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Cisco Systems' CEO Discusses F2Q 2014 Results - Earnings Call Transcript

Cisco Systems, Inc. (CSCO) F2Q2014 Results Earnings Conference Call February 12, 2014 4:30 PM ET

Executives

Melissa Selcher - Senior Director, Global Analyst & Investor Relations

John Chambers - Chairman of the Board, Chief Executive Officer

Frank Calderoni - Chief Financial Officer, Executive Vice President

Rob Lloyd - President - Development and Sales

Gary Moore - President, Chief Operating Officer

Analysts

Jess Lubert - Wells Fargo Securities

Amitabh Passi - UBS

Subu Subrahmanyan - The Juda Group

Brian Modoff - Deutsche Bank

Ittai Kidron - Oppenheimer

Paul Silverstein - Cowen

Kulbinder Garcha - Credit Suisse

Mark Sue - RBC Capital Markets

Ehud Gelblum - Citigroup

Tal Liani - BoA Merrill Lynch

Brian White - Cantor Fitzgerald

Operator

Welcome to Cisco Systems' Second Quarter and Fiscal Year 2014 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 will 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 96th 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, and 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 conference 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 in our documents filed with the SEC, specifically the most recent reports on Form 10-K and 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

Unauthorized recording of this call is not permitted. All comparisons throughout this call will be on a year-on-year basis unless stated otherwise.

I will now turn it over to John for his commentary on the quarter.

John Chambers

Mel, Thank you very much. In Q2 FY'14, Cisco delivered record non-GAAP earnings per share of $0.47 and revenues of $11.2 billion, down 8% year-over-year. The market and the dynamics in our business played out largely as we described in our last quarterly conference call. We saw the impact for emerging markets, service provider and high-end product transitions in our business as we discussed last quarter. I will provide more detail in the business update.

As we navigate these economic and product cycles, we are managing our business to deliver shareholder value. In this quarter, we returned a record $4.9 billion to shareholders through dividends of approximately $900 million and $4 billion in share buyback.

We managed non-operating expenses, reducing them in the high single digits year-over-year and Gary, Frank, really nice job on that. We built backlog just as we said we would. We believe this strategy that has enabled us to emerge stronger from every previous cycle remained solid.

We capitalize on the major market transitions, we partner with our customers to deliver innovation and solutions that fuel their business. In our view this next wave of the Internet, the Internet of Everything will encompass every technology transition we are seeing in the market today.

With the network squarely at the center, we are building the platform for the Internet of Everything with scale and security to address the unparalleled complex the requirements. We plan to continue to disrupt the market and disrupt ourselves to deliver the value and solutions our customers require.

Last year, we introduced entirely new approaches to networking, designed around future proofing the best customers are making today and enabling them to harness the benefit of Internet of Everything.

As we capitalize on these transitions, I would like to summarize the dynamics of our business in the following five points. First, the Internet of Everything has moved from an interesting concept to a business imperative driving opportunities across every major vertical. It was the central conversations at the Consumer Electronics Show and the World Economic Forum, the last couple months with CEOs, industry and country leaders globally. Anyone walking away from these events should characterize this year as the tipping point.

Second, we continue our strength in U.S. enterprise and U.S. commercial as we said we would at last quarter's conference call, with year-over-year orders up 13% in U.S. enterprise and 10% in U.S. commercial. While we face SDN, white label servers and public cloud solutions to this market we see our ability to deliver architectures and cost portfolio solutions with scale, security and CapEx and OpEx savings as a driver of our success in this market.

Third, we are managing through the economic and product cycles, just as we outlined at the last call. Emerging market orders declined 3% year-over-year as compared to last quarter's down 12% with the BRIC, Mexico down 10% this quarter. SP orders declined 12% and product transitions in core routing and switching contributing to double-digit revenue declines. As we move to reaccelerate growth across the businesses, we remain focused on managing the levers to deliver value to our shareholders, while making the investments to position Cisco for the long-term.

