Blair Christie – Senior Vice President, Corporate Communications
John Chambers - Chairman and Chief Executive Officer
Frank Calderoni – Chief Financial Officer
Ned Hooper - SVP of Corporate Development and Consumer Group
Pankaj Patel - SVP and General Manager of Service Provider Group
Robert Lloyd- SVP of Sales for United States, Canada and Japan
Rick Justice – Executive Vice President, Worldwide Operations and Business Development
Simona Jankowski - Goldman Sachs
Jeff Evenson - Sanford Bernstein
Mark Sue - RBC Capital Markets
Nikos Theodosopoulos - UBS
John Marchetti – Cowen and Co.
Scott Coleman - Morgan Stanley
Jason Ader – William Blair
Jeff Kvaal – Barclays Capital
Simon Leopold – Morgan, Keegan & Co.
Cisco Systems, Inc. (CSCO) F2Q09 Earnings Call February 4, 2009 4:30 PM ET
Welcome to Cisco Systems second quarter fiscal year 2009 financial results conference call. (Operator instructions) Now I would like to introduce Ms. Blair Christie, Senior Vice President of Corporate Communications for Cisco Systems. Ma’am you may begin.
Good afternoon everyone. Welcome to our 76th quarterly conference call. I am Blair Christie and I’m joined by John Chambers, our Chairman and CE0; Frank Calderoni, Chief Financial Officer; Rick Justice, Executive Vice President of Worldwide Operations and Business Development as well as Ned Hooper, Senior Vice President of Corporate Development and Consumer Groups and Rob Lloyd, Senior Vice President of Sales for the United States, Canada and Japan.
The Q2 fiscal year 2009 press release is on full national market wire and the European Financial and Technology Wire as well as on the Cisco website at www.cisco.com. I would like to remind you that we have a corresponding web cast with slides. In those slides you will find the financial information we cover during this conference call, as well as additional financial metrics and analysis that you may find helpful.
Additionally, downloadable Q2 financial statements will be available following the call including revenue by product and geography. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets and cash flow statements can be found on our website in the Investor Relations section. Just click on the financial section of the website to access the web cast slides and those documents.
A replay of this call will be available via telephone from February 4 through February 11 at 866-357-4205 or 203-369-0122 for international callers. It is also available from February 4 through April 17 on Cisco’s investor relations website.
Throughout this call we will be referencing both GAAP and non-GAAP financial results. The financial results in the press release are unaudited. The matters we will be discussing today include forward-looking statements and as such as subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent annual report on Form 10-K and quarterly report on form 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 conference call is not permitted and I will now turn it over to John for his commentary on the quarter. John?
Thank you very much. During the opening comments of this conference call I will focus on what I view to be the key take away’s for Q2 fiscal year 2009. First, a very candid discussion about what we are seeing in the market on a global basis relative to Q2 and its effect on our Q3 expectations.
Second, an update giving the current economic challenges and how we are number one reducing expenses, number two prioritizing our many opportunities for the future as well as how we are realigning resources as it relates to emerging markets, new market adjacencies and emerging technologies.
Third is the focus on our six-point plan for economic challenges and why we continue to be comfortable with our long-term growth goals of 12-17% assuming that the global economy returns to normal growth rates.
Finally, our revenue guidance for Q3 with the appropriate caveat. Frank will follow these opening comments with additional detail on Q2 fiscal year 2009. The third section of the call will focus on business momentum and strategy from a geographic, customer segment and product basis. Frank will then follow with some additional parameters around our guidance. I will wrap it up with some comments in terms of Cisco’s momentum going into Q3 and finally our Q&A session.
Q2 FY09 was a solid quarter for Cisco from a revenue and earnings perspective given the many challenges we are all seeing occur in the global marketplace. In terms of those areas that we can control or influence we continue to feel very comfortable with our long-term vision and differentiated strategy as we move into new market adjacencies and prioritize our existing opportunities.
Our organization structure leverages the power of communities of interest which we call councils which we believe are $10 billion opportunities, boards that we see as $1 billion opportunities and working groups. These organization structures allow us to more effectively prioritize resource across over two dozen cross functional opportunities as well as within each of our corporate functions.
We are pleased with our progress and are aggressively managing our expenses while at the same time aligning resources to where we think Cisco can gain share and differentiate ourselves in the future. We execute too with a compelling financial position and an innovation engine from both a products and business model perspective that should allow us to continue to be a leader in the marketplace.
The following is a quick snapshot of both our financial highlights and innovation position. First, Cisco generated $3.2 billion in cash in Q2 resulting in cash and investments of approximately $29.5 billion. This is the second highest level of cash flow from operations in any quarter.
Second, solid balance from a product, geographic and customer segment perspective, perhaps one of the broadest balances across the IT industry.
Third, continued success in being the number one or number two players in most of our 20+ targeted product areas.
Fourth, an innovation engine that results in broad product leadership across the entire range of products that we have in our history. Architected from the home to the data center, across our enterprise commercial, consumer and search provider market segments. We believe this product pipeline across all of our existing and new priorities is the strongest we have ever had.
Not only is our architecture across any combination of networks enabling the next generation of productivity, entertainment and business models but we believe we have the strongest position in terms of customer relationships with enterprise, government, service provider and channel partners in helping enable our customers’ goals.
For example, last week in trips across emerging markets, key customer events and at the World Economic Forum where I met personally with over 100 customers on an individual basis the consistent feedback was that Cisco is dramatically expanding our value to these customers across all of the above-mentioned market segments on a global basis from both a technology and a business partnership perspective. Many of these customers also stated their increasing preference for an end-to-end player for product leadership strength as well as financial strength and staying power that Cisco represents.
Just as we led in the first phase of the Internet, i.e. Web 1.0, from both an internal utilization and the expertise we offered our customers to enable this capability we believe that we are uniquely positioned to provide very similar leadership in this second phase of the Internet through collaboration enabled by Web 2.0 technologies. Once again, we are leading in terms of our own utilization and partnering with our customers to drive their goals of changing business models enabled by the network.
Our internal utilization of collaboration of Web 2.0 is exploding and loading networks aggressively. We will share some of the details with you later on the call but we do believe that same phenomenon will occur in our customers’ environments in the next several years.
Now moving on to a summary of our Q2 financials.
While year-over-year comparisons show that we are not immune to the challenging economic environment I am very pleased with our continued strong profitability and ongoing cash generation which provides us the flexibility to be agile and differentiate ourselves during this difficult period.
Revenue was $9.1 billion, a 7.5% year-over-year decrease. Cash generated from operations was $3.2 billion bringing our total cash and investments to approximately $29.5 billion which I think is the highest in the high tech industry.
Non-GAAP EPS were $0.32, down 16% year-over-year and GAAP EPS were $0.26, a 21% decrease year-over-year. Total non-GAAP gross margins were 64.0% a decrease from 65.6% last quarter. Non-GAAP operating expenses as a percentage of revenue for Q2 were 38.7% declining $178 million or approximately 5% quarter-over-quarter.
Our early stage internal start ups that we call emerging technologies were also solid in Q2 in terms of year-over-year order growth. Our strategy is to develop a reasonable percentage of these emerging technologies into what we categorize as advanced technologies with the realistic possibility of becoming $1 billion plus in sales and the number one market position in the respective product categories.
While these numbers are not financially material at this point in time, we believe with the proper execution they can become very significant to our growth rate in the long run. The emerging technology group orders in total grew approximately 48% year-over-year. The number of customers that ordered, for example, TelePresence systems is now 312 in total and grew by 65 new accounts in Q2.
While growth in most of our countries around the world was challenging, we did see some year-over-year order growth from the mid teens to high 20’s in the following countries: Mexico, Germany, Australia and Switzerland. However, we did find that the majority of our large countries such as the U.S., the U.K., India, Russia and Italy had negative order growth year-over-year in Q2.
We will provide additional details on products, geographies and customer segments later on in the call.
In summary, for those areas that we feel we can control or influence we are doing a reasonably good job. The key market transitions relative to collaboration, virtualization and digital networking which will drive productivity and growth in network loads for the next decade are evolving even faster than we thought one quarter ago. However, all of us are seeing the same financial and global economic challenges that have accelerated over the last two quarters.
