into Q4 and Q1. So I don’t want anybody resting on their laurels and to you as the shareholders we aren’t going to rest.

Melissa Selcher

Okay. Thanks, Brent. Next question please.

Operator

Thank you. Your next question comes from Brian Modoff with Deutsche Bank.

John T. Chambers

Good morning.

Brian Modoff – Deutsche Bank Research

Good afternoon guys. Hey John. A couple of questions real quick. Can you talk a little bit about on the switching side? What you’re seeing in terms of pricing pressure in 10-gig ports? What you’re seeing in terms of the adoption of 40-gig? Are you seeing that transition more rapidly perhaps and you maybe earlier anticipated? And then maybe a little bit of color around the 3850 and if that’s doing anything to help your trend on the Campus side, which has been somewhat anemic at least on the order side perhaps?

John T. Chambers

Yeah but first of all I want to congratulate Rob Soderbery and Rob Lloyd, you all took the switching market after last quarter, where candidly we lost port share, and I think in less than three months have got our port share gains back going again, nice way of saying it, the total port level we’re back gaining share.

In terms of the data center, I think the numbers speak for themselves on it. I think we need to do a little bit better in the modular component part. There is a transition of 10-gig to 40-gig, I think it’s more a price performance issue and in any many of our large accounts, government and federal, as an example head count is actually coming down. So there isn’t the normal push out of these verticals that we normally see leading it. Right now they are actually a negative drain in terms of the large financial institutions in the U.S., and the large federal government. Rob, would you have anything to that.

Robert W. Lloyd

3850 is ramping very nicely John, and we have a very unique position there, leveraging our strength in wireless and obviously the footprint we have in the wiring closets into the edge of the network. So, we’re going to watch that very carefully, but we do see a very nice ramp and we expect that unique value, we have again based on Cisco ASICs, and what we’ve done there will be interesting. I also watch the ramp of the Nexus 6K in the data center, and we do see the penetration rates of 10-gig driving lot of growth above 35% up in terms of 10-gig ports.

Melissa Selcher

Okay, thanks Brian. Next question operator.

Operator

Thank you. Our next question comes from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum – Morgan Stanley

Hi guys. Thanks, I appreciate it.

John T. Chambers

Hi Ehud, how are you doing?

Ehud Gelblum – Morgan Stanley

Good, how are you?

John T. Chambers

Actually pretty good.

Ehud Gelblum – Morgan Stanley

I want to drill down a little more on your data center growth, it seemed pretty – really pretty strong. You said UCS and Nexus together, talked about 77% growth. I want to compare that if that’s comparable to the 65% growth number you gave us last quarter and if it is, it means you’re accelerating there, so, from that kind of a basis, that you’re really taking some serious share and doing really well in the data center.

A couple of things I just want to dig down into, can you cut your customer base a little bit differently to give us some insight into these massively scalable debt data center guys, the Web 2.0 guys? And is a lot of that growth into those MSDCs or is it into enterprises and as for MSDCs, whether it’s the AWSs of the world or the Microsoft Azure’s as they get more cloud guys in general sort of just attract a lot of data center kind of mass, let’s say, how do you see that changing the business, how you do business and the competitive environment?

So, I guess, what’s happening now, in terms of growing your strength as well as, in the future? And following that into your U.S. enterprise, if you look at your order growth, the last three quarters, it’s accelerated. I think three quarters ago, it was 1% order growth. This is total U.S enterprise, then 4%, then 9% and I think this quarter was 10%. Do you worry that we’re on this pattern of four strong four weak, four strong four weak? I think, I asked you about this a couple of quarters ago, just how do you look at the next quarter, given, now you’ve had several straight positive trends?

Frank Calderoni

I think our position, going in reverse order of your questions, I try to remember them all, the enterprise growth is on a very good trend. I don’t see seasonality on that and I think it’s probably a very good indicator of economic growth. It’s nothing to write home about, but it’s very solid economic growth in terms of slow but steady in terms of the U.S. is how we’re modeling, and I think this is a solution-led sales, in a very tough environment. So, I would be disappointed if we don’t continue to maintain this type of momentum in the enterprise, give or take a couple of points on it.

In terms of what we’re seeing, it’s all geographies and all segments of the market. You are aware of a lot of the rumors in the market with some of the things we’re doing with the semi that has absolutely targeted the massively scalable data centers and the combinations of software and hardware and ASICs and UCS combined. Stay tuned if you’re really very excited on that and I think it will prove a lot of people perhaps scratching their heads in terms of the architectural discussion we had before and just repeating the same thing.

If you can’t win in the data center with software defined networks you sure as heck aren’t going to win standalone across an architecture of $180 billion installed base with APIs of each component parts all the way through it. In terms of our relevance as an IT player, it’s increasing and when you get Board of Directors coming through not the CIOs but the Board of Directors and top management, it really speaks Cisco’s position in the industry is changing.

I know to some people they might have described this in some of the news media perhaps as something that is primarily a router or switch vendor type play and movement a little bit slow. But what you’ve seen, I view as more as somebody flies underneath the radar, pretty much as a stealth fighter, and when we catch our competitors we usually leave them behind fairly quickly.

If sometimes Gary we take a little bit long to get focused on something but we really close well. That’s a nice way of saying I am real comfortable across all key customer segments where we are going. I think we are dramatically better positioned than the traditional data center players such as HP, Dell, and IBM as this transition occurs.