Fourth, we believe our focus on architectures is really paying off. As the pace and complexity of IT increases, Cisco's ability to bring together technologies, servers and solution across silos should continue to drive differentiation, preference and, over time, gross margins. Point players will be faster at times, but I believe you will see our advantage in delivering integrated architectures at scale win in the end.

Fifth, we said last quarter that our goal is to build product backlog and we exited Q2 with book-to-bill greater than one. We are pleased with our progress managing through the cycles in our market and our business and as such wanted to give you an update on our Q3 revenue guidance before Frank details guidance later. That allows you to help frame the rest of the discussion in this call.

For Q3, we expect revenue to decline in the range of down 6% to down 8%. As we execute on our plan to return to growth over the next several quarters, subject to all the appropriate caveats discussed during this call, we also plan to continue to build backlog. There is no question that we have moved from a compute centric to a network-centric model for IT. Cisco is building the simple, smart and highly secure solutions that will enable our customers to capitalize on the cost efficiencies, agility and growth opportunities that lie ahead.

Our approach is unique. It starts with the central role the network, which is the only place to connect everything, people, process, data and things. Our transition is from selling boxes like most of our peers to selling business outcomes. Our delivery is through architectures, partners and services and we will help our customers utilize their 180 billion Cisco install base to capture the most value today and build for tomorrow.

As we move into this next era of the Internet with our customers, our commitment to you is to invest to sustain our industry leadership position while balancing the evolution in our business and a very strong focus on shareholder return.

Frank, at this time, I would like to turn it over to you.

Frank Calderoni

Thank you, John. In Q2 FY '14, our business performed as we expected. We continue to manage through the transitions in our business and challenges we outlined in our last earnings call.

From a top and bottom line perspective, total revenue was $11.2 billion, down 8%, non-GAAP net income was $2.5 billion and non-GAAP EPS was $0.47 per share down 8% year-on-year. Our GAAP net income was $1.4 billion and GAAP earnings per share on a fully diluted basis were $0.27. Product revenue declined 11% and service revenue increased 3% with product book-to-billed greater than one. Overall non-GAAP operating margin was 27.8%.

In Q2 our total non-GAAP gross margin was 61.3% within our expectations of 61% to 62%. Non-GAAP product gross margin was 58.8%. As our overall volume of business was down this quarter, it negatively impacted our non-GAAP product gross margins in several ways.

First, we have less leverage in our cost structure. We did not get the full benefit of cost efficiencies at the lower volumes. Second, as our volumes in higher margin core products were lower, we saw an unfavorable mix impact toward lower margin products such as SP video and servers. Third, while the impact from pricing was consistent with prior quarters, it was at the higher end of the historical range in Q2. As we improve business volume, we expect it will balance the drivers of our product gross margins.

Our non-operating expenses were $3.7 billion or 33.5% as a percentage of revenue that's compared to 34.1% in Q2 of FY'13. Our headcount decreased by approximately 1,000 from the end of the fiscal year to 74,065. Our expenses benefited from reduced variable compensation expense as a result of our lower financial performance and efficiencies associated with our recent workforce rebalancing.

GAAP net income for the second quarter fiscal 2014, included a pretax charge of $655 million related to the expected cost of remediation of issues with memory components in certain products sold in prior fiscal years.

The charges related to the expected remediation cost for certain products containing memory components manufactured by a single supplier between 2005 and 2010. These components have been determined to have the potential to sell due to a design or manufacturing defect.

These are widely used across the industry and are included in the number of Cisco's products. Although the majority of these products are beyond Cisco's warranty terms and the failure rates are low, Cisco is proactively working with customers on mitigation. This results in a charge to product cost of sales during the second quarter fiscal 2014. This charge has been excluded from non-GAAP results as Cisco does not believe is a reflective of ongoing business and operating results.

Total cash, cash equivalents and investments were $47.1 billion, including $3.3 billion available in the U.S. at the end of the quarter. We generated operating cash flows of $2.9 billion during the quarter.