Our approach and underlying assumptions regarding our short-term strategy in the current environment has not changed. We start with a culture and a track record of using economic challenges to gain market and profit share as well as to move into new market adjacencies. We do our best to be transparent with you in terms of what we are seeing in the market. For example, it is almost a year and a half ago when Cisco was among the first to indicate that we were seeing some challenges in orders for the U.S. financial and some global accounts.
It is now clear that we are in a global economic slow down and for the company that operates in over 160 countries worldwide we will obviously be impacted. But if there is one lesson learned during the preceding economic challenges that Cisco faced in 1993, 1997, 2001 and 2003 it is the importance of rapidly positioning our company to not only weather the storm but to lead as we inevitably come out of the downturn.
We have traditionally done this extremely well and with the appropriate caveat believe that we have already positioned the company to do it once again. Time will tell if this confidence is justified and as we mentioned earlier we are already on track to over achieve our total expense reduction goal of at least $1 billion, nice job by the team on that, from our annual run rate and we are on our way to realigning an additional $500 million of resources based on careful prioritization of new growth opportunities.
We also want to use this call as we have done in the past to share very transparently what we are seeing in terms of order momentum and feedback from our customers. Again, with all the appropriate caveats that we could be wrong in our assumptions and strategies.
Last quarter we outlined our approach to economic slow downs and at this time we would like to give you an update on our progress. When we see these market transitions occurring we go to our play book for economic downturns where there are four basic guidelines that we follow.
The first guideline is to be realistic about the cause of your challenges. Is it primarily the macro economic environment or your strategy? We believe that our long-term strategy is working extremely well and we will stay focused on this continued implementation.
Second, determine the length and depth of the downturn and respond appropriately. As we were one of the first to discuss in our last quarter conference call, we felt this downturn was occurring quicker and with more severity than many of our peers. The length of the downturn is still in question and being very candid no one including us really knows how long it will last. The majority of our customers are guessing 2010 while a smaller group sees the upturn towards the end of 2009.
Given the coordinated activities of global central banks and the extremely large stimulus packages that are being implemented in almost all of our major countries I tend to be a little bit more optimistic than most of my customers. Time will tell if that optimism is appropriate.
Third, prepare for the upturn. We believe this is a time to differentiate ourselves from our peers and be aggressive in ways that will position Cisco for the future profitable growth and stronger market share leadership. This is the area that I believe we can uniquely position Cisco with our process driven vision, differentiated strategy and execution combined with our organizational structure around councils and boards that will allow us to move with speed, skill, flexibility and with a replicatable process as this upturn inevitably occurs. I will provide additional details on how we are preparing for the upturn in a moment.
Fourth, expanding customer relationships. We are attempting to move very rapidly across the majority of our service provider, enterprise and government accounts to dramatically expand both the technology relationship as well as the business relationship as it relates to the customer’s future growth and their own flexibility in managing through the downturn while preparing for the upturn. There is an increasing interest in understanding the value Cisco can bring to these customers in both managing through the downturn as well as preparing for the upturn and catching the next wave of both business models and productivity.
It is very important to understand our focus on resource prioritization and realignment as we aggressively move into market adjacencies during this downturn as compared to prior economic downturns. In short, this time it is different. In 2001, for example, we were at the end of a decade long run on product cycles, productivity and business model changes enabled by the first phase of the Internet. Unfortunately, our six advanced technology investments at that time were at last 3-5 years away from being significant in terms of financial results.
In 2009 we are in almost the exact opposite scenario. Our new product pipeline is extremely strong and most of the market adjacencies that we are entering have the potential to be material in the next 2-3 years. Just as we have done in prior challenges, and as we discussed in last quarter’s conference call we have also implemented a game plan for dealing with these challenges.
This game plan for the current downturn is called our six-point plan. In the six-point plan, point one is we will drive ever major element of our resource prioritization, new products and market adjacency decisions through our vision, differentiated strategy and execution model.
First, we believe our vision of how the industry will evolve is driven by an increasing role of intelligent networks will play in all forms of communications and IT is enabled by the network. This transition is occurring as we expected. Our differentiated strategy enabled by network collaboration and the products playing together over time in a tightly architectured structure is allowing us to move into market adjacencies with tremendous speed, skill and flexibility. Cisco will remain focused on both the technology and the business architectures to enable our customer objectives.
In short, our visions strategy execution is working well and we plan to stay focused on continuing to expand this approach.
Second, collaboration of Web 2.0 driving future growth and productivity. We will continue our rapid expansion of collaboration technology that new business models in both our product architectures and our own internal IT implementation. We plan to continue to quickly realign resources to focus on over two dozen market adjacencies that will loosely and then tightly come together with our core technologies. Our goal is to be the best example of using Web 2.0 technology such as TelePresence, WebX, Wiki, blogs, discussion forums, Cisco Vision, communities, etc. in an architectural process driven approach that drives productivity and new business models.
I cannot overemphasize the importance of any device to any content over any combination of networks enabled by Cisco’s technology architecture approach but it also is important that video will play in not only communications to life but also in loading networks, what we call visual networking.
Resource management and realignment, through our councils and board structures we have already realigned over $500 million of resources to these opportunities and we expect to realign another $500 million by the end of fiscal year 2009. We have successfully identified these opportunities, the resources required and the timeline. While we believe that some of the opportunities will have short-term impact on the next 6-12 months most are strategic investments that we believe will position us for the long-term growth.
Many actions we took this quarter including our continuing hiring pause along with a significant amount of non-headcount related expense reductions which Frank will provide more detail on later led to a 15% decrease in our discretionary operating expenses in Q2 FY09 compared to the prior quarter.
Fourth is being aggressive in our strategy, prioritize and execute. We will also be bold in taking good business risks during this downturn to build up our market transition opportunities and put our many assets to use in existing and new markets as the recovery occurs. I will attempt to briefly summarize both the approach as well as the required resource prioritization as we move aggressively into new markets.
Step one we are prioritizing our top five opportunities for the entire company and making sure that they are properly resourced. These top five priority opportunities are next generation company and next generation customer relationships or what we call internally Cisco 3.0. Second, collaboration/Web 2.0. Third, video and visual networking. Fourth, data center and virtualization. Fifth, globalization.
While we have continued to gradually decrease our total operating expenses we will be aggressive in both realigning and incremental funding based on future incremental opportunities. Then as a third step we will utilize our strong balance sheet to support our resource realignment, investment and acquisition strategy as we broaden our product portfolio and continue to fund our conservative, but strategic financing arm of Cisco Capital.
Fifth, investment in the U.S. and selected emerging countries. We intent to invest aggressively in two geographic categories; the U.S. and selected emerging countries. In our opinion the U.S. will be the first major country to recover. Therefore we will make many of our market adjacency investments in the U.S. We must gain from this economic pain that we are currently experiencing. This downturn, in my opinion, is both the biggest challenge of our lifetime but also represents the biggest opportunity to transform our company as well as our economy through a series of bold steps.
As a nation we spent the last decade helping other countries embed smart infrastructure and now we need to invest in leading technology infrastructures that can become the basis for economic recovery, future productivity gains and standard of living improvement for the majority of Americans. We believe we can transform our nation and spur our economy with smart digital infrastructure.
Smart digital infrastructure will have a profound impact on healthcare, energy, broadband and education. In each of these areas the role of government and business leaders must not only be to transform but also must evolve into collaborative structures to achieve benefits for the country. Business must evolve. Future business models must reflect global connectiveness but also a collaborative evolution in business structures which move away from the traditional hierarchy of command and control models.
Leadership will be based upon innovation and operational excellence. At the same time it is important to realize that we are a connected environment for global growth and perhaps for the first time through network technology as well as public/private partnerships we have the potential to meaningfully impact over three billion people in the world making less than $3 a day. It is something that should be a major disappointment to us all that we have not been able to more effectively address this global challenge.
We also believe countries like China and India are the best positioned among the emerging country peers to minimize the effect of the global challenges on their own economies. We are also optimistic that we will continue to see strong support of many governments around the world to minimize the effect of these major challenges.
Therefore, from an emerging countries focus China and India will be in our first wave. We will continue to invest in the downturn. Just as we needed to prioritize in our market adjacencies we need to do so in emerging markets. There will be a second wave of emerging countries that we will focus on including Mexico, Brazil, Saudi Arabia and Russia and a third wave of approximately two dozen select countries out of the more than 100 emerging countries where we do business.