Melissa Selcher

Thanks David. Next question please.

Operator

Thank you. Next question comes from Amitabh Passi with UBS.

Amitabh Passi – UBS

Hi, thank you. I had a clarification and then a question. On the clarification, John I thought last quarter you said UCS plus Nexus was running at a $3.5 billion annualized run rate, and I thought you said that number today was $5.5 billion. Just want to clarify that.

And then a question for Frank, I believe Gary said at a conference in February that you still had about $900 million that you could extract in terms of supply chain efficiencies in your COGS line. I just wanted to get a sense of where are we with respect to that goal, is that a goal for this year, and if you could give us any sense of just other efficiencies and improvements you can make in the supply chain on your COGS line as we progress through the year?

John T. Chambers

Gary, you take the second one, while I see if I can get the numbers together.

Gary B. Moore

So, specifically what I said and someone actually put it in the paper. I think it was Simone, and I called paper, what I said in the conference was that in the first year of our transformation work, that we’d pulled about $800 million improvement to gross margin for the value engineering, value design and some of the other work that we’re doing around component, negotiation et cetera.

What I said for this year, it would be that we had targeted another $800 million, we had upped that to $900 million and I think Frank and I did a review on this, probably 10 days ago and we’re actually moving ahead of that. So, it’s going to be in that range, but I would just tell you that on the specifically, everyone here is still focused on driving value and driving the operating leverage in our business. So, we continue to see opportunities like that and we haven’t dialed back on it at all.

Frank Calderoni

And it’s important I mean, that just shows even as you get two years, right, and have the pressure. So we have to continue to kind of stay, going back to the comment that John made before, as we continue to look at next year going into FY 2014, those are kind of goals that we said internally, that we have to constantly keep executing on, because that’s going to allow us to have that offset for what happens on the price side.

Gary B. Moore

Yeah I mean, so, John Kern and the entire team over there in supply chain not just with those types of work, but the whole manufacturing cost process, they’re driving very hard and then the other thing that we can do there. So, that was the $900,000 comment that you referred to. So, hopefully that answers that second part.

John T. Chambers

So to answer your question on clarification on the numbers, the UCS plus the Nexus 2000 5000 and 7000 is the $5.5 billion run rate. The last quarter, we referred to UCS plus the Nexus 2000 to 5000, which are the bundled architectures that we do in the data center, was at a rate of $3.5 billion and that was the clarification. Also, I don’t know if it was Ehad or Brent or Ben, but one if you all asked, is the UCS accelerating. I think the numbers already are spectacular, but they tend to go up and down a little bit, bookings didn’t grow quite as fast as revenues this quarters and so, I wouldn’t be modeling in the 70s, we’re obviously very pleased with growth of 60%, which I think it more what we experience typically from the UCS side of the house.

Melissa Selcher

Okay. Next question please.

Operator

Thank you. Our next question comes from Brian White with Topeka. Your line is open.

John T. Chambers

Hey Brian, Hello Brian.

Brian White – Topeka Capital Markets

Yeah John.

John T. Chambers

Okay.

Brian White – Topeka Capital Markets

Just on UCS, I’m wondering if you could break out UCS, I know in some quarters you’ve broken it out. I think last quarter, was it $2 billion annual run rate, maybe if you could break that out, and I’m also curious, is UCS being driven more majority by the converged infrastructures or majority just by standalone sales to customers with Nexus?

John T. Chambers

Converged infrastructure is much more cloud, as a part of it, Nexus architecture is part of it. We even get some bare metal sold through with the non-traditional blade piece, but it is largely an architectural sale tied to a converged architecture in cloud movement.

In terms of the business, it’s over the $2 billion run rate at the current time and I don’t want to get too specific on it, but it’s reasonably over, it isn’t over by about a magnitude of 20% or 30% but comfortably over the $2 billion run rate. And I think Mel that’s our last question. I want to thank everyone for spending the time today. We’ve got the clear message.

You want the script cut down to fewer pages and some of you have implied that our P/E ratio would go up in direct proportion to how many pages we took off and we intend to make it short and tight. We will try to keep the questions to the same type timeframe and Mel maybe other than end of year we ought to shoot for an hour conference call when we can.

Please give us the feedback overall. We know you got to earn your – we got to earn your trust and confidence every day. We’re committed to that. We are committed to becoming the number one IT player and we are committed to beating our competitors and still maintaining very good margins in a tough market. So, Mel, your closing comments.

Melissa Selcher

Great, thanks John. Cisco’s next quarterly call which will reflect our FY 2013 fourth quarter and annual results will be on Wednesday, August 14, 2013 at 1.30 pm Pacific, 4.30 pm Eastern. Again I’d like to remind you that in light of Regulation FD, Cisco plans to retain our long standing policy to not comment on financial guidance during the quarter unless it’s done through an explicit public disclosure.

Please call the Investor Relations Department with any follow-up questions from this call. Thank you for your participation and continued support. This concludes our call.

Operator

Thank you for participating on today’s conference call. If you would like to listen to the call in its entirety, you may call 866-502-6119. For participants dialing from outside the U.S. please dial 203-369-1860. You may disconnect at this time.



More From Seeking Alpha

    Rates

    View Comments (0)