We continue to drive our capital allocation strategy. As you recall, in Q4 FY'12, we committed to return a minimum of 50% of our free cash flow annually through dividends and share repurchases. In FY'13, we returned over 50% of free cash flow and I am pleased that in the first half of FY'14, we have returned in excess of the 150% of free cash flow to our shareholders comprised of $6 billion of share repurchases and $1.8 billion a dividend.

In Q2, we returned $4.9 billion to shareholders, a quarterly record for Cisco. This included $4 billion to share repurchase and approximately $900 million through our quarterly dividend. Our diluted share count decreased by approximately 100 million shares, driven by these repurchases. We expect the remaining impact of the Q2 share repurchase to further reduce share count next quarter.

In addition, today, our board approved an increase of $0.02 to the quarterly dividend to $0.19 per share an approximate 12% increase, representing a yield of approximately 3.3%. This dividend increase, combined with the anticipated share repurchases in the second half of the fiscal year, would comfortably exceed a return of over 100% for the full fiscal year of our free cash flow.

In Q3, we anticipate incurring additional debt to refinance our maturing bonds and enhance our domestic cash balances to support our ongoing commitment of returning cash to shareholders.

John, I would turn it back over you.

John Chambers

Thank you, Frank. I will now provide some additional detail on our Q2 performance and trends we are seeing in our business and in the market. I will start with an update on the three economic and product cycles we outlined in our last call.

First, we saw emerging orders declined 3% year-over-year compared to the 12% decline in Q1, with the BRICS [plus] Mexico down 10% as I said earlier. What we saw some improvement quarter-to-quarter, emerging markets remain challenged as we discussed in the last conference call. While this economic trend remains out of our control, we have put in place important programs and efforts designed to capture growth and position Cisco to capture share even if these markets remain challenged.

Second, service provider orders declined 12% year-over-year, SP Video orders including the set-top boxes were down 20%. Service provider orders, excluding SP Video, were down 7%. Product transitions and core routing, along with the emerging markets weakness, also negatively impacted service provider results.

Third, product transitions. At the end of last year, we introduced new switching and routing platforms which typically ramp up over four to eight quarters. Our next-generation routing business saw year-over-year revenue decline of 11% with orders down 5%.

As we manage through these transitions, we have announced reference customers for the NCS platform including Telstra, KDDI and BSkyB. We expect both the NCS and CRS-X to ramp through back half of the year. Switching revenue declined 12% year-over-year with orders down 6%, as we saw some deals delayed as customers architect and qualified their new application centric infrastructure systems. We were very pleased with the first shipping quarter of the Nexus 9000 as the booking pipeline from the beginning to end of the quarter nearly tripled. We believe we are firmly taking share in the 10Gig and the 40Gig data center switching markets.

I will now walk through the elements of the product portfolio that I have not yet mentioned in terms of year-over-year revenue growth. Data center revenue grew 10% with order growth rates in the mid-30s. Revenue this quarter in data center had some impact from lower backlog coming into the quarter and the timing of shipments. The pipeline continues to look very strong and UCS continues to take market share.

Wireless declined 4%. Cisco's cloud networking platform, Meraki, continues to perform very well growing over 100% year-over-year and more than doubling customers from 4,300 one quarter ago to 9,600 in this quarter, due largely to the power of the Cisco channel. Approximately one-third of Meraki's business is deferred. We are also seeing the wireless impact to more complex architectural deals in our large enterprises and service providers where wireless is part of a much broader solution which have long sales cycles.

Security revenue grew 17% with particular strength in network security up 21% and content security up 5%. We are seeing orders grow significantly faster than revenue up 30% this quarter as we continue to shift toward more recurring revenue models in this business.

The Sourcefire acquisition continues to perform very well and there is no question that the Sourcefire acquisition has accelerated our position as a leading security company and in our view, the only one capable of delivering an end-to-end architectural approach. We are very pleased with the performance of both Meraki and Sourcefire acquisitions as part of our build, buy and partner innovation strategy.

Now moving on to collaboration. Collaboration revenues decline 7% with a decline of 9% year-over-year in unified communications as we plan for the upcoming product refresh with our customers. The WebEx conferencing business had a very strong quarter up 21%. In WebEx we so many matrix including billable minutes and new customers options grow quite well. This growth came from both very large enterprise deals as well as good traction in the SMB space.