The strategy on emerging countries is simple. Over time we expect the majority of the world’s GDP growth will come from emerging countries. In expanding these relationships during tough times our goal is to be uniquely positioned as the market turnaround occurs. This is very similar to what we did in Asia’s 1997 financial crisis.
Fifth, the power of the network as a platform driving the future communications and IT. Finally, we will remain focused on our stretched goal of evolving into the top communications and IT company which will be enabled by the expanding role of intelligent networks. This can be the definition of a very successful implementation of our six-point plan after the inevitable upturn occurs.
At this time I would like to give you some additional data and customer feedback for you to understand why we are continuing to move rapidly to realign our cost structure and prioritize our investments after a reasonable Q2 fiscal year 2009.
There were a number of positives in the quarter such as our financial results, balanced product revenue, advanced technologies and solid momentum from some of our developing and emerging geographies. As we discussed last quarter at that point in time the U.S. and Western Europe were seeing the most challenges from our customers’ point of view regarding the health of their business and their own orders.
However, this challenge has now spread across all countries around the world. Unfortunately, what we said on last quarter’s conference call regarding challenges across the industry segment did continue. Customers not just in the financial, automotive and retail sectors but across most of our enterprise, commercial and service provider customers faced what they view as a very major challenging business environment.
While we would not normally provide monthly product order growth rates we believe that during uncertain times we should share very openly what we are seeing. Total year-over-year product order growth continued to deteriorate throughout the quarter. For example, order rates in November decreased by 9% year-over-year and December our order growth decreased by 11% year-over-year for products and in January our year-over-year order growth decreased by approximately 20%.
This order growth was normalized for the Thanksgiving and end-of-year Christmas holidays.
Overall for Q2, year-over-year product order growth decreased by 14%. While product revenue growth in Q2 decreased by 11%, book to bill was slightly below one. In summary, just as we were one of the first high tech companies to report our quarter that included October the challenges we saw in the U.S. as discussed in our Q1 call has spread globally.
The environment has continued to change dramatically in the last several months. It is important to note that Cisco is different than many of our peers and approximately 80% of our business is non-recurring each quarter and therefore it is a reasonably good indicator of spending patterns.
Secondly, our balance across all major geographies, major customer segments and over two dozen product families normally works to our advantage. But when you are the number one player in many of these categories and the slowdown has truly gone global across these industry segments, geographies and product families we will obviously be impacted.
It is very difficult given all the uncertainties going on in the market to provide a forecast given the dramatic variability. It continues to be one of the most difficult times in my career in terms of my comfort level with the forecast. It would not be a major surprise to see the numbers vary on either the positive or negative side of revenue guidance that we will provide for Q3. With that being said I still believe that providing some level of guidance is the appropriate thing to do for transparency and for our shareholders.
As we have said in conference call’s over many years Cisco has always been affected by major economic changes, capital spending patterns, new and existing competitors and our ability to execute or not on our strategies and other factors as discussed in our SEC reports. For the purpose of our long range goals as well as our quarterly guidance we are also seeing that our vision of how the industry and the market will evolve will be accurate and we will effectively execute on that vision.
In providing our revenue guidance for Q3 fiscal year 2009 we are going to assume that what we saw in terms of order momentum challenges especially in January will continue into the next quarter. This is also what we are hearing from our global customers, our field forecasts for the next quarter and the feedback that I and others received from customers in the last several months especially at the World Economic Forum last week.
With this discussion in mind, our revenue guidance for Q3 fiscal year 2009 including our usual caveats as discussed earlier and in our financial reports is for revenue to decrease in the 15-20% range year-over-year. Again, as a reminder, during each of the past economic slow downs Cisco has always navigated very effectively through difficult times to extend our share of our customer spend while moving aggressively into new market adjacencies.
As a result, we were better positioned coming out of the transition versus our peers. This strategy served us well during the last downturn when our strategic investments resulted in our advanced technologies segment today which represents approximately 25% of our product business. As we approach growth opportunities and challenges in front of us we bring a very experienced and broad leadership team that has been through these challenges together over the last decade.
We also bring a culture that adjusts very quickly to changes and has consistently continued to execute effectively regardless of those opportunities or challenges. As we have done before, leveraging market slow downs to move into many new market adjacencies. While we all wish these challenges would not occur, it is during these times that we have consistently gained the confidence of our customers, partners, shareholders and employees to be even stronger versus our peers following these challenges.
In summary, we believe that we are well positioned in the industry from a vision, differentiated strategy and execution perspective. We believe that we are entering the next phase to grow and productivity will center on collaboration enabled by network enabled Web 2.0 technologies.
We will do our best to provide product architectures and the expertise to help our customers in the implementation of these collaborative capabilities from a technology and a business perspective. We will also share with our customers how we have done this internally. In short we are going to attempt to execute a strategy over the next decade that is similar to what we did in the early ‘90s. As we said before it powered our growth for the next decade except for the obvious difference of being a company that has a run rate of approximately $36 billion per year and over 67,000 employees focused on these opportunities.
Now Frank let me turn it over to you.
Thanks John. For today’s call I will provide a recap of the financial results of the second quarter of fiscal 2009 and will then discuss why I firmly believe our financial strength, portfolio diversification and speed of execution helps us navigate market transition and continues to position us well for the upturn.
Total revenue for the first [sic] quarter was $9.1 billion, a decrease of 7.5% year-over-year well within our guidance for the quarter of minus 5-10%. Total service revenue was $1.7 billion up approximately 10% year-over-year with solid growth across our geographic theaters. Services revenue and our recurring product revenue stream primarily from WebX and IronPort businesses represented approximately 20% of our total revenue mix this quarter.
Total product revenue was $7.3 billion down approximately 11% year-over-year. Switching revenue was $3 billion a decrease of 11% year-over-year while routing revenue was $1.5 billion down 23% year-over-year. Advanced technologies revenue totaled $2.4 billion representing an increase of 1% year-over-year with good performance in video systems with growth of approximately 18% year-over-year.
We also saw growth in security of approximately 2% and application networking services of approximately 1%. Unified communications declined by approximately 5% year-over-year and home networking declined by 11% year-over-year. Other product revenue totaled $415 million, a decrease of 22% year-over-year related in part to our optical and cable businesses this quarter.
Total year-over-year revenue growth by geography ranged from up 1% year-over-year in both Japan and European markets to down approximately 12% in Asia Pacific. Revenue in emerging markets theater decreased by 11% and in the United States and Canada revenue decreased by approximately 9% year-over-year.
In a difficult economic climate such as this the continuing strength of our financial model enabled us to manage our gross margin levels. Q2 total non-GAAP gross margin was 64.0% in line with our guidance, down 1.6 points quarter-over-quarter and 1.2 points year-over-year. For products only, non-GAAP gross margin for the second quarter was 63.6%, down 2.6 points quarter-over-quarter and down 2.2 percentage points year-over-year.
The quarter-over-quarter decline was driven by lower volume, product mix and other manufacturing related costs. The year-over-year decline was driven primarily by lower volume, higher product discounts and pricing, product mix partially offset by cost savings. Our non-GAAP service margin for the second quarter was 65.7%, up from 62.4% last quarter and 61.8% in Q2 fiscal year 2008. This was driven by strong margin from both our technical support and advanced services and a more favorable services mix.
Service margin will typically experience some variability over time due to various factors such as the changes in mix between technical support services and advanced services as well as the timing of contract initiations and renewals.
Total gross margin by geography ranged from 59.5% for emerging markets to 70.3% in Japan. In the U.S., Canada and Asia Pacific our margins are relatively in line with the overall company gross margins. In emerging markets gross margins were 59.5% where we did see a decrease quarter-over-quarter in theater reflecting lower volume and additional reserves consistent with our conservative accounting practices.
We did see gross margins improve on a quarter-by-quarter basis both in our European markets and Japan.
Non-GAAP operating expenses were $3.52 billion in Q2 fiscal year 2009 down from $3.7 billion in Q1 fiscal year 2009 representing a 5% reduction quarter-over-quarter. As we announced last quarter we have been managing to our target of removing $1 billion from our annual run rate by Q4 fiscal year 2009.
Based upon our diligent focus and the speed of our execution on this effort in Q2 I firmly believe we are on track to exceed this target. I am pleased that our expense management performance drove discretionary spend down 15% quarter-over-quarter by reductions in our travel and outside services. I would like to thank the employees of Cisco for delivering these notable results.
Non-GAAP operating expenses as a percentage of revenue were approximately 38.7% in Q2 fiscal year 2009 versus 35.7% in Q2 fiscal year 2008. The foreign exchange benefit on a year-over-year basis was $95 million. Interest and other income was $95 million for Q2 which reflects lower net interest income as a function of lower market interest rates.
Our diversified, high quality cash and investment portfolio continued to perform well within the challenging financial markets with relatively minor asset impairments. I will provide more detail on our investments portfolio in a few minutes.
Our Q2 fiscal year 2009 non-GAAP tax provision rate was 22% consistent with Q2 fiscal year 2009 and our expectations. Non-GAAP net income for the second quarter of fiscal 2009 was $1.9 billion representing a decline of 22% year-over-year. As a percentage of revenue net income was 21%, a strong performance in this market. Non-GAAP earnings per share on a fully diluted basis for the second quarter was $0.32 per share versus $0.38 per share in the second quarter of fiscal year 2008 which represents a 16% decline year-over-year.
GAAP net income for the second quarter was $1.5 billion as compared to $2.1 billion in the second quarter of fiscal year 2008. GAAP earnings per share on a fully diluted basis for the second quarter were $0.26 per share versus $0.33 per share in the same quarter of fiscal year 2008.
Now moving on to the balance sheet, in this difficult macro economic environment we are also pleased with our historically solid balance sheet and how we continue to further strengthen our key balance sheet metrics as I will highlight shortly.
The total cash, cash equivalents and investments at the end of Q2 was $29.5 billion up from $2.8 billion in Q1 fiscal year 2009. Of this total balance $3.2 billion was held within the United States. During Q2 we generated $3.2 billion in cash flow from operations. This represents near record operating cash flow even in a very tough environment and our second highest cash flow quarter ever for Cisco.
Moving on to accounts receivable, we reduced our receivables 12% from Q1 fiscal year 2009 with a remaining balance of $2.9 billion. We remain very pleased with the quality of our receivables portfolio. At the end of Q2 day sales outstanding (DSO) was 29 days which was flat compared to Q1 fiscal year 2009.
Total inventory at the end of Q2 was $1.1 billion, a reduction of approximately $100 million quarter-over-quarter. Non-GAAP inventory churn were 11.3 this quarter relatively flat quarter-over-quarter and up 7/10 of a point from Q2 of last year. Our inventory purchase commitments at the end of Q2 were $2.7 billion, a 6% reduction from the end of Q1 fiscal year 2009.
For the quarter we repurchased $600 million of common stock or 37 million shares of our stock at an average price of $16.40 per share. We ended the quarter with approximately $6.8 billion remaining in the current stock repurchase authorization. Deferred revenue was $9.3 billion at the end of Q2 fiscal year 2009, an increase of approximately 16% year-over-year. Deferred product revenue was $3.2 billion up approximately 20% from last year while deferred service revenue was $6.1 billion up approximately 15% year-over-year.
At the end of Q2 our headcount totaled 67,318, a net decrease of approximately 329 from the end of Q1. In mid October we did implement a pause in our external hiring and we have continued that throughout this quarter.
Now I would like to discuss how we are managing Cisco’s financial position and why we believe this gives us a competitive advantage and strengthens our ability to lead in the future. We believe our vision, strategy and execution model will enable us to move into market adjacencies with tremendous speed, scale and flexibility. With $29.5 billion in cash, cash equivalents and investments, a solid balance sheet, our Cisco Capital Financing Arm and our robust portfolio of innovation all of which provide a key competitive advantage, we believe we continue to be well positioned to compete effectively in the market downturn and thereafter take advantage of the market upturn when it does occur.
Our conservative investment portfolio is invested in securities with an average credit rating of AA or better. Approximately 90% of our cash and fixed income portfolio is invested in cash or highest rated short-term A1 plus or long-term AAA securities. An ongoing focus on dynamic risk mitigation has significantly strengthened the cash and fixed income portfolio for Cisco since the onset of the financial crisis. This has resulted in an immaterial mark to market impact on our portfolio valuation in absolute terms or when compared to last quarter.
Continued diligent focus on our accounts receivables, supply chain and ongoing review of excess and obsolete inventory have delivered positive results again this quarter. As stated earlier, key metrics such as inventory turns, the level of purchase commitments and DSO remains strong and contributes to Cisco’s consistent performance.
Our financing arm, Cisco Capital, continues to provide financing to our customers and channel partners which enables incremental sales of Cisco’s products, services and networking solutions. In the first half of fiscal 2009 Cisco Capital originated or facilitated approximately $2.1 billion in lease and longer term loan arrangements. To update the numbers previously disclosed, at Q2 fiscal year 2009 we have a combined balance sheet and contingent liability position of approximately $4.4 billion. Of this $4.4 billion we have a net reserve and deferred revenue position of $2.5 billion.
This represents an overall reserve and revenue deferred position of over 50% of the financing portfolio position. We have continued to see positive payment behavior from our customers and will continue to monitor that closely and believe there have been no material impacts to the quality of our portfolio. Broadly speaking, we believe our portfolio has on average an approximate investment grade profile and we remain comfortable with the credit profile and the way we are deploying our capital.
Robust portfolio management and continued technology innovation are also key contributors in our ability to move quickly and take advantage of market transition. As we continue our expansion into new markets we have the ability to quickly realign resources to accelerate our company priorities first by freeing up resources and then by strategically applying them to the highest yielding business opportunities.
In Q2 fiscal year 2009 we committed a realignment approaching $500 million for the remainder of this fiscal year in existing talent and budget basically to specific opportunities on our top five company priorities which are virtualization, collaboration, video, globalization and Cisco 3.0. This is a true realignment and balancing within our portfolio and is not an increase in resources.
In summary we have long stated that our financial management and position are a competitive advantage for Cisco and that belief has been even further strengthened even in light of the current economic conditions. In one quarter’s time Cisco has realigned under $500 million into our growth areas and still managed to reduce our expense run rate.
In fact, it is my strong belief our business model and financial position will provide us with two key capabilities; speed and flexibility. We have been able to minimize negative exposure to our business as well as position ourselves to take advantage of opportunities in this market because we can act quickly and leverage the flexible, profitable nature of our financial position. Through continued prudent expense management along with calculated investments in our highest yielding business opportunities through our resource realignment and portfolio management I believe we will be able to balance the priorities of growth and profitability as we move through this current challenging economic environment.
This will allow us to focus on the things that we believe will grow our company over the long-term, capture these market transitions in our industry, emerge stronger and enhance Cisco as a global and market leader. We think our proven execution speed, market knowledge, management experience and our financial strength uniquely positions Cisco to continue as leader of a network centric marketplace.
I will now turn it back over to John. John?
Thank you very much. At this time I would like to move onto the geographic, customer product segment and strategy review. First, from a geographic point of view in this section of the call we will cover our geographies and then we will move onto customer segments and products for Q2 in more detail.
The products review will be in revenue growth terms but the geographic and customer segments will be discussed in orders unless otherwise indicated.
First from a geographic and customer segment point of view in terms of Q2 year-over-year order growth. In terms of our overall customer segment business the public sector was a bright spot across all geographic markets. Total public sector order growth was in the mid single digits and four of the five theaters had positive public sector growth. Enterprise and service provider were both down approximately 20% in terms of orders on a global basis. The commercial market was down in the high single digits from an orders perspective in Q2.
On to Europe. Given all the challenges that we have seen across Europe we have been relatively pleased with our consistent performance. The European markets in total were down approximately 5% year-over-year. The public sector and service provider both had positive growth in the mid single digits. Enterprise was down in the mid teens. Commercial was down in the high single digits. Germany was a very bright spot in Europe with growth in the high teens while the U.K. and Italy both had a very tough quarter with order growth down over 20%.
Japan order growth was down year-over-year in Q2 by approximately 4%. Public sector had a very strong quarter with growth of over 30%. Commercial was up in the mid teens while service provider was down approximately 20%. Enterprise was relatively flat.
Moving on to Asia Pacific. Asia Pacific order growth was down 12% year-over-year. Specifically, China was down in the low single digits and India was down approximately 30% year-over-year. Public sector had order growth of 3% in Asia Pacific. Enterprise was down in the mid 20’s from an order perspective. Service provider was down approximately 12% and commercial was down slightly.
Moving on to the U.S., the U.S. orders in Q2 were down approximately 18% year-over-year. Public sector growth was in the mid single digits. Service provider was down approximately 30%. Enterprise was down in the high teens. Commercial was down in the low teens.
Emerging market theater. Emerging markets were down by 23% year-over-year. Within that emerging market enterprise was down 35%. Service providers was down approximately 30%. Commercial was down by 10% and public sector orders were down by approximately 6%.
Now on to the products discussion. Q2 year-over-year product growth was down approximately 11%. In spite of a difficult economy we continue to drive technology innovation and product leadership from our core, advanced and emerging technologies. The following is a summary of these areas for Q2 in terms of year-over-year product revenue and growth.
Core product revenues declined 15% year-over-year. Switching was down 11% and routing down 23%. Services revenue increased by 10% year-over-year. Total advanced technology revenues grew approximately 1%. Video systems grew 18% and it became the largest advanced technology in terms of quarterly revenue. Unified communications was down 5%. Wireless was down approximately 6%. Security grew by 2%. Network home decreased by 11%. [Stories] decreased by 7%. Application networking services grew approximately 1%.
The areas that I consider the most interesting at this point in time is how quickly collaboration enabled by Web 2.0 is spreading across all Cisco functions in viral form with a very rapid take up. With that in mind I would like to share with you a brief snapshot as well as proof points as to how quickly the ramp of network Web 2.0 technology is occurring at Cisco in support of our business and organization goals.
Over the last 12 months our internal utilization of Web 2.0 is growing at a pace that is much faster than that of the first phase of the Internet that we experienced in the early 90’s where we entered orders online and supported our customers virtually over the network. A sampling of some of these technologies where the internal ramp is almost in all cases dramatically exceeding the ramp of the early 90’s includes the following: This is literally in the last 12 months what the growth rate has been.
The utilization of the collaboration enabled by WebX is up by 3,100%. TotalPresence meetings as I said earlier are averaging 4,000 a week which enables not only new business models but also new reductions in our travel expenses from a run rate of $750 million to the current run rate of approximately $350 million. Discussion forums are up approximately 1,600%. Cisco C-Vision, our internal version of You Tube is up 2,300%. All of these together are leading our networks even in today’s challenging times at a growth rate of over 400% which obviously requires additional routers and switches to support the network demand.
In summary, from a vision strategy and execution perspective although we would all like to avoid the downturns our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe our differentiated strategy is also achieving the benefits for both Cisco and our customers that we thought were possible. Finally, our execution is on target in terms of the results as measured by customer partnership perspectives, market share and share of our customers’ total communications and IT expenditures.
As the network becomes the platform we are [driving] these capabilities. Now Frank I would like to turn it back over to you for additional detail and financial guidance and other financial highlights.
Thanks John. 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.
The guidance we are providing is on a non-GAAP basis with a reconciliation to GAAP. It is very difficult to provide a forecast given the dramatic variability and the uncertainties going on in the market. These events increase the potential that actual results could vary materially from these expectations.
Therefore, we anticipate total revenue for the third quarter to be down approximately minus 15% to minus 20% on a year-over-year basis. At this point let me remind you that in light of Regulation FD Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.
Now let me give you additional details on the Q3 financial guidance. As we have said in the past forecasting gross margins have always been challenging due to various factors such as the volume, product mix, variable component costs, customer and channel mix and also the competitive pricing pressures.
That being said we believe that our total gross margin in Q3 will be approximately 63% reflecting the revenue guidance I just shared with you. We believe Q3 operating expenses will be approximately 40-42% of revenue. As you would expect in this environment we are focused on aggressively managing our expenses through a pause in hiring, further decreasing travel and discretionary expenses as well as deferring certain capital related projects.
As I mentioned earlier our goal is to reduce our expenses for FY09 by over $1 billion from our annual run rate by Q4 of FY09. This means we are targeting our Q4 2009 quarterly expense run rate to be reduced by about $250-300 million as compared to what we had in Q1 2009 as a quarterly expense run rate. I believe we are on track to exceed this target. While we will undertake appropriate expense management initiatives in the current environment we will also make some calculated investments into areas we believe we can accelerate the development in Cisco’s leadership.
Our strategy in the current business environment is to align our resources to maximize growth opportunities and grow our market position while aggressively managing our expenses. Based on this realignment there may be areas that we may de-emphasize in order to move resources to high impact areas. As we de-emphasize certain areas of our business we expect to have some limited restructuring that may result in a loss of some job functions. These are actions that we normally see as part of our ongoing business management but may experience a higher amount of this activity in the near-term.
At this time, despite these actions we are not planning any across the board workforce reductions. John will give you more specifics on this in his closing comments.
We expect interest and other income to be approximately $80 million in the third quarter. Our tax provision rate for Q3 is expected to be approximately 22%. While we expect to continue our share repurchase program it is difficult to predict the exact weighted average shares outstanding. We are modeling share counts to be flat quarter-over-quarter for EPS purchases. In this estimate of share count we are not taking into consideration any further change in stock price that could occur in the third quarter of fiscal year 2009.
As a point of reference, a $1 movement in our average stock price would change the calculated shares outstanding for purposes of determining earnings per share by approximately $4 million. Regarding cash flow from operations we would expect to generate $500-700 million per month.
For Q3 FY09 GAAP earnings, we anticipate that Q3 GAAP EPS will be $0.05 per share to $0.07 per share lower than non-GAAP EPS primarily due to acquisition related charges and stock compensation expense. Please see the slides that accompany this web cast for more details.
Other than those items noted above 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.
I will now turn the call back over to John.
Thank you very much. The following is a summary of my view of Cisco’s momentum and opportunities entering Q3 of fiscal year 2009 in areas that Cisco can control or influence our leadership from a product perspective, innovation, architecture and operational execution continues to be solid. Balance in a very tough environment given the global challenges continues to be reasonable across our geographies, products, services and customer segments.
This balance normally works to our advantage when there is a slow down in any product areas or customer segments for one or two geographies. However, when you are often the number one player across these categories and the challenges truly go global across all these categories it is almost impossible to avoid the impact.
As we said before, even if the market slows we don’t see this changing our long-term growth opportunities if we execute the way we have in prior slow downs and assuming that the global economy recovers to GDP growth rates similar to those in the middle of the decade.
As we continue into Q3 fiscal year 2009 we plan to aggressively invest in new and adjacent markets for the longer term. In terms of major areas where the momentum appears to be solid and even possibly gaining would be the following; innovation and product leadership look very solid across our core technologies, first and second wave event technologies and our new emerging technologies. Second, collaboration and networking Web 2.0 is moving past the early adoption stage and slowly becoming mainstream. TelePresence would be one of the best examples of this acceptance. Third, speed, scale and flexibility as well as replicatable capabilities are key as we move into new market adjacencies.
Our vision, differentiated strategy and execution process driven approach leverages collaboration and team work combined with our organizational structure of councils and boards is working very well. Fourth, our emerging countries, long-term inevitably the total GDP and GDP growth in emerging countries will outpace that of the developed market. Therefore, we will stay focused on our emerging country strategy.
However in the short-term given the economic challenges we will prioritize our countries into four groups as discussed earlier. Just like you build relationships with customers during tough times the same is true with countries and we are very actively implementing this strategy during these challenging times.
As we stated earlier we do believe that the challenges that initially affected the U.S. have spread to all other countries around the world. On a global and U.S. basis we see the same challenges and uncertainties from an economic, political and capital spending perspective that many of you continue to witness. As we said in last quarter’s conference call one area that we watch closely is service provider spending and unfortunately the concern we expressed last quarter turned out to be justified.
However, in the long run with increasing loads on networks and the rapidly expanding role of video and other Web 2.0 technologies in both the business and the entertainment segment of the industry service providers who want our opinion return to very solid growth markets for us. As such, you will see us continue to invest with these strategic partners.
One of the most important things you do during a period of uncertainty is to communicate in very open and transparent fashion with your shareholders, customers and employees. We believe Cisco is very well positioned to capture new opportunities due in large part to the importance the network plays in all forms of communications and IT as well as our process and organizational structure build around collaboration.
Our customers and even our shareholders are telling us that we are extremely well positioned for the long-term growth with the ability to move into new markets during the most challenging of times. While we have always done what is necessary as an organization to ensure the long-term success of our company, we have come to the decision at this point in time that the realignment and restructuring of resources to new opportunities is the most effective way rather than a large scale, across the board lay off to position us for the future.
If business continues to change dramatically we will obviously do what is necessary to bring our expense structure in line with revenue. If that is the case, lay offs could be necessary as they have been one time in the past. Also, in the spirit of complete openness we are constantly realigning and restructuring resources as part of our normal business process. As an example, in fiscal year 2008 and the first quarter of 2009 we realigned and restructured approximately 1,000 jobs of a global workforce of 67,000 employees.
With the speed we are now moving on some of these fronts we will continue this normal process which in the near-term could result in a reduction of 1,500 to 2,000 jobs. This is something we will continue to do in good and challenging times. I thought it was important to provide this level of detail especially to our employee family during these uncertain times.
Many of you have asked us if we need to do a broad company lay off in order to manage our expenses. My own view is if you are going to do a lay off and we try everything possible to avoid them, it needs to be a critical mass to justify the loss of business momentum, impact on employees and disruption in key projects. Being very transparent, our definition of a company-wide lay off if we had to do one would most likely be at least 10% of our workforce.
Let me be very specific here. In very direct terms we are not going to consider a lay off at this point in time. While there are no guarantees we think the odds are reasonable that if we execute effectively as outlined on this call we may be able to avoid large downsizing events.
I am counting on the help of each Cisco family member to help us effectively realign our resources into the broad growth opportunities in order to potentially avoid the requirements of a broad lay off. Again, if the market continues to slow we believe this will not dramatically change our long-term approach with the vision of how the industry will evolve and our differentiated strategy. In fact, we have under consideration the next wave of cross functional priorities and again my challenge to the organization will not be for one or two products or market adjacencies but another dozen.
From my viewpoint long-term growth I believe is not our challenge. Rather, our challenge is prioritization of both the opportunities and the resource allocation during these challenging times that will allow us to achieve these long-term growth goals. In fact, it is our intent to expand our share of customer spend during these corrections as we have done in the past. We also believe that our opportunities to expand in our current markets and market adjacencies is actually increasing.
This is true from the data center to the home market, from the service provider to the small business and consumer. Therefore, you will continue to see us invest aggressively where appropriate while maintaining our focus on the financial models. Once again, with our usual caveats as discussed earlier in our financial reports our Q3 fiscal 2009 guidance is for year-over-year revenue to decrease in the 15-20% range.
We believe our long-term growth opportunities remain in the 12-17% range, again assuming our usual caveats and global GDP growth. We will focus on what we can control and influence and attempt to position Cisco to gain momentum in market transition whether they are industry consolidations, product transitions, market adjacency opportunities or economic.
In summary, for those areas that we can control or influence we believe our vision, strategy and execution are in great shape and producing results. As always I want to thank our shareholders, customers, employees and partners for their support and continued confidence in our ability to execute during rapid industry consolidation, market transition and challenging economic times.
Now Blair let me turn it over to you.
Thank you John. We will now open the floor to questions and answers from the audience. We request that analysts please ask only one question. Bridget could you please go ahead and open up the call for questions?
(Operator Instructions) The first question comes from the line of Simona Jankowski - Goldman Sachs.
Simona Jankowski - Goldman Sachs
I wanted to ask you in addition to the obviously very difficult environment if you can comment on the competitive environment from the vantage point of first pricing because it does seem that was a factor in the decline in margins from a year-over-year perspective if I heard that correctly and one of your competitors last week also commented on pricing potentially getting more difficult. How much of that should we expect and then related to that one of your other broader competitors, HP has announced some initiatives as far as what they call the open network system with some best of breed partners. How much is that playing into the competitive environment as well kind of on top of the downturn that we are experiencing from an economic perspective?
If you look at what is occurring in this economic slow down it is no different in terms of pricing pressure versus what we have seen before. The competitors each time have perhaps changed. We will always have a couple of large competitors and a couple medium sized and small. The good news is if you are in markets that are going to grow and be exciting you will continue to see many theaters around the world both focused on the market as our partners and as our competitors. If you look at the discounting pressures and Frank alluded to it earlier they are not out of line at all versus what we have traditionally seen. The gross margin decrease was due primarily to mix and volume. In the mix side of the house whenever you have video numbers like we had which if I remember right were 18% year-over-year that is set top boxes and that does have a major mix on it.
I, like you, immediately went to the routing and switching products and looked up on them and actually our gross margins in those product areas were actually in very good shape this quarter and without giving too much away Frank has given a steady line across the table I think they were actually up slightly. So we have not seen dramatic changes there. We will face new competitors. Most of the time competition comes at us from a price point of view but we don’t see anything dramatically different in this marketplace and again we do not focus on competition. We focus on market transitions and that normally has served us pretty well. I hope that answers your question.
The next question comes from Jeff Evenson - Sanford Bernstein.
Jeff Evenson - Sanford Bernstein
I am wondering about your customers’ IT budgets both what your sense is for how their IT budgets are changing relative to their spending on your products and also do you feel like your customers currently have a good sense for what their IT budgets are for 2009 or at least for the first half of the year? When do they arrive at a firm budget?
Realizing it will probably vary by customer segment, service providers are obviously different than enterprise which are different than commercial and different than consumer but if I were to look at the service provider budgets are the ones probably over the long run I am most comfortable with because those networks are going to load up videos. We are getting closer to the service provider customers and they are looking at new revenue opportunities and how we help them monetize the loads that are occurring on that and I think we are positioned very well.
They can hold up for a period of time and I’m not sure if that is a quarter or two or how long it lasts and you can run your networks hotter but you have to, at a point in time, continue to spend there.
They are looking flexibility wise on how much impact the slow down is going to have on that and you are seeing as we did this quarter a number of them kind of hesitate as they watch. In terms of the commercial marketplace their budget it is very simple. When they feel good about the business they spend. When they don’t they don’t. So those are probably the best indications that we watch when you start to see an upturn it is first in the commercial marketplace.
The enterprise budgets are probably like Cisco in some ways. Basically we are squeezing discretionary expenses pretty tight. I view that IT has an unlimited budget but even with someone else even within that budget we have been pretty careful in terms of expenses that Rebecca has been making and a certain amount of her budget is in place and candidly I hold flexibility at my level. That is a nice way of saying I think you are going to see IT budgets move during the course of the year. You will probably see most of them if they are setting it at an entire year basis be relatively conservative and then based upon both how their business goes and the return we can show the customer, the flexibility on that. So it is not an easy answer but that is as good a job as I can do in terms of what we are seeing in today’s uncertain environment.
It is a nice way of saying it would not surprise me to see them change and more likely on the upside than the downside as you get further in the year if business turns up. I think it will be set conservatively.
The next question comes from Mark Sue - RBC Capital Markets.
Mark Sue - RBC Capital Markets
It seems you are extrapolating the last month of orders for your guidance for the entire upcoming quarter. Recognizing you typically see orders improve month to month are you considering the seasonal lift we see in March and April? Was there any noticeable change between the first half of January and the second half? John do you feel fiscal Q3 is a bottom?
I wish I knew. I normally have a very good feel for markets and listen to the customers. My customers don’t really know for sure. Most of them are being conservative and that can almost be a self-fulfilling prophesy as most of us understand. I personally believe that with this type of stimulus and candidly pretty effective implementation by central banks around the world it will be earlier than most people anticipate on the up turn but again I talk to all the economists and they don’t know for that side.
In terms of seasonality, Rick tracks those very tightly but it is remarkable that the seasonality tends to always be there. The question is how much is the run rate off. It is remarkably similar day by day and week by week and once you take out if dates are different like the holidays we track that very closely so I think you will see those trends stay. The only question is what is the growth rate off of those trends.
In terms of the first half of January versus the second half of January that would be cutting it too fine and I would share it with you if I thought it were material. I don’t think it is. I tend to watch the month and we watch the ramp rate of the month and as we discussed before the first month of a quarter is usually 25% or so. The second of your business then usually ramps up into the 30’s and into the 40’s. So you can do the math as you add up in terms of totals but in terms of January it was probably a normal flow to look at it but I don’t think it would add value to split it out more than that.
The next question comes from Nikos Theodosopoulos – UBS.
Nikos Theodosopoulos - UBS
I realize this is a sensitive topic and you provided a lot of information on the call but I wanted to go back to the headcount and Opex discussion. So just to make sure I have this right it looks like the company believes it can reduce Opex by at least $1 billion on a run rate when we look at first quarter to fourth quarter and that can be achieved by reducing headcount by 1,500 to 2,000 and realignment. I want to make sure that is the goal there. I mean the numbers behind it. My question is, let’s say revenues stay depressed for awhile, that level of headcount reduction probably doesn’t get you to an operating model that you would like. Is the assumption that revenues start growing again so you can avoid a broader reduction and that is what you will reassess at the end of the fiscal year?
Thank you very much for the clarification. We have already pretty much achieved $1 billion run rate primarily through discretionary spending. If you watch the ramp, even though last quarter it was 3.7 on expenses if I remember right I think the run rate was actually 3.8. The fact that we did 3.5 already you multiply that delta, let’s make my math easy, let’s say it is a reduction of $250 million and you multiple that by four you already have the $1 billion reduction.
We are going to continue to drive that aggressively. We are going to continue to realign and restructure and continue to keep constructive pressure on that. We are in a pretty good position in terms of expense management and what is interesting and what we encourage our peers to do when we reduce expenses this time we are going to focus not on how do you put the brake on and then when things start to turn up put the accelerator back on. A lot of the expenses will never come back. So our expense per employee on travel has gone from I think about $7.9 thousand per employee down to almost a run rate of $3.4 thousand. Here within the next quarter that will not come back. So we basically are building models for the future in terms of its implementation.
The second element we are going to do a balancing act. We clearly have a number of market opportunities that I very much want to go into. Ned has got a good pipeline of investments, acquisitions and I notice the bias lately towards the consumer side and I’m sure that has nothing to do with your area of responsibility but what I am sharing with you on that is we are going to be aggressive moving into that but I would expect to continue to keep very constructive expense pressure on and that is both through the restructuring and that obviously is incremental headcount reduction as well as additional discretionary spending and realignment.
I don’t lack for growth opportunities. I want to be very direct here. We will run this company for where we think we should be in terms of revenue growth, profitability, etc. and what is right for our shareholders in the longer term. So you won’t see our strategy change dramatically in a month or quarterly basis. It will obviously adjust as I alluded to in the careful wording and thank you for understanding the sensitivity of it, if we were to get surprised or if the market were to continue to deteriorate. At the present time we think we are in pretty good shape in terms of our expense management, our resource allocation and we would not have said that on this call if we didn’t have our arms around it.
If you look at the guidance that we provided for the third quarter that would assume an expense rate in the third quarter about $3.35 billion. Just what we had in Q1 of $3.7 in terms of that it already takes us out about $1.4 billion. So it shows in those two quarters. If you go at the rate we were truly at, 3.8, it really says we have taken it down even further. So it clearly shows there have been some aggressive reductions. There is still a substantial amount of our expense that is tied to some of the non-resource related expense which is what we are focused on.
So in simple terms if you look at our expense run rate which was about $15 billion overall, we are approaching a reduction of about $1.5 billion and we clearly have set in place the stretched goal there. We have already realigned $500 million and we are in the process over the next couple months of completing the realignment of another $500 million. That is a pretty dramatic resource realignment. Not many companies could do that on the breadth and depth of where we are headed. It will be a balance, and we will strike that balance. I would read into it more a level of confidence of not doing a major lay off across the board rather than a hesitation in a reverse way.
The next question comes from John Marchetti – Cowen and Co.
John Marchetti – Cowen and Co.
A quick question on where you are focusing your near-term efforts more on the U.S. market along with a couple of the other emerging markets. Are you seeing anything in the U.S. market that leads you to believe or that makes you more comfortable that is going to turn first? Or is it more just trying to play the it was the first to feel the pain and you expect it will be the first to turn up? Secondly, once you do get the U.S. back do you think the rest of the globe will follow on relatively quickly once the U.S. gets back on its feet for you?
Fair question. It is way more than just first-in, first-out. We look at the response that the government is doing, the action of the Fed, candidly in my opinion President Obama is off to a great start and I think his economic team is world class. The second is you look at their stimulus and their investment. A large part of that is going to be when consumers aren’t spending and business isn’t spending it has got to be government. A large part of those areas I think will be in the infrastructure, smart digital highways, the capability to do healthcare and education differently and obviously Cisco hopes to earn our share of business as that occurs.
Third, whether it is in the data center, smart grid, the entertainment sector, productivity, collaboration, Web 2.0 we see a lot of innovation occurring in our customers across the board in this area so if you really look at a lot of the market adjacency we are going into we see a lot of opportunity there. Ned even when you did your consumer announcement in some of our areas of interest it is the U.S. that often sees it first.
Now having said that, we still continue to see business process innovation in emerging countries. China and India I think will continue to be very aggressive within that scenario. We will try to strike the balance. Our logic here is we think the U.S. will be the most creative during this change. We will obviously adjust if that doesn’t occur but it goes way beyond a feeling of pride and commitment to the U.S. We think business will turn here in the U.S. first and candidly we think the plans look pretty constructive.
John Marchetti – Cowen and Co.
On the pace from there for the rest of the world?
I think you will see it follow. The U.S. is unfortunately and fortunately still the economic engine of the world. I think if the U.S. comes out it will have an impact. I actually think India and China are managing this downturn remarkably well. If you think about countries that feel pretty confident about their ability even though I didn’t like the numbers we had in India this quarter actually the India business leaders, and I’ll be over there next week for a week with them, were pretty optimistic and [inaudible] about their approach and the Chinese have an ability to adjust very effectively.
Rob, I’m going to ask you to spend a moment also on what we have done over the last year and a half in public sector because while a number of people might suddenly start focusing with these incentive plans in the public sector both in the U.S. and around the world we have been pretty aggressive over the last 18 months restructuring your operation and other operations to focus more on public sector. Share with us more what you are doing there and what your thoughts are.
Sure John. You already mentioned that public sector was one of the bright spots around the world especially in Europe and the U.S. We have seen continued investments in this area. In fact in the U.S. where we had a very successful Federal sales model beginning this fiscal year we shifted resources for state, local, education into that group creating a new public sector organization. I think the timing was pretty good because we are pretty well aligned right now to the activities of the Obama government. We see opportunities with smart buildings. We are seeing opportunities with smart transportation, infrastructure, public safety and security, health information networks and smart grid. So I think we have moved resources already and are in good shape to catch the upcoming spending which we expect is going to help bolster the budgets of state and local jurisdictions.
We also saw similar movement in Europe with putting focus on the public sector, Owen doing the same and Paul doing the same. So we are getting good at using these on a global basis but in very simple terms we have already started to move a pretty fair amount of resources in the field and again our other segments in the company advanced services, etc. into government.
The next question comes from Scott Coleman - Morgan Stanley.
Scott Coleman - Morgan Stanley
You started our your prepared remarks in part talking about the power of the platform and have obviously spent time talking about moving into adjacent markets. There have been a number of press reports lately about Cisco moving into the server market. Clearly a ripe opportunity for the company. I wonder how you balance that type of move with the partnership ecosystem that you have built over the years particularly given increased competition and the challenging environment?
As you would expect, I am not going to comment about products that we may or may not announce in the future. To answer indirectly your question we try to catch market transitions and within the network becoming the platform as you articulated and set me up for the question I will try not to blow the answer it is completely transparent whether the movie you are watching or the music you are listening to like the CES announcements is on the individual device, on the set top, on your PC, on the service provider point of presence or their data centers or the content generation data centers or somewhere out on the worldwide web that is tailor made for routing Cisco networking. As you think about that occurring we are going to move intelligence throughout every element of the network, security throughout every element of the network, storage into most of the elements, application capability into most of them so you will see us be aggressive from the home through the data center.
We don’t focus on stand alone markets. We don’t do stand alone products. Ned won’t do a stand alone device. We won’t do a stand alone similar mentality within the data center. It is how it architecturally comes together. So if you look at what we did with the Nexus 5000 announcement and how we are going to evolve it really speaks to a next generation of data centers in how we go after this market, a next generation series of partners, etc. All the way down to the same concept in the consumer space and I’m going to take this opportunity for you to just kind of weave these two together about interoperability of any device, any content in the home and what we are doing architectural wise and maybe use the new product announcements you just did that were extremely well received at the Consumer Electronics Show.
