Welcome to Cisco Systems third 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 77th quarterly conference call. This is Blair Christie and I’m joined by John Chambers, our Chairman and CEO; Frank Calderoni, Executive Vice President and Chief Financial Officer; Robert Lloyd, Executive Vice President of Worldwide Operations and Ned Hooper, Senior Vice President of Corporate Development and Consumer Groups.
The Q3 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 the additional financial metrics and analysis that you may find helpful.
Additionally, downloadable Q3 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 May 6 through May 13 at 866-357-4205 or 203-369-0122 for international callers. It is also available from May 6 through July 17th on Cisco’s investor relations website.
Throughout this conference 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 are 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 10K and quarterly report on form 10Q 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?
Blaire thank you very much. During the opening comments of the conference call I will focus on what I view to be the key take away’s for Q3 fiscal year 2009. First, a very candid discussion about what we are seeing in the market on a global basis relative to Q3 and its effect on our Q4 expectations. Second, an update given our current economic challenges and how we are first reducing expenses, second prioritizing our many opportunities for future growth as well as how we are third realigning our resources with a focus on investing in new market adjacencies, emerging technology and emerging markets. Finally, our revenue guidance for Q4 with the appropriate caveats. Then I will pass it over to Frank who will follow the opening comments with additional detail on Q3 fiscal year 2009. The third section of the call will focus on our business momentum from a strategy point of view, customer segment, geographic and product basis. Frank will then follow with some additional financial parameters around our guidance. I will then wrap it up with some comments in terms of Cisco’s momentum going into Q4. Finally, our Q&A session.
On to Q3 fiscal year 2009. Given the many challenges that we are all seeing occur in the global market place it was a solid quarter for Cisco for most of our financial measurements and a very solid quarter from an earnings perspective, an expense focus perspective and how effectively we realigned resources to new markets. All those categories were working well.
In terms of those areas that we control or influence we remain very comfortable with our long-term vision and differentiated strategy as we move into these new market adjacencies and prioritize our existing opportunities. Our new organization structure of councils, boards and working groups as discussed on the last call is working very effectively. These structures allow speed, scale, flexibility and rapid replication. An example of speed, skill and replication since our last conference call we have added three more market adjacencies to our list which at the last conference call was at 26. These three new ones include virtual healthcare, second is safety and security and three is smart communities bringing the total of these cross-functional priorities or market adjacencies to 29.
Of perhaps equal importance, our largest customers understand how this highly innovative management structure and these business models we have been talking about can launch these many major products into market adjacencies with quality. That is something probably as a key tipping point we will talk about more later in terms of our customers grasping what this means in terms of speed but also the ability to move in so many markets at one time.
We are pleased with our progress in aggressively managing our expenses and being close to exceeding our stress goal of reducing the total annualized expense run rate by $1.5 billion. Frank did a terrific job by the whole team but you and Randy let that and I want to congratulate you on it. This was translated from a non-GAAP operating expense run rate that was a peak at a point in the quarter as high as $3.8 billion per quarter. To the current run rate, which I put at about $3 billion based upon analyst maybe abnormal to a given quarter.
We have also addressed these new market adjacencies with resource realignment approaching $1 billion. We exit Q3 with a compelling financial position and an innovation engine from both products and business model perspectives and should allow us to expand our leadership in the market place.
The following is a quick snapshot of our Q3 financial highlights. First, Cisco generated $2 billion in cash in Q3. Frank right on your forecast you gave me at the end of the last quarter and remarkably accurate, resulting in a total cash and investments of approximately $33.5 billion. We repurchased $1.2 billion of stock during the quarter. Earnings per share on a non-GAAP basis were $0.30 and GAAP earnings per share were $0.23. This reflected our continued progress on expense reduction even that of unexpected results from total non-GAAP gross margin of approximately 55%, solid service contributions with 9% year-over-year growth combined with our continued progress in core advanced technology, emerging technologies and our movement into these new market adjacencies.
Product book to build was approximately one. DSO’s were 27 days. Inventory turns were 10.7. Revenue was $8.2 billion, 17% year-over-year decrease. Non-GAAP operating expenses declined $374 million or approximately 10.6% quarter-over-quarter in Q3 and as a percentage of revenue was 39% which was dramatically better than our guidance of 40-42%. Our internal start up as well as our acquisition of small companies continued to fill out our architectural strategy. Our video strategy from the home to the service provider to the enterprise is being described by many of our customers I talk with as world class innovation and execution.
All of us understand the benefits from telepresence which had another outstanding quarter growing over 70% year-over-year in terms of orders and over 130% in terms of revenues year-over-year with 45 new customers in Q3 and approximately 400 new system orders. We now have half a dozen customers with 50+ telepresence systems deployed and a total well over 300 customers in our total customer base. For the first time, we are now seeing some customers talk about hundreds of telepresence systems and in not the too distant future to dramatically evolve not just their communications within their organization and to their extended contacts market place but also changing their business models.
However, with the pending addition of pure digital with the Flip video capability, customers are getting a concept of how video plays out from the device through intelligent networks combined with system security all the way to telepresence. In simple terms, any device over any combination of networks with any content with video and not just the killer application in terms of network load but probably the most important architectural play in the next generation of the Internet.
Perhaps the most important take away from this quarter in my opinion is our ability to execute and innovate in 29 new market adjacencies combined with very solid operational execution to accomplish these ambitious stretch goals while at the same time dramatically reducing expenses.
In summary, for those areas we can control or influence we feel we are doing reasonably well. The key market transitions relative to collaboration, virtualization and video networking which will drive productivity and growth in network loads over the next decade are evolving even faster than we though one quarter ago. Perhaps the most frequently asked question by our shareholders are focused on how Cisco is seeing the current global economy, our thoughts in terms of global business starting to level off and what are our expectations when the possible up turn may occur.
However, an important point to remember about our vision and differentiated strategy for the future is it does not vary dramatically by month, by quarter or even by year. While we attempt to be very transparent with what we are seeing in the market and have established a very good track record in terms of seeing trends early, our views do not tend to change every month or every quarter. Even when they do evolve to change dramatically is really the exception. It is with this consistency of staying focused on the long-term while not getting distracted by the short-term market activity that we believe has and will continue to be one of the keys to our future.
Having said that, for the first time in many quarters many of our global customers are describing the business momentum in a different way than prior quarters. That they are seeing some stabilization, a leveling out or in other words they are finally beginning to have something reasonably solid underneath their feet is how they are describing their current business as opposed to what has been over the last several quarters a continued deceleration in their business.
Then almost without exception they immediately follow those comments that even though the business appears to be stabilizing it is at a disappointing year-over-year growth number. No one knows for sure when the up turn will occur but as we have said in prior quarters we are going to be very aggressive this year in positioning ourselves for the inevitable up turn while continuing to maintain tight financial management and aligning resources to new opportunities.
Our play book and game plan for handling economic challenges that we discussed in great detail in last quarter’s conference call is simply working very well. There is also a large advantage to having a leadership team that has been through these types of challenges over four times in the last two decades.
As we have said in all of our recent conference calls it is very difficult given all the uncertainties going on in the market to provide a forecast given the dramatic changes in the global markets. It continues to be one of the more 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 either on the positive or negative side of revenue guidance that we provide for Q4.
With all that being said, I still believe that providing some level of guidance is the appropriate thing to do for transparency and for our shareholders. Also, as we have said in conference calls over many years, Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors and our ability to execute or not on our strategy and other factors as discussed in our SEC reports. For purposes of our long range goals as well as our forward guidance we are also assuming that our vision of how the industry and market will evolve will be accurate and will be effectively executed on in terms of that vision.
Unlike recent prior quarters, our year-over-year order rate comparison did not significantly change in each of the three months during Q3. While our forecast accuracy still has room for improvement our field teams are improving the accuracy of their forecasts. As a reminder, for the last several quarters our annual order rates were worse in the third month for each of those quarters which we then used as the basis for the growth rates that we forecast for the next quarter.
In Q3, much like the majority of our customers, the year-over-year growth rate in each month of the quarter went well below what we would like to have seen. However, it was consistent for each of the three months from a year-over-year perspective and that is the first time that has happened in quite a few quarters.
In terms of linearity in the quarter, month one, month two and month three compared to their counterparts in prior Q3’s over the years as a percentage year-over-year each month was much more normal or what we would have expected during normal years. Let me be very specific in saying that while the business appears to be leveling out, again at a lower rate than anyone would like, it needs to level out before an up turn could potentially occur.
Again, no one knows how long this leveling out will last or whether it will result in an up turn several quarters from now or if there still remains a very real possibility it could still go down. With all this in mind we continue to provide our guidance with all the appropriate caveats one quarter at a time and encourage each of our shareholders to not get too far ahead of themselves in building on the positives of this quarter. With this discussion in mind, our revenue guidance for Q4 including our usual caveats as discussed earlier in our financial reports is for revenue to decrease in the 17-20% range year-over-year in Q4.
Again, as a reminder during each of the past economic slow downs, Cisco has always navigated very effectively through difficult times to expand our share of our customers’ spend while moving aggressively into new market adjacencies. As a result, we were better positioned coming out of the transition versus our peers. For example, this strategy served us well during the last down turn when our strategic investments resulted in the advanced technology segments which I think are about 25% of our business and our new organization structure of councils, boards and working groups.
In summary, we believe that we are very well positioned in the industry from a vision, differentiated strategy and execution perspective. We believe we are in the next phase of the Internet as growth and productivity will center on collaboration enabled by network web 2.0 technologies. We will do our best to provide the product architectures and the expertise to help our customers in the implementation and 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 very similar to what we did in the early 90’s. As we said before, it powered our growth for a decade.
Now Frank let me turn it over to you.
Thank you John. Let me start this afternoon by reiterating that I remain confident that our financial strength enables us to execute in both good and challenging environments. We believe our portfolio diversification, focus on innovation, operational excellence and speed of execution enables us to effectively navigate market transitions.
Cisco posted a very solid quarter in Q3 FY09. These results showcase our ability to manage profitability across varying economic cycles while delivering products and services that provide real value to our customers. For today’s call I will provide a recap of the financial results for the third quarter of fiscal 2009 and highlight some of the management actions we have taken to manage through the current environment and position Cisco for when the markets eventually improve.
Total revenue for the third quarter was $8.2 billion, a decrease of approximately 17% year-over-year within our guidance for the quarter of -15% to -20%. Total service revenue was $1.7 billion, up approximately 9% year-over-year with solid growth across our geographic theaters. Revenue from our recurring revenue stream represented approximately 23% of our total revenue mix this quarter versus 20% last quarter. Total product revenue was $6.4 billion, down approximately 22% year-over-year. There is no doubt that this has been a very difficult macro economic environment.
Switching revenue was $2.6 billion, a decrease of 20% year-over-year. Modular switching revenue was down 22% year-over-year while fixed switching declined 17% year-over-year. Routing revenue was $1.4 billion, down 32% year-over-year representing a decrease of 36%, 25% and 23% year-over-year in high end, mid range and low end respectively. Advanced technologies revenue totaled $2.1 billion representing a decrease of 12% year-over-year. Within advanced technologies video systems declined approximately 5% year-over-year, unified communications decreased approximately 7% year-over-year and security declined 14% year-over-year.
Other product revenue totaled $370 million, a decrease of 36% year-over-year. Total revenue decreased across all geographies on a year-over-year basis. Quarterly revenue ranged from -14% in both European markets and Japan to -22% for both Asia Pacific and the emerging markets theater. The U.S. and Canada Theater was down 15%.
Despite the challenging revenue environment the strength of our financial model enabled us to effectively manage gross margin. Q3 fiscal year 2009 total non-GAAP gross margin was 55.1%, above our guidance up 1.1 percentage points quarter-over-quarter and 0.10% points year-over-year. For product only, non-GAAP gross margin for the third quarter was 64.6%, up 1 percentage point quarter-over-quarter and down 1.2 percentage points year-over-year.
Despite the impact of lower volume and increased discounts the quarter-over-quarter increase was driven by cost savings from better than expected lower manufacturing related costs and stable product mix. We are pleased with the product mix this quarter as we normally experience a slight degradation of margin due to mix.
The year-over-year decline was driven primarily by product discount pricing, lower volume and product mix partially offset by cost savings. Our non-GAAP service margin for the third quarter was 67% up from 65.7% last quarter and 60.9% in Q3 fiscal year 2008. Service margin performance was better than expected due to strong margins in both technical support services and advanced services from across the board cost improvements as well as from delays in certain projects.
As mentioned previously, service margin will typically experience some variability over time due to various factors such as the change in mix between technical support and advanced services as well as the timing of contract negotiations and renewals. Total gross margin by geography ranged from approximately 60% for emerging Markets Theater to approximately 72% in Japan. Gross margin improved on a quarter-over-quarter basis in U.S. and Canada, the emerging markets theater which was up one percentage point quarter-over-quarter and Japan. Asia Pacific and European markets showed declines in gross margins on a quarter-over-quarter basis due to unfavorable product mix.
Non-GAAP operating expenses were $3.1 billion in Q3 fiscal year 2009, down from $3.5 billion in Q2 fiscal year 2009 representing an 11% reduction quarter-over-quarter. The quarter-over-quarter improved performance was due primarily to a decrease in variable compensation and sales commission expenses, a decrease in certain discretionary expenses such as travel, meeting and events, outside services, marketing and other expenses as well as a benefit of $36 million quarter-over-quarter from foreign currency exchange rates.
Non-GAAP operating expenses as a percentage of revenue were 38.6% in Q3 versus 35.7% in Q3 fiscal year 2008. The foreign exchange benefit on a year-over-year basis was $137 million. I would like to take a moment to thank our entire workforce for their continued efforts to achieve these results during the quarter and help put Cisco in a strong financial position.
Interest and other income was $80 million for Q3 which reflects lower net interest income as a function of lower market interest rates and incremental interest expense associated with our $4 billion debt issuance earlier this quarter. Our diversified, high quality cash and investment portfolio continued to perform given the challenging financial markets. Our Q3 fiscal year 2009 non-GAAP tax provision rate was 22% consistent with the Q2 FY09 and our expectations.
Non-GAAP net income for the third quarter fiscal year 2009 was $1.8 billion representing a decline of 24% year-over-year. As a percentage of revenue non-GAAP net income was 21.5%, a solid performance in this market. Non-GAAP earnings per share on a fully diluted basis for the third quarter were $0.30 per share versus $0.38 in the third quarter of fiscal year 2008, a 21% decline year-over-year. GAAP net income for the third quarter was $1.3 billion as compared to $1.8 billion in the third quarter of fiscal year 2008. GAAP earnings per share on a fully diluted basis in the third quarter were $0.23 versus $.29 in the same quarter of fiscal year 2008.
Now moving on to the balance sheet. We are very pleased with our strong balance sheet performance. We continue to further strengthen key financial metrics in spite of the continued difficult macro economic environment. The total of cash, cash equivalents and investments at the end of Q3 was $33.6 billion, up $4 billion from Q2 FY09 driven primarily by the increased cash associated with the February 2009 debt offering.
Of this total balance, $6.4 billion is held within the United States. Over the long term we continue to target a net realizable cash and investment balance of $10-15 billion and onshore of $2-5 billion. We generated $2 billion in cash flow from operations in Q3 fiscal year 2009. Compared to 2QFY09 the change in cash flow was primarily the result of the change in deferred revenue which was driven by the timing of two [tier] shipments and the related cash receipts during the quarter. Lower net income and higher tax payments in Q3 also contributed to the decrease in cash flows versus Q2.
Moving on to accounts receivable, our receivables decreased 17% from 2Q fiscal 2009 from a balance of $2.4 billion at the end of Q3 FY09. We remain very pleased with the quality of our receivables portfolio. At the end of Q3 day sales outstanding (DSO) was 27 days, down two days compared to Q2 FY09 driven primarily by strong collections and lower service billings. Total inventory at the end of Q3 was $1 billion, a reduction of $84 million quarter-over-quarter. Non-GAAP inventory turns were 10.7 this quarter, down 6/10 of a point compared to last quarter and down 1/10 of a point from Q3 of last year. Our inventory management as measured by turns remains world class.
Inventory purchase commitments at the end of Q3 were $2.2 billion, an 18% reduction from the end of Q2 fiscal year 2009. For the quarter we repurchased $1.2 billion of common stock or 77 million shares at an average price of $15.57 per share. We ended the quarter with approximately $5.6 billion remaining in the current stock repurchase authorization.
Deferred revenue was $8.8 billion at the end of Q3 FY09, an increase of approximately 2% year-over-year. Deferred product revenue was $2.7 billion, a decrease of approximately 6% year-over-year while deferred service revenue was $6.1 billion, up approximately 6% year-over-year. At the end of Q3 our headcount totaled 66,558, a net decrease of approximately 760 from Q2 FY09. The reduction in headcount this quarter was the result of our continued pause in external hiring and the early impact of some limited restructuring consistent with our previously announced plans to reduce approximately 1,500 to 2,000 jobs as a result of realignment and restructuring activity to occur in the second half of fiscal year 2009. At this time we expect the number of job reductions related to the limited restructuring to be at the high end of this range by the end of the fiscal year.
Now I would like to highlight how we are utilizing our strong financial position to sustain our investment in innovation, drive operational excellence in our business and ensure continued attention to our customers’ needs, all of which I believe strengthens our ability to emerge from this current market environment as an even stronger force in the industry.
Our business model provides us with the flexibility to continue to aggressively invest in new technologies and market adjacencies. Through strong portfolio management in one quarter we realigned resources to our top five strategic priorities, launched the first unified computing architecture to the market place and increased investments in key customer segments such as public sector.
We remain committed to driving operational excellence and productivity improvements throughout the business. Our cost and expense management activity this quarter enabled us to manage our business costs while still investing in areas where we believe we can accelerate development and Cisco’s market leadership.
During the quarter we took a number of actions including reducing travel by approximately 50% compared to Q2, centralizing procurement activities to optimize our buying power and aligning select core business processes for greater efficiency. As a result, we are well on track towards exceeding our target of removing over $1 billion from our annualized expense run rate by the end of this fiscal year and in line with our internal stretch target of $1.5 billion, a strong testament to the collective execution by our employees.
I am extremely proud of the financial execution we achieved this quarter. From a working capital perspective we believe we implemented the right actions and strategies to effectively manage our cash flow and protect our strong balance sheet. With continued focus on our accounts receivable and supply chain including our ongoing review and optimization of inventory levels we have delivered positive results again this quarter.
Our non-GAAP inventory turns of 10.7, purchase commitments in line with current demand and DSO of 27 days all remain solid and contribute to Cisco’s consistent performance. In Q3 we also closed a $4 billion debt offering, a portion of which was used to refinance $500 million of unsecured debt. They key to our success has been our focus on customer needs and our ability to collaborate closely with them to develop creative and differentiated solutions such as providing extended warranties across some aspects of our portfolio.
Our financing arm, Cisco Capital, continues to provide solutions to customers and channel partners and has enabled incremental sales and opportunity. At Q3 fiscal year 2009, Cisco Capital had a combined balance sheet and contingent liability position of approximately $4.7 billion. We continue to see positive payment behavior from our customers and believe there has been no material impact to the quality of our portfolio.
As I have discussed with you today we continue to make investments in innovation and new market opportunities. We have continued our emphasis on strong operational excellence and we have sharpened our focus on customer intimacy, all of which we believe continue to position us for future success. We are confident that through continued improvement in expense management, calculated investment in high yielding business opportunities and strong portfolio management we are managing the company to balance the priorities of growth and profitability in the future.
I will now turn it back to John.
Thank you very much. Now moving on to Chapter Three regarding strategy, customer segment, geographic and product review. From a financial review this quarter may have been the most innovative and operationally efficient quarter in our history. The innovation and execution has never been broader and more successful ranging from product announcements, technology architectures and business architecture leadership in our customers’ minds.
Cisco has had an explosion of collaboration internal with our companies enabled by network web 2.0 technologies in everything we do. I always listen carefully to our customers and in many ways our customers’ feedback on this activity in Q3 was pivotal. Truly a tipping point in terms of both their understanding and in many cases their commitment to next generation intelligent networks becoming the platform for connectivity, standard of living and global competitiveness.
In some ways it is difficult to describe why this quarter was so unique and the rapid expansion of many of our customers’ positive expectations of Cisco’s ability to work with them in terms of innovation, top leadership and execution enabled by many of these activities. Perhaps the best way to capture and summarize this effect is to give you a series of examples which occurred in this quarter and in total may accomplish my goal in sharing with you what these customers are beginning to see and their total picture and view of Cisco from a partnership and commitment perspective, not in talking about individual products, architectures or individual services, but in the combination together.
First, virtualization. Virtualization first in the data center and then going all the way to our homes is becoming a reality as illustrated by our announcement of the Unified Computing System in March. As we discussed for some time we are seeing significant market transition in the data center as networking, computing, storage and software technologies begin to converge and then compete with each other in new ways.
Cisco has always believed that disruption creates opportunity. We have executed well by delivering innovative solutions and unique ecosystem relationships to address this rapidly changing market. Our Unified Computing Systems and the Nexus product families bridged the [inaudible] and the data center for the first time by creating one unified architecture.
There is little doubt this disruption in the data center will accelerate in the next 12 months due to the rapidly changing technology trends such as the rise of scalable, processing and virtualization. The competitive landscape is changing and while a new class of very large, well financed and aggressive competitors will bring their own product categories to aggressive new markets, we believe the network will be the intersection of innovation through an open ecosystem and standards.
We will continue to not be surprised to see acquisitions, industry consolidation and new alliances among companies as they build towards serving this new market. As we enter this next market phase we will get closer to some partners and compete more with others while delivering the best solutions for our customers.
What is most exciting about this market transition is the rise of new business models enabled by technology architectures such as cloud computing and the opportunity to finally address customers’ greatest needs in terms of reducing cost and complexity while increasing their business agility. Many of our customers believe that future data center can best be enabled by the network and we think this uniquely positions Cisco to lead through this next market transition.
The Cisco Unified Computing System unites compute, network, storage, access and virtualization resources in a single energy efficient system to reduce customer cost and complexity. In our opinion, it is truly a game changer in the data center. However, the technology architecture that occurs first in the data center will expand through the enterprise and then go all the way to the home. What you are seeing is really a new product category in the next generation data center that combines the network, computing, software and storage into one architectural category.
Second, the second phase of the Internet revolution is becoming viral and accelerating at three to five times the pace of the first phase of the Internet revolution a decade and a half ago. We all understand that phase one was about orders being entered online, customer support provided over the Internet which Cisco led internal utilization first and then expanded across multiple industries over the next decade.
While theoretical in some customers’ minds in the past, the numbers are now irrefutable and our leading edge customers are for the first time clearly understanding the impact. I am going to provide you with a lot of data, each piece being interesting, however it is the total concept of this data as the key take away just as it was for our customers.
The following numbers are the growth rates achieved within Cisco in each category over the last 12-13 months. Remembering we have about 66,000 people, logging at Cisco has gone from 3,000 users to 13,000; a 300% increase. Discussion forums have gone from 2,500 users to over 40,000; a 1,600% increase. YouTube at Cisco which we call Cisco Vision is now used by 54,000 of our 66,000 employees; a 3,100% increase. Cisco’s WebX Connect Utilization is up by 3,900%. The key take away is not just the volumes or a “back to the future” type of comparisons of what Cisco did in terms of being the first major company to enter orders online or offer online customer service.
It is the speed, skill and replication that we are seeing that allows us to dramatically realign resources and enables us to address what many consider impossible goals to move to 29 new market adjacencies while also reducing expenses.
Third, new business models for travel. Using myself as an example but asking you to think about this concept and how it expands to each Cisco employee and over time each employee of our customers and then how we will work to change work in the future.
In the first 90 days of this calendar year I made 252 customer visits. While I went around the world twice physically, 200 of these visits were virtual through telepresence. Many of the meetings were first time and it has become common to present to an entire senior management team of a global fortune 100 also from non-English speaking global fortune 100 companies or to even heads of state using this technology.
We now average 4,700 telepresence sessions weekly and have permanently cut our travel budget from the $750 million run rate it was over the last year in terms of a peak to a $350 million run rate per year. In Q3 during the tough times, as you would expect, we actually took that cut down from $350 million to $240 million on a temporary basis.
Expanding how we are using collaboration and network web 2.0, one step further in terms of innovation and operational excellence, let me use an example of how we launch our new products such as Unified Computing Systems in March. The bottom line is think about this; key take away, 1/10th the cost, ten times the effectiveness. That is how it is compared to examples like our CRS announcement of a number of years ago. 1/10th the cost, ten times the effectiveness. At the time of this announcement we had $4 billion media impact. We had 13 live telepresence locations combined in eleven cities for the initial announcement that did not include customers.
53 active attendees including six partner CEO’s, eleven industry analysts, 35 press, 7 financial analysts in various locations and 832 virtual Cisco TV viewers that were invited to the session. Following the formal announcements were the customer announcements. 483 customers in the room and over 6,000 virtual attendees. Record traffic resulted and news on Cisco online, 85,000 views. Usage of Flickr’s social networking photo site exploded to 32,000 hits. Record high traffic on Cisco blogs just to platform blog on [inaudible] got 18,000 hits.
Point four, video architecture. Think of the recently announced acquisition of Pure Digital Flip as a tipping point in our enterprise customers’ understanding of our end-to-end video strategy. While we are just starting to externally share our vision and differentiated strategy with the consumer, and I think we are well on the way to making it very exciting, as you are aware over the last several years we expanded our leadership first in the network home with Linksys, then moved into the video entertainment with Scientific Atlanta followed by our announcement this year at the Consumer Electronics Show in areas such as media hub, unifying music from any device to any device in your home and then over time virtually, and now are dramatically expanding our network video strategy to the consumer throughout the home with our recently announced acquisition of Pure Digital and the Flip.
Make no mistake about it. We will have an in doing architecture in the home for video just like we are developing an end-to-end architecture for video in the enterprise. While you might think of the Flip as a consumer device it is just as useful in our business line. The number of applications enabled by this network web 2.0 device in the business world is exploding.
Again using myself as an example I carry the same two devices in my business life and my personal life. A PDA and my Flip. Another key take away is to understand in my opinion the argument about consumer devices and business devices as well as the two architectures completely blurring is over. The real question is how do the CIO’s in the enterprise business facilitate this change and that is from a number recent meetings with some of the top CIO’s in the world. They get it. They understand the change and it is how they facilitate it rather than slow it down.
I had a chance to meet with our top level customer technology advisors recently which is a group who can be tough in a very constructive way. Their overall comment was very simply summed by one of them saying Cisco you nailed the video architecture.
As a not too subtle reminder, we believe that video will account for 90% of the load on networks in the future. Intelligence in the network is required to get the right device to the right screen with the right capability to search video content in a secure way across any combination of networks while at the same time having an ability to push the content to common, communities of interest. Stay tuned because you will be hearing a lot more about video from us over the next several years.
A fifth element, smart grids and the entire green initiative. It is an area many of you may not have realized Cisco’s though, execution and partnership leadership not to mention future business potential. Not to mention future business potential. We have moved to bringing important solutions to the market in terms of category and architectural though leadership in the world. In less than six months. This was highlighted by GE, Florida Power and Light and Cisco’s recent energy smart Miami announcement several weeks ago.
Sixth, smart connected communities. Through a combination of public/private partnerships on a global basis, we have developed and set the pace for what cities of the future will become in terms of how they will use network architecture for enabling everything from smart grids, green initiatives, safety and security, transportation, intelligent buildings, e-government, healthcare and education.
For example, in the last month we have announced a connected architecture with the top leaders in South Korea and specifically in Incheon where we announced under Mayor Heon’s leadership and [Garo] International, the key developer of the new Incheon Economic City outside of Seoul. They believe that this vision of the future could create an incremental 200,000 sustainable jobs in this new city as well as bringing in incremental growth that would add as much as 1% to the total GDP of South Korea. With all the appropriate caveats for the opportunity for Cisco over the next 3-5 years, it could be several hundreds of millions of dollars. We are driving similar strategies with other companies in countries around the world.
Sports and entertainment, an area which may surprise you but one that will play out over the long run in terms of video entertainment for the home and our service provider strategy is our focus on changing the fan experience. First it will occur in sports stadiums and then it will go all the way to the home. In one meeting this quarter we had over 42 professional sports teams with key representatives in the meeting, many of the commissioner level, for major league baseball, basketball, football and hockey. Again, more to come from our focus on sports and entertainment over the next year.
In summary, I could have talked about another dozen innovative concepts this quarter alone where we have demonstrated effective execution and implementation in the new market adjacencies. In short, our new business model is enabled by our vision, strategy and execution combined with our new organization structure built around communities that we call councils, boards and working groups is working extremely well in enabling the innovative and effective operational examples like we just discussed.
At this time, we will cover our customer segments, geographies and products for Q3 in more detail. The customer segments and geographies will be discussed in terms of orders unless otherwise indicated. The products review will be in terms of revenue.
Now moving on to customer segments as measured by orders on a year-over-year basis on a global term. In terms of our overall customer segment business the public sector was the least impacted across all of our customer segment markets, but it was still down 12%. The U.S. public sector which includes both federal and state and local was down in the mid single digits. Japan and Asia Pacific public sector were both positive at 12% and 20% growth respectively while the public sector in Europe was down 11%. The emerging markets public sector was down approximately 10% year-over-year.
In other global customer environments enterprise and service provider orders were both down by 27% and 33% respectively on a global basis. Consumer was down by 19%. The commercial market was down by 31%. Again this is in terms of orders.
Geographies. Moving on to orders by geography and as a reminder this is in terms of orders year-over-year. Japan order growth was down year-over-year in Q3 by approximately 20%. U.S. orders in Q3 were down by approximately 20% year-over-year. Federal business was thawed in the U.S., growing in the low double digits while State and local government in the U.S. was down in the mid-teen’s. The total enterprise and commercial markets in the U.S. were down in the low 20’s. Service provider was down approximately 30%.
Moving on to Asia Pacific. Order growth rate was down 27% year-over-year. Commercial was down approximately 20%. Service provider was down in the mid 30’s. Enterprise was down in the high 30’s. China was down in the high single digits while India was down over 30%.
European markets. In total we are down approximately 28% year-over-year in Q3. Enterprise was down in the mid 20’s. Commercial was down in the mid 30’s. Service provider in Europe was down in the low 30’s.
In emerging markets not counting emerging markets in Asia were down by 31% year-over-year. Enterprise was down in the low 20’s. Service provider was down in the mid 30’s. Commercial was down in the mid 30’s.
Moving on to product. Product numbers in Q3 will be in terms of revenue year-over-year but will be similar to what we saw in customer segments and geographies. Routing was down 32%. Switching was down approximately 20%. Total advanced technologies were down 12% in terms of revenue year-over-year.
In terms of advanced technologies video was down 5%. UC was down 7%. Wireless was down 12%. Security and the network home were down 14%. Application networking systems was down 31% and storage was down 45%.
Other products including WebX itself was up 18% and telepresence as we said earlier was up 138%. In terms of total revenue mix for Q3, routing was approximately 17%. Switching was 32%. AT’s were 25%. Services were 21% and the others were about 5%.
In summary, although we would 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 benefit to both Cisco and our customers that we thought were possible. Finally our execution is on target in terms of results as measured by our customer partnership perspective, market share and share of our customer total communication and IT expenditures as the network becomes the platform for delivering these capabilities.
Now Frank I would like to turn it back over to you for some additional financial guidance and other financial highlights.
Thank you 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 reconciliation to GAAP. It continues to be difficult to provide forecasts given the variability and uncertainties going on in the market. These events increase the potential that our actual results could vary materially from our expectations.
Therefore, we anticipate total revenue for the fourth quarter to be down approximately 17-20% year-over-year. At this point let me remind you that in light of Regulation FD, Cisco will not comment on the financial guidance during the quarter unless it is done through an explicit public disclosure.
Now let me give you some additional details on the Q4 financial guidance. As we have said in the past forecasting gross margin has always been challenging due to various factors such as volume, product mix, variable component costs, customer and channel mix and also competitive pricing pressures.
That being said, we believe total gross margin in Q4 to be in the range of 63% to 64% reflecting the revenue guidance I just shared with you. We believe Q4 operating expenses will be approximately 39-40% of revenue. This Q4 guidance reflects normalized expenses based on the seasonality of our business and continued expense management initiatives. We anticipate that we will have removed $1.5 billion from our annualized expense run rate by the end of the fiscal year as we mentioned earlier.
We expect interest and other income to be approximately $30 million in the fourth quarter. Our tax provision rate for Q4 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 count to be flat quarter-over-quarter in weighted average shares outstanding for EPS purposes. In this estimate of share count we are not taking into consideration any further change in stock price that could occur in the fourth quarter 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 $12 million.
Regarding cash flow from operations, we would expect to generate $500-700 million per month. For our Q4 FY09 GAAP earnings we anticipate that Q4 GAAP EPS will be $0.05 to $0.07 per share lower than the non-GAAP EPS primarily due to acquisition charges and stock compensation expense. Please see the slide that accompanies this web cast for further details.
Other than those items noted above there are no other significant differences between our GAAP and our non-GAAP guidance. This guidance assume no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant.
John I will turn it back over to you.
Frank thanks very much. Well done. The following is a summary of our view of Cisco’s momentum and opportunities entering Q4 of fiscal year 2009. In areas that Cisco can control or influence our leadership from a product perspective, innovation, architecture and operational execution not only continues to be solid as we said before but most importantly our customers are beginning to grasp the productivity implications and the importance of both the technology and architectural play. That is a big change from what we have seen before.
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 the global economy recovers to GDP growth rates similar to those in the middle of the decade, as we continue into Q4 2009 we plan to aggressively invest in new and adjacent markets for the longer term.
As we anticipated in last quarter’s conference call and it unfortunately developed as expected, 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 the economic, political and capital spending perspectives that many of you continue to witness. One of the most important things you do during periods of uncertainty is to communicate very open and transparent fashion with your shareholders, customers and employees.
We believe Cisco is very well positioned to capture new market opportunities due in large part to the importance that the network plays in all forms of communications and IT as well as our process and organization structure build around collaboration and web 2.0 capabilities. Our customers and even more our shareholders are telling us that we are extremely well positioned for long-term growth and the ability to move into new market adjacencies even during the most challenging of all times which I actually believe is the time that you do move into adjacencies.
As we said on last quarter’s conference call and are reconfirming now we have always done what was 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, across the board lay off to position us for the future.
If business were to change dramatically versus our expectations we would obviously do what is necessary to bring our expense structure further in line with revenues. If that is the case lay offs could be necessary as they have been one time in the past. However, at the present time it looks reasonably good with all the appropriate caveats for our employees that we will be able to avoid a broad based layoff or a salary reduction.
As a follow on message to our employee family it is up to all of us now to execute against our vision, strategy and execution business model. I want to thank this entire Cisco family for working together as a team to ensure our company is in a solid position to not only weather the challenging economic environment but even more importantly be ready to accelerate as the market returns. I know it has not been easy and we are all working hard to maintain our culture of innovation, trust and a stretch mentality and at the same time giving back all during a tough period of time for ourselves, our families and our friends.
Again regardless of what happens to the economy short-term we believe this will not dramatically change our long-term opportunities with our vision of how the industry will evolve and our differentiated strategy. From my viewpoint long-term growth I believe is not our challenge. Rather, our challenge is prioritization of both the opportunities and resource allocation especially during these challenging times that will allow us to achieve these long-term growth goals.
Therefore, you will continue to see us investing aggressively where appropriate while maintaining our focus on our financial models. Once again, with our usual caveat as discussed earlier and in our financial reports our Q2 fiscal year 2009 guidance is for year-over-year revenue to decrease in the 17-20% range. That is for Q4 fiscal year 2009.
The next part I thought a long time about [standing up] but I know some of our shareholders do not believe this growth is capable and we have talked about. To me, I believe and I think our leadership team believes as a whole our long-term growth opportunities remain in the 12-17% range assuming with our usual caveats about global GDP. I think you are beginning to see our customers capture this understanding and to realize the large number of market adjacencies that we are moving in with the network being the platform for everything we are doing and capturing the vision going from the home to work, across any combination of networks with any combination of devices with a common security strategy. We are the only player that is set to do that across the markets.
I don’t want some of our shareholders to misunderstand what I am saying. I have heard your advice. I will always try to be transparent. I may not be always right but I will try to be always transparent. I might question why that isn’t reversed. Why aren’t you saying 12-17% should be what you are targeting and maybe be more aggressive? We will see how that plays out. We will focus on what we can control or influence and attempt to position Cisco to gain momentum in market transitions whether they are industry consolidations, product transitions, market adjacency opportunities or economic.
In summary, for those areas we can control or influence we believe our vision, strategy and execution are in great shape in producing the 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 are now going to open the floor to Q&A so we do request that each analyst ask only one question so we can get as many in before our call is over. Operator if you could please open the call to questions we will go ahead and begin.
(Operator Instructions) The first question comes from the line of Tal Leoni – Bank of America.
Tal Leoni – Bank of America
I have a question, I am sure other people are going to ask about expenses. I want to focus on the revenue side. Embedded in your guidance is growth in switching. Switching went down sequentially 16% two quarters ago and another 16% this last quarter and the embedded growth in the guidance is in the neighborhood of 3-5%. What is driving switching down so much that is above and beyond the trends we are seeing in every other division and why do you think next quarter we are going to see such a nice recovery?
Let me break it down into a couple of pieces. First of all, during the quarter it was really solid. I don’t want to miss that key point. The second is enterprise customers tend to move as groups. As you know switching ties very tightly to enterprise. Third, when you look at switching architecture with many of the enterprises actually reducing headcount, etc. and just now starting to load their networks with the web 2.0 technologies we talked about I think where you want to look at switching growth is where will it be out 6-12-24 months from now and is our architectural play right?
Having said that, I got very little push back in terms of when I presented to our top customers around the world over the next 2-3 months about our architecture in switching. Candidly their comfort level getting actually even closer to Cisco and understanding everything from a security strategy to our leadership in each product category as well as flexibility. Even in this quarter with very strong competition from many sides our switching discounts was fine.
Now I’m not predicting what the mix will be by individual products next quarter so I heard your comment on that but I am saying we are going to be fine in switching. I am very comfortable with where we are overall. We will miss our forecast by individual segments or products in a given quarter up and down but we are pretty good on the overall trends. That is a nice way of saying I think our switching architecture is in very good shape. I am very comfortable with our strategy here and even more comfortable with our position in our enterprise accounts and moving into small markets.
The next question comes from Simona Jankowski - Goldman Sachs.
Simona Jankowski - Goldman Sachs
Acquisitions have always been part of your growth strategy and you have in fact commented again on your expectations in the last 12 months that remaining the case. It is interesting when we look back at that period that your cash flow generation has been some of the strongest it has ever been and valuations have been some of the lowest they have ever been and yet you made the fewest acquisitions you have ever made in such a period of time. Can you just comment on why that is? Then related to that, with the UCS now launched should we assume that the focus of your acquisitions going forward will be based maybe more on the video and home virtualization side or are there two pieces of the data center strategy that need to be filled out?
You have a series of very fair questions. First of all, if you watch our acquisitions actually Ned’s team has been working overtime over the last few months and don’t worry team we are going to reward you with kind words, not with salary raises. A little bit of humor there. If you watch, we have done three acquisitions very recently and in the process of completing them all in our top five priorities. Ned I am going to have you talk about them in a moment. But to the second part of your question we are not positioned structurally to move in internal development and acquisitions and new strategic partners, because remember the partners you want in the future aren’t necessarily the ones you see out of your rear view mirror from the past, and all the above categories. Not just our top five priorities but our top 29. Acquisitions will continue to be an integral part. I think you know that myself and our leadership team are fairly conservative. Make no mistake about it we have a very large war chest and we tend to use it over time.
We wanted to get a little bit of firmness underneath our feet before you begin to look and I think what you are now seeing is that starting to occur. Having said that, Ned maybe you can talk for a minute or two about areas where you are architecturally thinking and obviously consumer which is near and dear to your heart is one of the areas feel free to focus on. The key take away there, data centers are very important to us. We have moved very aggressively there with product announcements and architectural plays but it is one of 29 even though it is in the top five.
Thanks John. So first of all I would comment that we always drive our acquisition strategy based on our strategy for the market and the market transitions we see as opposed to the fluctuations that are occurring in the public markets or our cash balance. We have been very clear about those top transitions as we have talked about in the call today; video, collaboration, data center, virtualization and globalization. The three deals we did this last quarter focused on globalization, video and on the data center and virtualization markets. We continue and expect to continue to be very active when we see opportunities we believe will be significant in our ability to execute across those market transitions and drive our strategy in using both cash and stock where appropriate to do acquisitions.
At the same time our internal engine development is going fair. We are really cranking.
The next question comes from Ittai Kidron – Oppenheimer.
Ittai Kidron – Oppenheimer
Great job on the balance sheet and the OpEx. First, on the gross margin side, can you give us a little bit more color as to what in the mix you expect to change to drive your gross margin down sequentially again? How much visibility do you have into that or is it just a general caution there? Also, with regard to the tax rate there has been a lot of discussion about taxation of overseas profits. What is your perspective on this? How do you think the company will handle this issue if it rises?
Two separate questions and both of them pretty substantive. Which one would you like for us to hit?
Ittai Kidron – Oppenheimer
The gross margin one.
First remember the gross margin are a combination of what occurs at a point in time between product mixes. So we are not re-guiding up or down. We are about where we expect to be in gross margin. Some quarters will be a little bit ahead of that guidance. Some quarters a little bit lower. Frank, specific comments?
Let me just start by saying clearly we are very pleased with how things turned out from a gross margin perspective this quarter. Now as you know we have had several efforts underway. We are really driving tight management of our inventory as we have seen a decline in the overall volume based on what is happening with bookings and revenue. We have also been aggressively managing our resources to help support both the services side as well as the product side. We have also had some efforts underway to tightly manage credit risk as the markets have been really challenging over the last several months and of course dealing with some of the pricing pressure that we continue to see with our discounts.
So despite all that what we have seen in the past quarter is really everything went in a favorable direction for us and therefore we did see margins come in better than what we had guided in the start of the quarter. Now with this entire environment that we have with lower volumes and also from a discount perspective, we can’t always assume that is going to continue and that everything is going to go in a positive direction.
An example would be if you look at some of our product mix, we normally see a reduction or impact in our product mix from a product standpoint. We did not see that in the third quarter which was a positive impact. We can’t anticipate that is going to be the same in the next quarter. So that is also going to impact us as we give guidance for Q4. Then the other thing that we look at is some of our cost improvements. From a seasonality standpoint if you look back several years we get the lowest amount of cost reduction in our Q4 so there is taking that into consideration. Then lastly if you look at service margins, coming in at 67% in the quarter that is the highest we have ever seen and that really depends a lot on what happens on the mix between our technical services and advanced services.
We are not anticipating that mix is going to be a favorable mix primarily because we are being much more aggressive on advanced services which tends to have lower margins. So taking that all into consideration is why we feel extremely comfortable of giving the guidance of 63-64 for Q4.
The next question comes from Mark Sue - RBC Capital Markets.
Mark Sue - RBC Capital Markets
How does the lack of month to month order improvements relate to the overall tech environment which seems to have improved February to March to April? What was the year-over-year order rate for April and does the lack of change imply a long period of facing and it is just a return to seasonality that gets you to your up sequential guidance?
It is a series of questions. Let me not handle them as statements and let me do it in the reverse and I know what you are asking here. This was the first quarter that followed normalcy. This is to me probably from a macro economic issue the most important thing that we did in the quarter in terms of seeing the results. You have to have that type of leveling out and consistency in February, March and April. The second thing is I would actually be worried if it were spiking up and down because if you spike up four months and back down the next month or a given month can not be the trend. It is when you see it several times in a row, that we are for the first time seeing it leveling out with all the appropriate caveats it can go any way from here, but it feels dramatically better than before.
I think probably the best question that I could ask and directed to a customer the other day was on a scale of one to five where are you today versus what you had said just a quarter ago? I’m not talking about business. I am talking about total economic scenario. I would have said a three versus just a quarter ago a two. So it is that type of balance I think we are seeing. You saw our range narrow. You saw our message which was very clear that with the changes we make through Q4 we are beginning to level out expenses and we are going to be aggressive in making multiple moves especially in our own internal 29 market adjacencies.
So, those are all positives. I am very comfortable with where we are in the tech industry and when I talk to our customers it doesn’t matter if it is a service provider, it doesn’t matter if it is enterprise, it doesn’t matter if it is the channels and I talk to our governments and for the first time we are starting to become a consumer player. We are well positioned across the board. So I think people who get real excited about a month up or down, as you have seen and if you listened to people who were giving guidance on that they would have been super excited in October. Unbelievably pessimistic by February. Really down in March. Back up in April. Our view hasn’t changed. We have been very consistent on the execution. We are very good. It doesn’t change our strategy by much.
Mark Sue - RBC Capital Markets
So does consistency mean the worst is over?
It has to level out before it can get better and we will see. Our customers are saying it is leveling out. No one is projecting a turn. It takes a couple of quarters to turn. I don’t think you are going to see a dramatic turn occur quickly. I think it will be more gradual. That is what we have been saying all the way along. When only 5% of my customers just two or three months ago would have said it has a chance to turn by the end of this year going into next year, that is where when you all pushed me I said [inaudible] although no one knows. That is what I would have got. So I don’t want to read too much or too little into it but it feels better, a pretty fair amount better, versus just a quarter ago.
The next question comes from Ehud Gelblum – JP Morgan Chase.
Ehud Gelblum – JP Morgan Chase
A couple of clarifications. First of all, I may have missed this. Did you give product order growth for the quarter? You said that the month by month was the same but did you give what that number was? I know you said the 20% for January but down 20% to last January. I can’t remember because I don’t have my notes whether you gave what those three numbers were? Then my actual question has to do with emerging markets in India. Those were big growth drivers for you when things were doing very well in 2006 and 2007. Now they have been down significant double digits for several quarters. Emerging markets down 31% and India down 40%. What from a concentration conversation you were having in the last couple of quarters you were focusing much more on the U.S. as well as India. How are you looking at the re-emergence of the emerging markets and India? Will that take a couple of years? Do you still think the U.S. is the first to emerge and they kind of follow later? How do we look at emerging markets in India and what kind of time frame will they come back from the U.S. with respect to the U.S.?
Several things. First, you can do the math fairly quickly. You figured out our services had a very solid quarter. We are using service led solutions. Advanced services and technical support got very good execution. Couldn’t be more pleased with what William, Gary, Joe and the whole team is doing. In terms of the products overall you can articulate pretty quickly doing those numbers. It was mid 20’s. Mid 20’s in terms of product orders was pretty consistent in terms of all three months. So that is what really made me very comfortable. That had to occur before you had a chance at an up turn or even sustained leveling out time period.
In terms of our strategy it used to be a different point of view talking to customers around the world, government leaders around the world, all of which I have done in the last 90 days in an unbelievable cycle. While people might have said the global economy can come back and the U.S. perhaps can follow coming out most every government leader and business leader now would say it has to be the U.S. coming out for them to return to reasonable numbers. The exception we would say otherwise at the present time of our customer base.
In terms of the emerging markets this is what we are focused on. You say what about the emerging markets? Our strategy doesn’t go up or down based on a quarter or two. I am very comfortable first in the U.S. leadership. I am an optimist on our country. It is going to do great. I think we have the ability to bounce back like no other country in the world. We said well before it was popular to say so that we felt the U.S. would have to lead us out of this and we felt that it would.
Secondly, we said three main emerging countries. First was China. Second was India. Then we just announced two weeks ago Mexico. If you watch has occurred in China they have done a very good job on the stimulus package. They have applied their changes fairly quickly and while they have got a ways to go our growth in China was just down in the mid single digits. Or maybe upper single digits if I remember the number right. That was actually pretty good given all of the traumatic change they have gone through.
India got surprised. As you know they are in the middle of an election cycle. Again, the strength of the democracy is the weakness of the democracy. It is going to have to get the elections through before they make some of the changes they have to make at the government level. When businesses got surprised on their GDP growth which I know because I was there the week before it was announced, it was lower than government or business expected. They did exactly what happened here in the U.S. They took their foot off the gas. They are going to watch and see what happens, etc. I am very comfortable with India being a player not 2-3 years from now. Much quicker than that assuming the U.S. does recover which I believe it firmly will?
In terms of Mexico, again an ability to partner with a country. We do that at the President level where we were with President Calderon. His ministers get it. His country gets it. We were with ten of the top twelve major conglomerates representing 70% of the GDP growth. Very well positioned there.
Nice way of saying we will use these transitions or disruptions to build customer relationships and be positioned very well on the way out. I know you were deliberately asking me my comfort level with the emerging markets and doing it from a challenging point of view. I actually feel very good with where we are there and you will see us do the same in the U.S. I have spent a lot of time with automotive companies that probably will not produce much in the next 12 months but you will see we will form relationships tighter and when we come back they will remember who was there for them.
Ehud Gelblum – JP Morgan Chase
I was not challenging you John.
The next question comes from Nikos Theodosopoulos – UBS.
Nikos Theodosopoulos - UBS
I have a numbers question. I wanted to ask about the product deferred revenue. If I calculate it right it fell pretty significantly sequentially about $522 million or about 8% of the total product revenue reported in the quarter which on a historical basis is a pretty big change on a sequential basis for Cisco. So I’m trying to understand how did that impact the overall product revenue number in the quarter? Why did it change so much and does swings in product deferred like that change the impact of book to bill?
Very good question. I’m going to ask Fred to address it. It is one that I know several of our shareholders have been asking questions about because sometimes deferred revenue especially deferred total revenue or product revenue might indicate a problem. It is actually the reverse for us here. All three elements of Frank’s answer or four elements will probably be good. So I’m putting you on the spot now Frank. Don’t mess it up.
If you look at the overall deferred revenue from a quarter-over-quarter standpoint both product and services are down 6%. As you all recall, we have three components of deferred revenue. We have a product business. We have a services business and then we also have our distribution channel which we call our two-tier channel.
The first thing I would say as far as the decline if you look at it from a quarter-over-quarter standpoint and a year-over-year standpoint overall it was up 2%. Part of the decline has to do with just the overall reduction in volume of our business across the board. The second part really has to do with our two-tier business. What we have experienced over the last two quarters is as you mostly would expect in this environment our two-tier distribution partners have been reducing their inventory levels.
As a result of that we feel more of a reduction or tighter management of that channel in the third quarter versus the second quarter. So when you look at the dynamics from a quarter-over-quarter standpoint and really that plays into the deferred revenue we had tighter inventories which in turn had a lower amount of deferred revenue.
I think overall if you look at that I think that really demonstrates kind of health in the channel where we don’t have huge inventories built up especially in this kind of environment.
So actually our traditional product revenue decrease was even less than what our business was down. Services looked very great and channel is actually very good in terms of positioning overall.
The next question comes from Paul Silverstein – Credit Suisse.
Paul Silverstein – Credit Suisse
Given that last quarter product orders were down 14% and guidance was down 15-20% and you came down 17% and change, this quarter you just said down in the mid 20’s. Your revenue guidance is better than that down 17-20%. Can you remind us the translation linkage between your order book and your revenues?
Book to build was one. So you go into it with a good healthy backlog in terms of weeks of backlog. Secondly, services are about 21% of our business so if you are kind of backing into it think of routing 17, switching 32, advanced technologies 25, others about 5 and services 21%. Services are very solid on it. The fact that probably Frank merited with appropriate overview but Frank is doing a great job. Couldn’t be more pleased. The 17-20% indicates that leveling out. It is really a mix of that. While I want to be very specific we are not calling an up turn. What we are saying is it has to level out before it can go up. There is always a chance it can go down but that tightness on that end and also our expense guidance begins to give you a little bit of help on what to expect. That is about as optimistic as I think you should be at this point in time in the markets. Again, remember just a month and a half ago or two months ago people were the most pessimistic. I was risking my life and many people said how do you remain optimistic? The answer was we keep our focus a year or two years out. So that is the way I would answer it.
I would tell you that guidance is pretty comfortable and a little bit more optimistic than we would have been just a quarter ago.
The next question comes from Samuel Wilson – JMP Securities.
Samuel Wilson – JMP Securities
I hate to do this as the last question but I would like to put you on the spot a little bit. A lot has changed in the last 90 days. There has been a lot of press about your relationship with IBM and HP and I wanted to end the call by you sort of going on the record and saying what you think the relationship right now is with IBM and HP and how you think it is changing given all that has happened in the last 90 days.
Let me expand on the question since you are going to be our last one on that since we want to end at 3 for our commitment to you all and keep the calls tight. If you look at our partner relationships they continue to evolve very, very effectively and we have done that over two decades here. While some of the partners in the past will be partners in the future, when you are going into new areas you are going to have different partners as you move into those. So as you think about it, think about most of the demand we deliver to our partners. It is created by Cisco. That can be easily moved to other areas. It is not all of it but it is a vast majority.
The second element is to think about our partnerships in the future will be and think about companies like Accenture and WebPro and Emphasys and Tata. Think of it as Intel and Microsoft. Think of it as EMC and VM Ware. Think of it as players like that in terms of where we are going. HP is going to be a competitor and that happens. When you have overlaps in terms of moving into market adjacencies there are going to be some people you are going to partner with closer and there are going to be others that you are not.
There will also be some areas like with IBM where we will partner at times and compete at times and we do that at the Microsoft level. The key point I want to make is if you look at those 29 market adjacencies and just walk through them for a moment and think through how many different partners and partner sets we are going to give each one and think about how broader range we are going into with a track record of being number one or number two every time we have entered a market. That is pretty unique.
There are going to be times when some of our partners say that is too close for me for you to do. I clearly understand that. There will be other times where I might feel the same in reverse. I actually think that is healthy. Rob, a little bit about what is our relationship with our channels, how we fulfill business and then I will wrap it up Blair if that is okay.
Sure John. I think one of the most important things to consider is we did think through all those implications relative to years ago and we have spent so much time on building what I think is the industry’s most envied channel that our ability to fill in those places where we draw demand primarily in the enterprise and service provider I think the capacity is out there as we speak. We will overlap with HP. We will continue to work together with service partners like IBM and Accenture and others. So I feel very comfortable with our roots to market. I think we are in excellent shape to take advantage of the up turn when it occurs.
In summary, I said this in my opinion was the most innovative and operationally sound execution quarter we have had and some of you might say tell me that again and why. If you really watch our product introductory cycles we are moving into new markets with a speed no one has ever even attempted to do and I would argue with a speed probably five to ten times what anybody else has done.
Secondly, for the first time customers who have been watching this and they say I get it. I now know what the innovation is in this business model and secondly I watched it execute. You are going to make it happen. That is the enterprise and service provider customers who are closest to us.
Third, our relationship with our customers and channels has never been tighter. If you want the capability to be able to focus and pivot in one area and have Ned going with three or four major pillars in the consumer space. Pivot again and go into the data center and play in areas in terms of virtualization we haven’t done. Pivot again and go with a video architecture across the board. Pivot again and be the world leader in collaboration of web 2.0 and it isn’t just a Silicone Valley thing anymore, a high tech company. Our enterprise customers know we are the leader in this. They know we have the top leadership. They know we can help them more than anybody else. Our relationships have been tighter.
So while many of the things you do “innovation” wise it isn’t until the customers say hey this is a benefit to me and bring it home does that occur. You are really starting to see that occur. So, with all the appropriate caveats which I thought we did a good job of covering in the script I think what you look in terms of our future it is a very bright future and my comfort level with the long-term both in terms of growth opportunities as long as you can control the influence is extremely strong.
With that, Blair, let me turn it over to you to close.
Very quickly. Cisco’s next quarterly conference call which will reflect our fourth quarter fiscal 2009 results will be on Wednesday, August 5, 2009 at 1:30 p.m. PT/4:30 p.m. ET. Downloadable Q3 financial statements again are available following this call including revenue segments by both 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 slides and the documents.
Again, I would like to remind you that in light of Regulation Fair Disclosure, Cisco plans to retain its long standing policy to not 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 for your participation and continued support. This concludes our call.
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