It is worth noting that our goal to move more Cisco's revenue to recurring is taking place today in our collaboration businesses, security businesses and with respect to some of our recent acquisitions like Meraki. This quarter we saw product deferred revenues increase approximately $100 million quarter over quarter. Over time, you will see us introduce new consumption models in other parts of our business that align with how customers want to buy IT today which will also help us drive better visibility going forward.

Services revenue grew 3% with both technical services and advanced services up 3%. As we discussed last quarter, service revenues are currently tied closely to product growth. So the deceleration in product momentum continues to impact service revenues. Continued investment and consulting services, remote monitoring smart services and analytics would drive additional opportunities in the quarters to come. We did begin delivering a new set of security services this quarter continuing to better address our customers' top priority.

Now on to our cloud business. We will not report this as a specific product category but rather reflected across our product categories continues to grow very well. On the cloud infrastructure side, we once again advanced our position as the leading cloud infrastructure provider. In Q2 we saw double-digit booking growth with massively scalable data center customers as they chose and purchase the Cisco UCS and Nexus portfolio. Our cloud services business also continued very strong growth. As mentioned before, we experienced very strong growth in Meraki web ask and security cloud services business.

At Cisco Live in Milan, in January, we announced several important additions to our cloud portfolio, including Cisco InterCloud, the ability to create interoperability and highly secure hybrid cloud environments across multiple public and private clouds.

While our peers' talent workload mobility within their proprietary cloud offerings, only Cisco can enable organizations to combine and move workloads, storage, compute and applications across different clouds and hypervisors, securely, with all the associated network and security policies.

I will now move onto provide background on our geographic and customer segments in terms of Q2 year-over-year product orders unless specifically stated otherwise. In Q2, product orders declined 4% year-over-year. As we said earlier, total product book-to-bill was greater than 1.

To provide a geographic view of orders this quarter, Americas declined 5%. In the U.S. balancing out strong enterprise and commercial momentum, U.S. public sector declined 4%, within U.S. public sector state and local and education grew 7% and U.S. federal declined 16%. U.S. service providers declined 11% as we managed through the SP Video transition and product cycles mentioned earlier.

Now moving on to Asia-Pacific, China and Japan, which as a region declined 5%, China declined 8% as we and our peers continue to work through the economic and political dynamics in that country.

The Europe, Middle East Africa and Russia region declined 2%. Northern Europe and the U.K. are showing good momentum, while Southern Europe continues to be challenging. Signs suggest Europe is stabilizing, they are still fragile especially in the South.

Moving onto a segment view, enterprise declined 2%, commercial grew 1%, public sector grew 1% on a global basis, and as mentioned above, service provider declined 12%.

As we said on last call, managing through product and market cycles is part of being a leader in the technology industry, we feel very confident in our ability to work through these cycles overcoming the coming quarters. We will continue to tell you exactly what we see and manage the business to perform to the expectations we set with you as we did this quarter.

Frank, I am now going to turn it back over to you.

Frank Calderoni

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

The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP. As John discussed earlier, we expect total revenue to decline in the range of 6% to 8% on a year-over-year basis. For the third quarter, we anticipate non-GAAP gross margin to be in the range of 61% to 62%.

Given the business volumes assumed in our revenue guidance it is most likely to be at the low end of this range. Our non-GAAP operating margin in Q3 is expected to be in the range of 26.5% to 27.5% and our non-GAAP tax provision rate is expected to be approximately 21% in the third quarter.

Our Q3 FY'14 non-GAAP earnings per share is expected to be in the range of $0.47 $0.49 per share. As we communicated last quarter, we expect FY'14 non-GAAP earnings per share to range from $1.95 to $2.05.

We anticipate our GAAP earnings to be lower than non-GAAP EPS by about $0.10 to $0.13 per share in Q3'14 and $0.56 to $0.62 for the full year. This range includes pre-tax impact of approximately $50 million in Q3 FY'14 and up to $550 million for the full year as a result of our anticipated restructuring charges related to our workforce reduction plan that we announced last quarter.