Many people thought we did link through an acquisition and the Scientific Atlanta with set top boxes but we weren’t sure we could really play in the consumer market. In this Consumer Electronics Show just a couple of weeks ago we received more press than any other player except Microsoft in number of stories written, etc. We won a number of the consumer new product announcements and directions but again these are not stand alone devices. That is how we share any device to any content, data, voice, video wire to wireless.
Thanks John. As you pointed out I think what we are seeing very simply, and this is driven as we look at all of our strategies by the customer and in this case the consumer, the consumer demand is shifting from point products and point applications to what we refer to as the media enabled home. The ability to connect all of their devices together and be able to share and experience their content and media across all those devices equally. The network is exceptionally well positioned to be able to be the platform to enable that to happen.
When you look at the announcements we made at CES specifically our media hub platform which opens up media for the first time to be shared seamlessly across devices connected to the network both within the home and outside the home as well as our partnership around connected devices and opening up the technology on the network to enable consumer electronics consumers to connect and enable their consumers to connect easily and provision easily to the network. We have the opportunity to really drive that network platform and it really is an architectural approach as we have always talked about.
What is exciting here is it is much what we have seen before. When the network becomes a platform it opens up a whole new set of applications, business models, directions and what we have seen in the past is it makes the market bigger for all of us. I think there are some peers who will tend to focus on the device level and say this is my territory and you are in my territory. We have never done that versus our peers and we are not going to do it forward. We think the pie will get dramatically bigger. We’d like a smaller piece of the pie but we think it is going to be a lot bigger revenue wise than what you would get. I think that comes with us coming out of the internet background.
Because we had so much material today and we wanted to be very specific on the detail, we are going to run a couple minutes longer than normal. You won’t see our calls go that long normally but we wanted to due to the importance of getting the data right and people not misunderstanding what we are doing. We went a little bit longer and I apologize for that. Rather than stop at this time I would like to take a couple more questions.
The next question comes from Jason Ader – William Blair.
Jason Ader – William Blair
I wanted to ask you about your approach to acquisitions in this environment. You said I think in the past, or at least I think I heard you say you wish you were more aggressive during the last downturn and given the transition that is going on in data centers especially and in light of potential person repatriation legislation as part of the stimulus package I was wondering would your approach to acquisitions be different this time around?
Breaking the question into a couple of pieces, first is the exciting part about today’s market is just about everybody is for sale. The second most exciting part is the prices are pretty reasonable, Ned, even by your standards. Our ideal target has not changed. 100 engineers and product if you have just come to market with a product that is hot or you have just come to market and I think you will see us active in all segments of the market. In fact if I were betting it would not surprise me to see us move on the consumer side before you see us move on some of the other areas.
In terms of your indirect question, why haven’t you moved, the answer is real simple. The market continued to go down. So by not moving up to this point in time it has probably been a good decision on our part. Nobody can judge the bottom and obviously we are not going to attempt to but our watching the market at this time has served us very, very well in terms of direction but my ideal target has not changed.
Having said that if we come out of this economic slow down without being very aggressive on both our internal development which we clearly have painted a picture today we are going to do, our new ideas and new approaches and acquisitions starting with the consumer because I have signed off on Ned’s business plan to move to $3-5 billion for his area of responsibility to get the chance to $10 billion and Ned I am going to hold you accountable for that, but you will see us active across the board in each category and I would say up to now our hesitation in terms of timing has worked out well.
We don’t try to figure out when the bottom will be. We tend more when the market transitions will occur. They clearly are occurring in our opinion over the next 6-12 months and this is tailor made for us in terms of the approach.
Unfortunately the repatriation decision was turned down in the Senate last night. That would have been a great chance to see an additional $600-750 billion brought back to the U.S. and put into the market which is almost the size of the stimulus package but I understand the decisions on the politics side and we will move on from that but that probably should not be part of your analysis in terms of cash availability for me or other players.
The next question comes from Jeff Kvaal – Barclays Capital.
Jeff Kvaal – Barclays Capital
I was wondering if you could give us a flavor if there was a particular customer set that was weaker towards the end of the year into this year and what gives you the confidence to include the January decline year-over-year as the bottom end of the revenue guidance range for the third quarter?
Very fair question. I just want to think for a second. I think the one that weakened a little bit faster than we expected would have been service revenue. We saw that in most geographies around the world even in Japan where the next generation network is going to occur. They kind of took the foot off the gas pedal for a period of time. Didn’t hit the brakes but sure as heck weren’t accelerating. Here in the U.S. our big interface customers such as Verizon and AT&T where we have got great relationships they slowed a little bit and Comcast, Time Warner and other cable companies did as well.
Another answer is particularly in the U.S. is the extraordinary growth leading up to this downturn that we experienced there. I think comparisons really exacerbate some of this in the short-term.
I agree Rick. But also networks are going to get loaded long term and if you were to say back to the second part of the question, you can’t stop putting in storage or servers. You basically can only run those and when they get filled you have to add more. The network you can run hotter and you can balance a little bit and live with a little degradation in the process and so that was probably the one that surprised me a little bit with the speed with which it slowed down. Having said that our relationship has never been stronger across most all service providers around the world and the loads are continuing to increase.
You have a temporary, perhaps, hesitation in terms of as these companies lay off people but the loads will continue to grow on the network and so that is probably the one that I say has the potential to come back with the most predictability.
To the second part of your question it is probably the commercial marketplace that I will watch. That tends to spend. When business picks up they spend. They tend not to pay as much attention to the “herd” and bottom line if business is good they spend and if not they don’t. Other aspects, hot product sale and we have seen again even in the tough season the holidays the real hot products, high definition TV’s, etc. did sell well even in tough times.
I hope that helps. I know it is not an ideal answer but it is kind of a snapshot of what we are seeing.
The next question comes from Simon Leopold – Morgan, Keegan & Co.
Simon Leopold – Morgan, Keegan & Co.
Maybe we can leave on a more positive note. You talked about being a bit more optimistic in terms of a recovery maybe late in 2009. If you could talk about what a recovery might actually look like in terms of what recovers first for you, clearly you have suggested Web. What I’m wondering is routers have been down quite a bit so I’m wondering if they snap back or do we continue to see more favorable trends from some of the advanced technologies? A little bit more color on what the recovery looks like even if you can’t talk about the timing.
To the question that you started with, routers tend to tie very closely to loads on networks and tie very closely to what service providers are seeing. So I think while there is a lot in enterprise and some in the commercial marketplace your question about router numbers will turn up as network loads continue to grow and that is inevitable. The only question is how quickly does it snap back to your point. The second part is how good a job do we do in partnering with the service providers to help them monetize these loads which is a very important issue for them as they go forward.
However, to your second part that you are leading me towards the advanced technologies look pretty good and Rob we were talking about that about areas that we think we could be even more aggressive on. Ned you and I were talking this morning about video and architecture playing more across the board. TelePresence, as an example, will become material a year from now in terms of volumes and it is probably the best way for CEO’s really to understand what collaboration and Web 2.0 is about.
If you are saying John what do you think is going to be the hottest thing we are talking about a year from now? It is going to be collaboration Web 2.0.
I mean you watch those ramp up numbers which we saw that is identical to what happened in 1993 and 1994 when we were the first company really doing a lot of orders over the Internet and doing the majority of our support over the Internet. These numbers are equally aggressive except they are by month not by quarter. For those of you who have been following those numbers with us you notice they have up ticked every month that has occurred over the last 12.
My own view, what is going to be the most exciting on this up turn is Web 2.0 technologies changing business models and collaboration? Now people at first tend to hesitate about jumping into that until they see the pay back and productivity then they tend to ramp but that is probably an area that I personally am the most excited about looking 12-24 months out.
I want to thank you for ending on a positive note. Blair I always tease you about wanting to take one or two more questions and make sure we get one we can end on a positive note with. Simon saved us on that one.
As a reminder, Cisco’s next quarterly conference call which will reflect our third quarter fiscal year 2009 results will be on Wednesday, May 5, 2009 at 1:30 p.m. PT, 4:30 p.m. ET. Additionally, downloadable Q2 financial statements will be available following this call including revenue segment by product and geography. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets and cash flow statements can be found on our website in the Investor Relations section. Again, just click on the financials section of the website to access those.
Again I would like to remind you that in light of Regulation Fair Disclosures Cisco plans to retain its long standing policy not to comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. Please call the Investor Relations Department with any follow-up questions from this call. Thank you again for your participation and continued support.
This concludes our call.
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