During Q2 FY'14, we recognized pretax charges to our financial statements of $73 million related to that announcement. Please see the slides that accompany this webcast for more detail. Other than those quantified items noted previously, there are no other significant differences between our GAAP and our non-GAAP guidance. This guide assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant. And as a reminder Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

I will now hand the call back over to John for detail on the business momentum and trends. John?

John Chambers

Frank, thank you very much. Managing transitions has been a core foundation of our success for nearly 30 years. The Internet of Everything is the biggest market opportunity ahead encompassing every technology trend in the market today. In recent months the Internet of Everything has become the center of most every conversation with CEOs, industry and country leaders. 2014 will be the inflection point for the Internet of Everything.

The level the excitement we see in the conversations were having today and with customers about the next wave of the Internet, reminds me of the mid-1990s. At that time, we saw the Internet and e-commerce moving from just a tech thing to something that did impact every industry. Like customers did when the Internet and e-commerce were becoming mainstream, customers are turning to Cisco as a trusted partner today to capitalize on the opportunity and minimize the risk in their business as they move into the Internet of Everything.

As we saw in the e-commerce day, there is a light between thought leadership and mainstream adoption and we still are only in the beginning stages. We are seeing tangible early traction, for example, in our top 50 targeted accounts with over $2 billion opportunity for Cisco. We are managing the transitions in our portfolio today and building for the Internet of Everything for tomorrow. This is how I am looking and evaluating our progress.

First, our willingness to change and disrupt. You heard me say for at least two years, the pace of change has become exponential. Multiple transitions are occurring at the same time requiring Cisco to transform on multiple fronts faster than we have done before. Our scale, customer relationships and number one market position in most of our targeted categories gives us a huge advantage as we deliver a new model for IT. The next generation of network will collapse the OSI stack from seven layers to three, bringing applications, networking and security together at scale. This will not only happen in the data center as we are seeing today but across the campus, access and into the cloud.

Second, customer traction. We don't get to decide whether or not we will emerge as the number one IT company. Our customers do. What we do get to decide is how we continue to deliver the value to our customers to retain the market leading position. This will be done by selling business outcomes enabled by architectures. I look closely at how we are engaging with customers and moving from technology provider to a trusted business partner. Whether it is the $3 billion of value creative in the city of Barcelona through connected and intelligent infrastructure or the first digital country Israel or several major retailers basing the networks on Cisco in order to prepare for the Internet of Everything, our customers are coming to us to capitalize on the opportunity.

Third, operational excellence and disciplined cost management. We managed non-GAAP operating expenses very well this quarter, decreasing 9% as we focus on cost management and productivity. This execution shows we are able to focus on cost as we transition the business. We continue to focus on operating as an efficient organization while at the same time making the right investments to drive long-term growth.

Fourth, creating shareholder value. As we execute our strategy to become the number one IT company, we have also committed to returning at least 50% of cash flow annually to our shareholders. As Frank said earlier, we will comfortably exceed the amount for the balance of the fiscal year. When our operating results have been impacted by a challenging macro environment in the emerging markets along with choices we are making to transform the company, we demonstrated that our confidence in the future and our support for shareholders by materially increasing our capital return as we did last quarter. We continue this focus on shareholder value with the $4 billion share repurchase this quarter and the dividend increase we announced today.

Change has always been good for Cisco and our track record for transforming ourselves, both as a company and as leaders, is unparalleled. We are as close to our customers and partners as ever. We understand their challenges and where they need us to be there, and we are using this position to build the products, solutions and platforms to meet the demands of the market. This to me, has always been the key leading indicator of future success and financial results, and gives me confidence that we will emerge as the number one IT company.

Mel, let me turn it over to you.

Melissa Selcher

Thank you, John. We will now open the floor to Q&A. We still request that sell side analysts, please ask only one question. Operator, please open the floor to questions.

Earnings Call Part 2: