Cisco Systems (NASDAQ:CSCO)
Q4 2006 Earnings Conference Call
August 8, 2006 4:30 pm ET
Blair Christie - IR
John Chambers - President, CEO
Dennis Powell - CFO
Charlie Giancarlo - Chief Development Officer
Rick Justice - SVP, Worldwide Field Ops.
Jim McDonald - CEO, Scientific-Atlanta
Tim Long - Banc of America
Alex Henderson – Citigroup
Brant Thompson - Goldman Sachs
Nikos Theodosopoulos - UBS Warburg
Jeff Evenson - Sanford Bernstein
Jiong Shao - Lehman Brothers
Tal Liani - Merrill Lynch
Ehud Gelblum - JP Morgan
John Marchetti - Morgan Stanley
Mark Sue - RBC Capital Markets
Subu Subrahmanyan - Sanders Morris
Paul Silverstein - Credit Suisse
Samuel Wilson - JMP Securities
Inder Singh – Prudential
Welcome to Cisco Systems fourth quarter fiscal year 2006 financial results conference call. At the request of Cisco Systems, today's call is being recorded. If you have any objections, you may disconnect at this time. Now I would like to introduce Ms. Blair Christie, Vice President of Corporate Communications and Investor Relations. Ma'am, you may begin when ready.
Great. Thank you and good afternoon everyone. Welcome to our 66th quarterly conference call. This is Blair Christie and I'm joined by John Chambers, our President and CEO; Dennis Powell, Chief Financial Officer; Rick Justice, Senior Vice President of Worldwide Field Operations; Charlie Giancarlo, Chief Development Officer; and Jim McDonald, Chief Executive Officer of Scientific-Atlanta.
The fourth quarter and fiscal year 2006 press release is on First Call, First National Business Wire, the European Business and Technical Wire and on the Cisco web site at www.Cisco.com. If you would like a fax of the press release, please call 408-526-8890 and follow the instructions. A corresponding webcast with slides and additional information regarding Cisco's financial statements can be found on our website in the Investor Relations section. Additionally, a replay of this call will be available via telephone at 866-357-4205, or 203-369-0122 for international callers.
Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results. Our non-GAAP financial results were previously referred to as pro forma in prior conference calls. Please note, we have provided non-GAAP and GAAP reconciliation information in the slides accompanying this webcast, as well as on our web site in the Investor Relations section.
Throughout our call today, we will provide both Cisco and Scientific-Atlanta financial information in order to illustrate the impact of this acquisition on our overall Q4 and fiscal year 2006 results. Where we refer to Cisco standalone, the financial information represents Cisco's performance excluding the results of this acquisition.
The financial results in the press release are unaudited and the matters we will be discussing today include forward-looking statements, and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ from those that are contained in the forward-looking statements.
Unauthorized recording of this conference call is not permitted, and I would now like to turn it over to John for his commentary on the quarter.
Thank you, Blair. In this quarterly conference call, we're going to palette a new way of presenting the information based on requests from many of you. The first goal is to cut the time for the total narrative part of the conference call down; and second, to present the key takeaways for the quarter as well as the revenue guidance for the next quarter in the opening comments.
The opening comments will be followed by a detailed, yet abbreviated, discussion versus prior conference calls of the financials by Dennis. The third section of the call will focus on general business momentum and strategy on a geographic, product and customer segment basis. Dennis will then provide additional financial parameters around our guidance for Q1 and then I will wrap it up with some general comments in terms of Cisco's momentum going into fiscal 2007; and finally our Q&A session.
This briefer format will be supplemented with more detailed information in the slides accompanying this webcast. This should leave room for more questions and answers at the end and still result in the calls becoming shorter with the goal to reduce the time of the call by 15 to 30 minutes. We appreciate your view and constructive feedback to Blair and her team on this new approach.
Now onto the discussion of Q4. I would like to summarize this quarter as a very strong quarter and a record quarter from a revenue, net income, GAAP and non-GAAP earnings per share perspective. To put these record results in perspective, I will summarize the quarter highlights. First from a key financial perspective; second from a geographic perspective, followed by customer segments and fourth, products.
In this discussion and in future quarterly conference calls, we will discuss product growth and other key financials primarily from a revenue perspective and use order growth rates to add color and momentum to the discussion. The geographic and customer segment discussions will be primarily in order growth numbers, as this is how we run our business.
The key financial highlights for Q4 include the following: record revenue of approximately $8.0 billion, a 21.3% year-over-year increase, and a Cisco standalone increase of 12.5%, which was slightly above the high end of our guidance for this Q4 of 10% to 12% from a Cisco standalone perspective. Order growth was very strong with product book-to-bill comfortably above 1.
The key takeaway here is that when you see our ending backlog for fiscal 2006 as published in our 10-K in September, we will have increased our Cisco standalone product backlog approximately $700 million over the ending backlog of fiscal 2005. This increase was due almost entirely to the strong order growth in Q3 and in Q4.
Non-GAAP net income was $1.9 billion, an increase of 15.1%. Non-GAAP earnings per share were a record $0.30, and GAAP earnings per share were a record $0.25.
Cash generated from operations was approximately $2.3 billion, we repurchased approximately 2.8 billion of common stock and we exited the quarter with approximately $18 billion in cash, cash equivalents and investments.
From a Cisco standalone geographic perspective, momentum was strong from an orders perspective and balance was good across the five theaters during Q4. In fact, four of the five geographic theaters experienced stronger annual product order growth when compared to a very strong Q4 of last fiscal year, Europe being the one exception.
In spite of the slower GDP growth that occurred in the U.S. in calendar Q2 and slower growth of some of our technology peers in their Q2, our business remains strong. In the U.S., orders grew in the upper teens year-over-year while total worldwide orders grew in the mid-teens. As anticipated, we saw very strong order growth from the emerging markets theater of approximately 40% year-over-year. While in Europe, we did see some improvement versus earlier in the fiscal year with orders growth slightly improving to the high-single digits.
From a Cisco standalone product perspective, the balance was extremely good across routing, switching and Advanced Technologies. Routing revenue grew year-over-year by 12%, switching revenue grew year-over-year by 8% and Advanced Technologies revenue grew year-over-year by 23%.
Of the Advanced Technologies, storage area networking, unified communications, formerly known as enterprise IP telephony, and wireless led the way. We believe we are gaining market share versus almost all of our competitors, but we also believe we are getting a larger share of our customer's total spend on communication and IT.
From a Cisco standalone customer segment perspective, we saw continued strength in the commercial market with product order growth of approximately 20% year-over-year. The service provider business remains strong with standalone orders growing approximately 18%. Scientific-Atlanta -- congratulations Jim, by the way -- was above the high end of our guidance with approximately 15% year-over-year revenue growth.
From a momentum perspective, of particular interest in the service provider market was the very strong order growth rate of the CRS-1, comfortably exceeding the $100 million mark per quarter order rate. The U.S. service provider segment continued at an extremely strong pace, growing in mid 20's year-over-year from an order perspective.
The global enterprise business was solid with growth in the low double-digits, while our U.S. enterprise orders grew in the mid-teens year-over-year when not including in the federal business.
From a commentary perspective, we executed as we outlined in our Q3 call. We will always try to share with our shareholders, in a very transparent way, both our reasons for optimism and occasional caution. Going into Q4, we did share some caution and this concern appears to be appropriate, at least on a macro and general technology spending level.
However, from a Cisco perspective, the key takeaway on Q4 from a U.S. perspective, the momentum remains strong. The commercial and service provider segments of the U.S. maintained a very strong year-over-year order growth rates experienced in prior quarters while the U.S. enterprise business grew in the mid-teens year-over-year.
The record results for Q4 are due in part to our successful implementation of our strategy, given our vision of how the communications and IT industry would evolve. As intelligence moves throughout the network, the network is becoming the platform that enables most forms of communications in IT. Our business and technology architecture approach to this evolution is gaining both market share results and share of total customer spend.
In terms of revenue guidance for the upcoming fiscal 2007, including our usual caveats discussed in prior calls, we project year-over-year revenue growth of approximately 15% to 20% and Cisco standalone revenue growth of 10% to 15%, which is consistent with our prior long-term guidance.
Our Q1 FY07 year-over-year revenue guidance is for revenue growth of approximately 19% to 21% and Cisco standalone year-over-year revenue growth of 11% to 13%. At this time, I would like to turn it over to Dennis for further discussions of the financial highlights.
Thanks, John. Now for some comments on our P&L. We're very pleased that revenue for both Cisco standalone and Scientific-Atlanta exceeded our expectations this quarter. The business was strong across geographies, product categories and customer segments. We enhanced our financial leverage with strong gross margins and improved operating expense productivity, resulting in solid growth in operating income.
Total revenue for the fourth quarter was $8 billion, an increase of 21.3% year-over-year. Cisco's Q4 standalone revenue was $7.4 billion, or an increase of 12.5% year-over-year. Scientific-Atlanta Q4 revenue was $582 million, or 15.3% increase year-over-year for the comparable period when aligned to conform to Cisco's fiscal quarters.
Scientific-Atlanta product revenue is categorized in the following Cisco product revenue segments: video systems, home networking, optical, other and services. Routing revenue totaled $1.65 billion, up 12% year-over-year; switching revenue was $2.83 billion, an increase of 8% year-over-year; Advanced Technologies totaled $2.0 billion, including $513 million of Scientific-Atlanta sales, representing 65% increase year-over-year on a combined basis. Advanced Technologies revenues not including Scientific-Atlanta grew 23% year-over-year. As a reminder, beginning in Q1 FY07, optical will no longer be included in our Advanced Technologies product category.
Service revenue was $1.25 billion, up approximately 18% year-over-year due to growth in our technical support, advanced service and Scientific-Atlanta businesses. Q4 total non-GAAP gross margin was 65.3%, down from 65.7% last quarter, resulting from the three months impact of Scientific-Atlanta versus two months last year.
For product only, non-GAAP gross margin for the fourth quarter was 65.1%, down slightly from 65.3% last quarter. Non-GAAP product gross margins for Cisco standalone and Scientific-Atlanta both improved sequentially. However, the inclusion of three full months of Scientific-Atlanta in Q4 versus two months in the prior quarter slightly reduced combined gross margins as we expected.
Our service margins on a non-GAAP basis for the fourth quarter were 66.3%, up from 65.2% in Q4 FY05 and down from 67.9% last quarter. Non-GAAP operating expenses as a percentage of revenue were approximately 35% in Q4 FY06, down from approximately 36% in both 4Q05 and 3Q06. Our Q4 FY06 tax provision rate for the non-GAAP and GAAP results was 28%.
Non-GAAP net income for the fourth quarter was $1.9 billion compared to $1.6 billion in the fourth quarter of fiscal year 2005, representing a 15% increase year-over-year. Non-GAAP earnings per share on a fully diluted basis for Q4 were $0.30, up from $0.25 in the same quarter of fiscal year 2005, representing a 20% increase year-over-year. GAAP net income for the fourth quarter was $1.5 billion. If we had included the FAS 123 expense previously disclosed our footnotes, 4Q05 net income would have been approximately $1.3 billion, representing a 22% increase year-over-year.
GAAP earnings per share on a fully diluted basis for the fourth quarter were $0.25. Again, if we had included the FAS 123 expense previously disclosed in our footnotes, 4Q05 earnings per share would have been $0.20, representing a 25% increase year-over-year.
Total revenue for fiscal year 2006 was $28.5 billion, an increase of approximately 15% over fiscal year 2005 revenue of $23.8 billion. Total Cisco standalone revenue for fiscal year 2006 was $27.5 billion, an increase of approximately 11%.
Non-GAAP net income for fiscal year 2006 was $6.9 billion, up approximately 14% from 2005 non-GAAP net income. Non-GAAP earnings per share on a fully-diluted basis for fiscal year 2006 were $1.10 up from $0.92 in fiscal year 2005, representing a 20% increase year-over-year.
GAAP net income for fiscal year 2006 was $5.6 billion. GAAP earnings per share on a fully diluted basis for fiscal year 2006 were $0.89. If we had included the FAS 123 expense previously disclosed in our footnotes, fiscal year 2005 GAAP EPS would have been $0.71, representing a 25% increase.
Product backlog at the end of fiscal year 2006 was $2.65 billion, excluding Scientific-Atlanta, compared with $1.95 billion at the end of fiscal year 2005, an increase of $700 million. In our 10-K, we will report a backlog of approximately $3 billion which includes approximately $400 million for Scientific-Atlanta.
Now moving on to the balance sheet. The total of cash and cash equivalents and investments at the end of Q4 was $17.8 billion, compared to $18.2 billion last quarter and $16.1 billion at the end of fiscal year 2005. During Q4, we generated approximately $2.3 billion in cash flow from operations and used $2.8 billion to repurchase 139 million shares of our stock at an average price of $20.35.
For the full fiscal year 2006, we generated $7.9 billion of cash from operations and used $8.3 billion to repurchase 435 million shares of our stock at an average price of $19.07. The remaining approved amount for stock repurchase is approximately $4.6 billion.
Moving on to accounts receivable, we ended the quarter at $3.3 billion, up from approximately $3.0 billion in the previous quarter. The increase in accounts receivable was due to increased sales and the impact of linearity. At the end of Q4 FY06, DSO, or days sales outstanding, was 38 days compared to 36 days at the end of Q3.
Total inventory for Q4 was $1.4 billion, up from $1.3 billion last quarter, a change of $58 million. Non-GAAP inventory turns were 8.3 times, up from 7.4 times last quarter and 6.6 times in Q4 FY05. This increase in turns was due to the continued implementation of our lean manufacturing initiative. A breakdown of our inventory can be found in the slides that accompany this call.
Our inventory purchase commitments for Q4 were $2 billion as compared to $1.7 billion for Q3 and $954 million for Q4 of the prior fiscal year. The year-over-year increase reflects the inclusion of $295 million of purchase commitments for Scientific-Atlanta and the continuation transition to the lean manufacturing model.
The rise in purchase commitments is also due to higher backlog on a year-over-year basis and longer lead times in the broader supply chain.
In response to longer lead times, we have increased our purchase commitments of certain component items for targeted high-demand products, such as the CRS-1 12000 Series routers and the Catalyst 6000 switches.
Our total Q4 FY06 reported headcount ended at 49,926 a net increase of 1,630 from Q3 and an increase of 11,500 year-over-year. The year-over-year increase is primarily due to the acquisition of Scientific-Atlanta and the additions in sales headcount.
In conclusion, we were very pleased with our performance, both on a fiscal year and a Q4 basis. We continued to maintain strong financial leverage with non-GAAP operating income above 30% of revenue. We continued our strength in operating cash flow, generating $7.9 billion for fiscal year 2006. Finally, our strategy around the network of the platform is working really well and we are strongly positioned for the next year. I will now turn it over to John.
That sounded like a great comment at the end, Dennis, that I would normally make. Anyways, nice job.
In this section of the call, we will cover our geographies, customer segments and product review for Q4. Unless specifically indicated, all comments in this section are for Cisco standalone only. In this section, we are going to attempt to condense these areas versus what we've done in prior calls, and again, we welcome your feedback.
As a reminder, book-to-bill was comfortably above 1. It would be a safe assumption in almost all areas of this discussion that orders grew faster than revenues.
From a geographic point of view, there are positives from all five of our theaters. The U.S. maintained its strong momentum, led by service provider and commercial with order growth in the high teens or better. Enterprise was solid with order growth in the mid-teens, not including federal. While this was clearly very good from an enterprise perspective, its run rate was down from approximately 20% in Q3 and Q2. We are obviously pleased with the Q4 enterprise growth rates, especially given the results of some of our peers in this customer segment.
Emerging markets continued their strong momentum with orders accelerating to approximately 40% year-over-year. Asia Pacific had another solid quarter with year-over-year growth of approximately 20%. China had a very solid quarter with order growth of approximately 40% year-over-year.
Europe momentum, as we said earlier, is slowly improving with order growth in the high single-digits with commercial and service provider having good results, growing in low double-digits, while the enterprise grew in the mid single-digits level.
In Japan, after five quarters of year-over-year declines, Q4 was flat in terms of orders and year-over-year.
Now moving into the customer segment discussion. To put the following into proper perspective and as we reviewed in prior quarters, a rough rule of thumb is that the enterprise represents approximately 45% of our business, commercial and service provider slightly above 25% respectively, and consumer, 4%.
The commercial market segment continues to lead the way as it has over the entire year with order growth of approximately 20%. The service provider segment continued to gain momentum with order growth in the high teens and the enterprise segment grew in low double-digits from a global orders perspective.
Balance was very good across all theaters in the commercial marketplace. Our commercial strategy, which is one of the areas where we made major investments across all functions, is continuing to achieve the results that we thought were possible with good execution. We're also gaining market share versus almost all of our peers in this service provider market segment.
As you would expect from earlier comments, the emerging markets and the U.S. theaters were the strongest in the service provider segment from an order growth perspective. Of particular interest in our execution in the service provider market was the expanding growth of our high end routing products.
The CRS-1 had a very strong quarter. Revenues were approximately $80 million, increasing over 100% year-over-year. In Q4, orders for the CRS-1 comfortably blew through the $100 million order milestone, increasing year-over-year by over 200%.
Scientific-Atlanta is another cornerstone of our architectural strategy for the service provider market. In positioning our acquisition decision of Scientific-Atlanta, we shared that their growth at the time of acquisition was in approximately the 10% to 12% range and that if the acquisition and synergies were effective, that growth potential was in the 12% to 14% range. We were obviously very pleased with year-over-year revenue growth this quarter of approximately 15%.
Of particular interest in this quarter was a shipment of 1.44 million digital set-top boxes, a 33% increase in units shipped versus Q4 of last year. Perhaps of even more importance is the role that Scientific-Atlanta's video expertise plays in our service provider accounts from a strategic business partner perspective.
In summary, from a service provider perspective, our technology and business architecture strategy is moving Cisco from a tactical or a strategic technology partner for our service providers to a strategic business partner relationship in many of our accounts. While it is too early to say for sure, I would personally parallel this progress to a very similar evolution that Cisco achieved in the enterprise market in the mid-1990s. All of us understand the business results and strategic positioning in the enterprise accounts that Cisco has achieved since that time period.
The enterprise customer segment showed the most growth in our emerging markets, U.S. and Asia Pacific theaters with the European enterprise continuing to be challenging. We gained market share versus most all of our peers in the enterprise market segment in both product areas and geographies. As you would expect, the strong results in Advanced Technologies, which are usually deployed first in enterprise accounts, again speaks to the success of both of our technology and business architectural approach for the enterprise customer.
Moving next to the product discussion. As a reminder, in this discussion and in future quarterly conference call product discussions, we will cover the products primarily from a revenue perspective and use orders to add color or illustrate momentum trends.
Revenue balance was very good across our core routing, switching and Advanced Technologies. For the purpose of understanding our momentum, order growth was greater in each of these three areas than revenue growth.
Revenues for routers grew approximately 12% and switching grew 8% year-over-year. Advanced Technologies grew by 23% standalone. That is not including any of Scientific-Atlanta's products. Storage led the way with revenue growth of over 65% year-over-year, followed by unified communications growing approximately 50% year-over-year. Optical and wireless growing in the mid-20s from a revenue perspective, while the network home and security groups grew in single digits from a year-over-year perspective.
Our technology architecture play with the convergence of layers 1 through 7 of the OSI stack continues to gain traction and mind share. For example, customers understand the leadership, total cost of ownership, flexibility and investment protection advantages they receive when they install a Cisco switch, as an example, which allows them to easily and cost-effectively add market-leading voice, data, routing, security, wireless, and other capabilities to their existing Cisco switch that they just purchased.
This is a very powerful competitive differentiator versus all of our competitors, however are usually present only in one or two product categories and often do not loosely or tightly integrate their products from an architectural perspective.
In summary, our vision of how the industry was going to evolve appears to be playing out very much as we expected. Our strategy is also achieving the benefits to both Cisco and our customers that we thought were possible. Finally, our execution is on target in terms of the results as measured by our customer partnership perspective, market share gains and share of our customers' total communications and IT expenditures, as the network becomes the platform for delivering these capabilities.
It is my pleasure now to turn the call back over to Dennis for a detailed discussion of the financials regarding our Q1 financial guidance for fiscal year 2007. Dennis, back to you.
Thanks, John. Let me remind you again that our comments include forward-looking statements and you should review our recent SEC filings that identify important risk factors, and actual results could differ from those contained in forward-looking statements. As a reminder, we're providing guidance on a non-GAAP basis with a reconciliation to GAAP.
I will be providing guidance for Cisco on a combined basis, including the effect of Scientific-Atlanta. You will also find the details of the discussion in the slides accompanying this webcast.
As John mentioned earlier, for the full fiscal year 2007 we anticipate that our annual revenue will increase by 15% to 20%, which reflects Cisco standalone growth of 10% to 15%. We anticipate revenue growth for the first quarter to be in the range of 19% to 21% year-over-year, which reflects Cisco standalone growth of 11% to 13% year-over-year.
Regarding gross margin, forecasting gross margin has always been challenging due to the various factors such as shipping, volume, product mix, variable component costs, customer and channel mix, and competitive pricing pressures. We believe gross margin will be approximately 65%, meaning it could be slightly above or below this level. This reflects the consistency of core Cisco and Scientific-Atlanta gross margins.
With the continued investment in our field and engineering organizations that John has discussed in this and previous conference calls, we believe Q1 operating expenses will be in the range of 36% of revenue. We expect interest and other income to be approximately $150 million in the first quarter.
Our tax provision rate is expected to be approximately 26% for Q1 and for fiscal year 2007, a decrease from 28% in fiscal year 2006. While we continue to expect our continuing share repurchase program, it is difficult to predict the exact weighted average shares that are outstanding. We are modeling share count to be flat to down 50 million in weighted average shares outstanding for EPS purposes. There could be an increased volatility in the share count due to changes in the stock price, of course.
Regarding cash flow from operations, we would expect to generate between $500 million to $700 million per month at these revenue levels. For our Q1 FY07 GAAP earnings, we anticipate that Q1 GAAP EPS will be $0.04 to $0.06 per share lower than non-GAAP EPS, primarily due to acquisition-related costs and stock option expense. Please see the slides that accompany this webcast for more detail.
Other than those items noted above, there are no other significant differences between GAAP and our non-GAAP guidance and this guidance assumes no additional acquisitions, asset impairments, restructuring or other events which may or may not be significant. I will turn the call back to John.
Thank you, Dennis, and thanks for raising the cash forecast. We have been discussing that for a while, and a healthy give and take I have been receiving on that.
The following is a summary of my views of Cisco's momentum and opportunities entering fiscal year 2007. In areas that Cisco can control or influence, our momentum is even stronger than it was a year ago.
Four of our five theaters, as I said earlier exited, Q4 with business momentum greater than Q4 of the prior year. Our strategic value to our service provider customers is increasing both from a technology and a business architecture perspective and has the potential to continue to expand this value even throughout this next year.
The integration of Scientific-Atlanta, I think it's fair to say Jim is ahead of what both Jim McDonald and I would have anticipated to be at this point in time. While success is still dependent upon solid execution, our role with Scientific-Atlanta and service providers has the potential to continue to expand in this next fiscal year.
The commercial marketplace remains very solid and while we did see a slightly slower growth rate in enterprise, it too remains solid. Our European results are showing gradual improvement with Germany and France potentially leading the way for the next year. It is too early to say if this trend will definitely continue. We continue, as many of our peers are also seeing, to experience some challenges in the UK, even though we have a very strong team in that country.
Japan for the first time – Rick, I guess it's a year-and-a-half, appears to be slowly gaining momentum. The primary area that we will be focusing on the next one to two years will be the next generation service provider network build outs. While we have been working on them for a number of years in the past, we could start to see the volume in the second half of fiscal year '07 or the first half of fiscal year '08 occur if we're successful.
Asia Pacific continues to remains solid. Our architectural strategy in the emerging markets is working extremely well. Barring some major economic or political surprises across many of these emerging countries, I would expect this theater to have the potential to grow over twice the growth rates of the other four theaters if we execute effectively.
Our balanced product momentum across our core technologies and Advanced Technologies is the best that I've seen in a number of quarters. But again, it is the loosely and then tightly coupled product strategy for these technologies that dramatically differentiate Cisco from our peers. Charlie, I think it's fair to say that our pipeline of potential in core routing and switching products looks very good.
Our continued evolution of our first wave of Advanced Technologies and the emergence of a second wave of Advanced Technologies is evolving as expected. At the same time, we're beginning to plant a potential third wave with our early stage emerging technologies.
In summary, our product pipeline is in excellent shape and it really looks exciting. Having said that, obviously the proof is in the results. I was especially pleased with the market share gains across almost all of our product areas, given the challenges that many of our peers have experienced. The opportunity for continued market share gains looks reasonable.
We see the same challenges and uncertainties from an economic and capital spending concern that many of you have witnessed over the last quarter. We will focus on what we can control and influence and attempt to position Cisco to gain momentum in market transitions, whether they are industry consolidation, product transitions or economic.
In summary, for those areas that we can control, we believe our vision, strategy and execution are in great shape entering fiscal year 2007.
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 transitions and occasionally challenging economic times. Now Blair, I'd like to turn it back over to you.
Thank you, John. We will now open the floor to Q&A for the audience. We still request that sell-side analysts please ask only one question and as a reminder, our goal is to end the call earlier than we have in the past.
Operator, could you please open the floor to the first question?
Our first question comes from Tim Long - Banc of America.
Tim Long - Banc of America
John, you talked a bit about the GDP environment being a little weak in the second quarter and also seeing some of your peer companies, as well, in other areas having tough quarters. Just give us your sense as to why you think it is that Cisco continues to perform much better than the peers? Is it as simple as the sales force hires, or do you think there's something else inherent in this technology that is allowing you to outperform?
How sustainable do you think that is, given that we have heard the same type of macro concerns for a few quarters and you guys continue to do well? So maybe the GDP correlation is not as strong as you thought? Thank you.
Fair comment, Tim. If you look at it, the last quarter as we shared with you, we saw a little bit of caution that perhaps some other people in the market didn't see at that point in time. We were extremely pleased obviously with the results. But the reason that I think we were so successful, Tim, is that the world of networking is changing. It's no longer about transport, it's about how you change business, how you change life experiences.
The way we're going after that is not only how you combine the OSI stack layers 1 through 7 together -- which none of our peers have attempted to do -- so we combined the routing, switching, wireless, security, other capabilities together with a common architectural approach which has huge competitive advantages in the market, which shows up in market share gains, but also has a much lower cost of ownership.
The third major component part of that is that I think people are learning how to really drive productivity and entertainment and therefore revenue streams for service providers by use of networking. It isn't just about raw transport, it's about intelligence throughout the network. As that occurs, really making that work well is one of the biggest advantages we have.
It isn't just from a technology point of view, it's how you help an automotive company like a DaimlerChrysler or how you help a service provider in a partnership achieve their revenue goals and their business process change. So we come at it from a business side as well.
If you really look at our momentum in service provider, we're really beginning to get the architectural play that I think we experienced in the mid '90s in the enterprise. That has huge implications on it. So if you look at it, I think we're in a much better position not just as you alluded to, tied to GDP or say we're moving into new markets -- either emerging markets or sales force increases -- to get growth. I think the role of intelligent networking in the network is truly becoming the platform to deliver application and services is going to be very key as we move forward. That’s what we're hearing from customers.
I guess in summary for a long answer, we're seeing that from government leaders and business leaders around the world. It's hard to put a number on it. But the requests that we have to spend time at the very top of the organization is probably up more than threefold versus a year ago. So thank you, Tim.
Our next question comes from Alex Henderson - Citigroup.
Alex Henderson – Citigroup
Great, thanks. I was hoping you might give us some thoughts on what your plans are and how you are approaching the sales force expansion that has been going for a pretty extended period at this point? It's pretty clear that your sales force expansion really had a significant role in the quarter, particularly with the commercial and emerging markets being big areas of expansion and delivering excellent results.
Are you planning on continuing the process? How many people did you hire in the quarter on that front? What is your strategy relative to a slowing economic backdrop and sensitivity on that issue?
Alex, I'll take the easy part of that and then give it to Rick. Rick with talk about it in detail, but probably a 20% increase in the sales force in terms of sales reps, not total headcount.
Secondly, we continue to see the payback, literally, as we shared with you before, step up quarter by quarter.
Third, while we might be hitting a pretty good point in our very largest enterprise customers, there is a second and third tier of very important enterprise customers where more investment can occur. As you alluded to, the commercial marketplace as well as the emerging geographies are the opportunities for us.
In a mathematical point of view, a sales force is easy to add, they're relatively inexpensive and they pay for themselves remarkably quick. It's self-selecting if they don't produce the results. So Rick, maybe take us a little bit further and tell us where it worked and your plans for this next year.
Alex, I think we're going to continue on the road we've been on to this point, with a little variation, of course. As we build out to productivity levels in certain geographies around the world, we won't continue to hire aggressively there. But certainly when we look at the emerging markets and the emerging countries in general -- that's the emerging market theaters, some of the emerging countries in Asia Pacific -- we see a tremendous amount of opportunity. So that will probably be the priority in terms of our headcount as we go into FY07.
But we still see specific opportunities, as John mentioned, in the low end of enterprise, also within commercial as all theaters around the world are having success there. So we'll be a little bit more targeted, we will keep our eye on the top and bottom line as we move along, but we're still seeing the return and so we're going to continue to use the formula.
Our next question comes from Brant Thompson - Goldman Sachs.
Brant Thompson - Goldman Sachs
Great, thank you. A question, then a piece I'll categorize under housekeeping. You gave a range in terms of the fiscal year '07 top line of 10% to 15% for Cisco standalone. Could you talk through what factors we should be watching through the year that might make that be the upper end of the range or the lower end of the range? You had mentioned Japan and Europe both potentially turning the corner, as well as the potential for the carrier business to accelerate. But if you could flesh that out a little bit?
Then under the housekeeping bucket, could you guys give us an update or some type of statements around some of the stock option issues that we've been seeing with other companies in the market and how Cisco sits relative to stock option expense and timing? Thank you.
I'll take the first one, and Dennis, if you'll take the second one. If you look at overall, if I were in your position as a shareholder and watching either spending and opportunities for Cisco, or if you view us as a bellwether within the IT communication industry for the industry group, I would watch several factors.
The U.S. continues to be 45% of our total business. So U.S. momentum is very key to us and the good thing about U.S. is we have a very balanced operations, commercial enterprise, service provider and consumer marketplace.
I would watch the key trends in U.S. The commercial marketplace in the U.S. tends to be spending. They don't watch what the GDP numbers or projections are. They spend if their business is good and we have seen commercial hold up remarkably well, not just in the U.S., but globally from that perspective.
Enterprise tends to be a little bit more sensitive to perceptions in the market or quick to respond to their trends. Service provider I would watch the U.S. and globally. You're starting to see the U.S. service providers start to lead in many categories, which I think is fair to say, perhaps a few years ago they were not in terms of architecture and new service generation areas. So I would watch key wins in that, how we are doing or not doing in our video implementations, architectural wins, commitments on major Ethernet build outs, et cetera.
I would watch the Japanese market. We have invested for two years and for longer than that in our product development cycle for this next generation of IP, really generation 2 NGN build outs. We think we are positioned well, but we have to earn that, and secondly, then we have to execute. I would watch that in the second half of the year.
We are okay geography-wise, as long as four of our five theaters do reasonably well. You're always going to have one theater or one country within a theater struggling a little bit, so it's that balance.
Then I would watch the Advanced Technologies. Obviously, the Advanced Technologies grew very healthily in the low 20s this quarter in terms of revenue; bookings grew faster than that. We like the balance and we think we're beginning win this architectural battle.
So those are the kind of big five areas I would watch. Dennis, for the housekeeping question?
Brant, I want to thank you for asking the question. With all of the publicity, it's a very fair question to ask. We're very comfortable with our accounting for stock options. As many of you know, Cisco has had a firm policy requiring stock options to be determined in advance, which has been in place for over a decade. But given the recent attention to this issue, Cisco thoroughly reviewed its issuance of stock option grants and I can say with confidence that we did not change stock option grant dates to give employees a lower exercise price. So we're very comfortable, Brant, with the accounting for stock options and we stand behind all of our financial statements as we reported.
Brant Thompson - Goldman Sachs
Our next question comes from Nikos Theodosopoulos - UBS Warburg.
Nikos Theodosopoulos - UBS Warburg
Thank you. I was wondering if you can comment on two things. Number one, during the call, you talked about the DSOs going up a little bit and you commented on linearity. If you can just give some color on that.
The second part is, can you give a quick explanation why the tax rate guidance is going down? Thank you.
I'll take the linearity question; Dennis, if you'll take the second piece. The linearity was exactly almost to the 1% mark what we would expect in a given quarter. Reminding everyone from prior quarters, usually we get 25% of the quarter's orders, plus or minus 2% or 3% in the first month of the quarter, about 31% of the orders in the second month of the quarter, and if everything is going smoothly, about 44% of the orders, plus or minus 2% or 3%, in the third month of the quarter. This one was almost identical to what we have traditionally seen.
Just to follow on that, John. I think while the orders are coming in on that rate, the other factor that impacts that is the shipments, of when the shipments actually will go out. So we did see a higher level of shipments happen in the third month this quarter than what we saw in the third quarter and in the quarter a year ago. So just as a result of the flow that it went through the manufacturing process.
On the tax, Nikos, we have been working for several years on continuing to develop our tax strategy. As you know, we have about 50% of our business that is international. So we have been working on our structure to ensure that we are positioning our tax entities in the appropriate countries to get us the best tax rates that we can, and that tax strategy is simply paying off for us now and continuing to pay off as we see continued growth in our international locations.
Thank you, Nikos.
Our next question comes from Jeff Evenson - Sanford Bernstein.
Jeff Evenson - Sanford Bernstein
You changed the name of enterprise voice to unified communications during the quarter. One, just wondering if you can go through the rationale for making the change and what you're seeing is different in the market? Also, to what extent if any did your growth rate during the quarter come from sucking in other products into that category?
Okay. Jeff, not above sucking in, but we'll tell you when we do it. If there is a growth rate, it was 50%, it was awesome, and that was standalone. I think that's really a tremendous tribute to Don Proctor, Charlie and everyone in the field executing well and no reclassification. It speaks to, I think, a fundamental trend. Then I'm going to ask you, Charlie, to comment on unified communications overall.
The fundamental trend is if you look at productivity for the future, it's going to be about collaboration and how you change your business models around that collaboration and teamwork. Now a year-and-a-half ago, I would have said that maybe 10%, at most 15% of the productivity would come from that. I now think it might be as high as 40% plus. So it really speaks how you use unified communications to really change organization structure, speed of delivery of products, many of those things that is very positive.
So it isn't just about IP telephony and where that's going from unified communications and how you tie these products together, it changed the productivity model.
So Charlie, if you will, take the question in two categories: the direct question about unified communications, but also how you're starting to develop internal start-ups and using unified communications as an example to really make a difference on how quickly Cisco can go to market and how these products, instead of doing an acquisition and then trying to figure out how we couple them together after the fact, how we can design them from the beginning to be loosely and then tightly coupled.
Absolutely, John. Thanks for the question. Jeff, first of all, unified communications was announced as our next generation continuation of IP communications. We announced that in January, so we were just, if you will, this quarter aligning our reporting name to what our product category is that we've been using externally now for six months. That was announced at VoiceCon earlier this year to a lot of praise and applause at the time.
It is one example of a technology category that's generating a lot of new areas of business for us. Yes, we have great growth. But to John's point, we have introduced the ITIC system, the IT Interoperability Communications system that allows radio interoperability, all based on the same capability. We've announced video teleconferencing, video telephony advantage, that's part of that overall communications suite, and we have announced Unified Personal Communicator on PCs that are part of that suite.
What John was referring to and what we're seeing is a tremendous amount of customer accolades for what we have been doing in this area and for what we are planning over the next year or two. So it's a very exciting area for us.
Finally, just to fully answer John's challenge here, John as you know has challenged us to three to four new Advanced Technologies on an annual basis. To that end, we have started up a number of internal start-ups, innovations, some of which have already been announced, but many of which will be announced over the next several years. The continuing improvements in unified communications are just part of that.
Charlie, it's the best pipeline we've had and I want to congratulate and your leadership and all the team on doing that very well. I have a couple of favorite new products coming out, but we'll wait to a later time to really talk about those. Blair is kicking me underneath the table on that.
Our next question comes from Jiong Shao - Lehman Brothers.
Jiong Shao - Lehman Brothers
Thank you very much. On last quarter's earnings call, you talked about the October quarter booking seasonality typically sequentially down mid single-digits. Given the strong momentum you have seen today, could you just talk about, is that possible that seasonality for October is going to be better or worse than what that's mid single-digit sequential rate, or how we should look at that currently? Thanks.
If you look at it, the seasonality in our business starts Q1, builds again to Q2 to Q3 to Q4. Q3 is very dependent upon service providers to make that quarter because sometimes they have a weak quarter from the enterprise perspective. It ends at an outstanding, we hope, Q4, which clearly this one did. Then you start your sales momentum over again. So Q1 is always down in terms of orders versus Q4 ever since I've been here for 11 years. So that is the normal cycle.
In terms of what we can control as I alluded to earlier, we feel very good about the momentum going into it and we clearly have some backlog built to be able to use that in Q1. We gave guidance, which for us is aggressive from 11% to 13%, given all of the scenarios that are going on. So we feel pretty good about Q1, Jiong, and that would be how I would characterize it.
Our next question comes from Tal Liani - Merrill Lynch.
Tal Liani - Merrill Lynch
You typically break out the Advanced Technologies trends, and I'm wondering if you could elaborate on the strengths and weaknesses in this segment? Also if you can discuss federal vertical, what are the percentage of revenues and what are the trends? Thanks.
Okay. I will do very quickly the Advanced Technologies and the other one was federal. The booking trends almost across the group, and if I remember right, Blair, I think it was five out of the six actually had faster booking growth than revenue growth. As a whole, they grew comfortably. Book-to-bill was comfortably above 1 as well.
The trends are very good. It's why I think you look at orders for momentum for your question and you look at revenues perhaps in terms of market share. I tend to, as we've discussed before, look toward momentum overall. The area that I'm most comfortable with, I think this is why you plant your seeds, Charlie, multiple years ahead of time. You look at storage area networking, we're just executing extremely well and we're learning how to move more aggressively in the data center, which opens us up for potential moves later on.
So I really like that, and being a prior data center person myself at IBM, I think we made excellent inroads there and market share gains. I think candidly, we're beginning to encourage an industry consolidation among many of our peers in many areas of communications and IT.
The unified communications, a major push for us, it feels really good in that, great market momentum, still of course is learning how to sell. Wireless, I think it is the wired and wireless capability that is very, very key there.
Areas that we have to improve on, Charlie, we have to really I think decide how aggressive we're going to be in the consumer market. I don't think it's an execution issue there, because our peers and market share are actually gaining in the small to medium size business category, which we're doing extremely well in as well. But the consumer market, I'd like to see us double up, you've got to make that decision. Clearly, we're going to go with our marketing campaign, et cetera, on brand later in the year in this category.
But the area that I'm most excited about in all of Advanced Technologies is actually the video's role. Jim, it's a good one for me to throw over to you just to maybe answer part of the question, which is, it's an outstanding quarter. Well above what you and I thought was possible, and Charlie and Mike. It's 15% year-over-year growth, it's a record in terms of DVD shipments with 695,000 units, high-definition shipments 293,000 units. Your international, it's $150 million from international, 25% of our business and we're just learning how to get our sales forces together.
But having made calls with you, you all bring a balance to Cisco that allows us architecturally to fill out, I think the third piece of perhaps a five-piece move that we need in service providers. Why is it working so well, and how is the integration going both in terms of business but of equal importance in terms of the acquisition? That really is a huge growth area for us just beyond the numbers.
John, I think it starts with the comments you made in your remarks about the service provider industry, in general, is doing quite well across the world. So if you look at it, the service provider business in general is doing well because there's a lot of opportunities for the service providers to grow their business. One advantage of reporting 30 days later than we had in the past is that we get to see a lot of our customers who have already released their results. If you look at a lot of our customers, they reported 15% growth, so it's pretty clear that we're going to have good quarters if we maintain our market share, and we were able to grow market share during the quarter.
So I think if you look at it, our customers see an opportunity to grow their business. Their business is doing well and they're willing to invest to continue to grow in that environment.
In addition to that, you're seeing more competition in the market so people want to be on the front end of investing as opposed to being in the back end of investing. I think as you talk to the customers, they're looking for vendors that can provide more of the end-to-end system. It gets more complicated as you take and integrate all of these services, so they're looking for people who can help them integrate it. Of course, the combination of Scientific-Atlanta and Cisco allows us to fill in a lot more of the end-to-end system and it allows as to integrate the video, data, voice and wireless all into the customer.
So we bring a lot more to the table and we can add a lot more value and I think our customers are in a good industry. They're growing their business and our business is growing with them and our combination can add a lot more value.
Jim, in terms of the acquisition, when we decided to do this with you, we went into it with eyes wide open that the vast majority of acquisitions fail. My definition of failure is – do you keep the people or not; do you continue the current run rates, do you actually gain market share, does it fit strategically? They're really hard. Is it working well, and perhaps why? I said it earlier in my views on this, but I know you well, you always say what's on your mind. How do you read it so far?
Well, I think neither Scientific-Atlanta or Cisco went into this with our eyes closed. We both spent an awful lot of time on looking at where we saw the markets going over the next few years. As we told our shareholders, we saw a consolidation in the industry. Of course last week, Adelphia was purchased by Time Warner and Comcast, so you're continuing to see the consolidation. Of course, the customers want an integrated solution and they want to deal with your vendors.
So I think we looked at it in very carefully in terms of what we needed to do over the long-term. I think you all looked at it very carefully. So I would say that we have really had no surprises in this integration at all. It's going quite well, our organizations work very well together.
Usually, a good benchmark is you look at turnover, and if you look at turnover in our organization, it's the same as it was before and it was quite low before and it's still quite low.
So I think the other thing is we're finding lots of places where your organization can help us find more sales and in a few areas we've been able to lead you all into areas where we had strength. So we're seeing a lot of integration advantages, whether it's in volume and procurement, whether it's in being able to leverage parts of the international business where we just didn't have the coverage, or it's in product things that we could have a much more complete product line.
So I think all of the benchmarks would say that the integration is going quite well, our organizations are very culturally similar, and in general I think we're certainly pleased with it.
It's kind of exciting, Jim. Those Georgia Tech graduates, they fit in well to our culture. In fact, I think the only thing Jim and I disagree upon is he likes Kentucky where he was a basketball player, I like Duke where I wish I could have played. But that's our biggest point of disagreement. Rick, real quickly on federal?
The question you on federal you had specifically, what does that represent in terms of our overall business? Usually as a percentage of our U.S. business overall, it's about 10%. I think for the year of FY06 was a little above that, for Q4 slightly below that. As a percentage of worldwide business, it's about 5%. So I think it's important to keep that in perspective.
Now the federal customers today continue to embrace, we're talking about AT, particularly IPC. Our AT mix as a percentage of our bookings in federal is actually up 4% this year. So there's a lot of enthusiasm there. But the most highly impacted area in federal of course is defense and DOD where all IT purchases are under careful review and prioritization in view of the situation with the war.
So we feel good about our interactions, our opportunities, and we feel we're going to get more than our fair share. But people are a little bit cautious from that
I think everyone has seen the budget challenges. And by that 4%, Rick, you're talking about a percentage of the total business it's up 4% as a percentage
When you look at our AT mix of all products, we measure it AT with core products, they're buying more AT than core. So they are embracing the newer technologies. That's what I meant by that. No, I wasn't commenting on the federal business being up or down.
Our next question comes from Ehud Gelblum - JP Morgan.
Ehud Gelblum - JP Morgan
Question on your revenue guidance as well as John, some of your comments with respect to what you're seeing from a macro perspective. You're looking at a quarter where your book-to-bill was comfortably above 1 for the fourth straight quarter in a row. You have added a bunch of new salespeople over the last year, 3,000 or 4,000 more; your backlog is up 36% year-over-year versus your revenue only up 12%. So it sounds like a lot of good things are going on going into the next quarter.
I'm wondering, as you looked at that guidance for next quarter, I know it is strong guidance -- one more thing actually. You're guiding for 11% to 13% year-over-year growth in Q1, but 10% to 15% for the year. That doesn't necessarily mean there's an acceleration, but it sort of implies 15% is higher than the 13%. So it gives some implication that as the year goes on, perhaps the year-over-year growth rates gets stronger. Dennis, I'd love your thoughts on that.
But how much of a guidance for the first quarter is your thoughts on regular seasonality, despite all the strength that I've tried to articulate here, versus some unknowns based on what you're kind of sensing about the economy that you just want to protect yourself for? I guess if the price of gas were $0.50 cheaper than it is right now and there was no war in the Middle East, what would the guidance perhaps have been is what I'm looking for?
World hunger a little bit too, but Ehud, a very fair question. A couple of general thoughts. The first is, backlog really helps you. It allows you to run your business more effectively. Rick doesn't have to focus about what sequence the orders come in or what mix he has, manufacturing runs smoother, sales productivity is up, Dennis' people are out saying how do we do a better tax strategy as opposed to how we focus on the quarter, et cetera. Lots of reasons for that, and last quarter was no exception.
Remember, we are a build to order company, so that's a lot different than our peers in terms of the backlog we need to run efficiently. As more of our products move beyond routing and switching and we're starting to see, Charlie, some of the products come up on the $2 billion range perhaps this next year, in terms of run rate. But you need to be also able to handle bumps.
I think everybody understood the hazardous material issue in Europe this last quarter. We had a fair amount of our major assembly lines of one of our contract manufacturers, we had somebody struggle with an ERP implementation, we had component shortages on another, we even had a ship catch fire and somebody put part of our products in the water. So the backlog, while you want to be able to handle bumps, it allows you not to miss a beat as you go through it in terms of direction.
Ehud, I think last quarter, we articulated perhaps a little bit more caution than some of the people in the market might have seen at that time. At the present time, I think people see it fairly clearly. Standard deviation on expectations is a little bit wider than a quarter ago, but we're comfortable with where we are in the market and that's why we did give a range as you alluded to.
If you're an optimist, then you look to see how we view guidance in Q2. If you want to be a little bit more conservative, obviously we gave a range for that. So I wish I could answer more specifically than that, Ehud, but that would be my best cut on it. Thank you for the question.
Our next question comes from John Marchetti - Morgan Stanley.
John Marchetti - Morgan Stanley
Thanks. John, there's been a lot of press reports lately about Cisco potentially changing its business model to separate some of the software away from the hardware. So with the business momentum clearly being solid here, what opportunities do you think this brings to you in the future that you're not capturing today?
Breaking the question into a couple of pieces. Often, I will make a statement of direction to deliberately challenge everybody in the Company to move. So when we first announced the Advanced Technologies, I think we had your team sweating pretty hard on how do we do at least three of those a year in terms of direction. I think you guys are getting your arms around it pretty well.
My challenge to the market and perhaps people are reading a little bit more into this, is we have to learn how to combine not just hardware and software and ASICS together in an architectural play, but how we really focus more on being able to charge as we go forward for software applications and learn how to do that as a Company in a lot of applications.
But I think that's perhaps where my comments have been carried a little bit further out then we are. That is more, here's a statement of direction on how we're going to get there in balance.
Having said all of the above, if the network does become the platform -- I clearly believe that it will -- that will change how applications are designed and written. As Charlie stated very aggressively before, we clearly intend to play in the collaboration application space and partner in the business applications space.
So I think what you're seeing is a trend that Charlie and I are really pushing the Company on and one that will probably expand further in future calls. Thank you very much John.
Our next question comes from Mark Sue - RBC Capital Markets.
Mark Sue - RBC Capital Markets
Thank you and welcome back, Dennis. Can you help us understand the specifics of what you're working on when it comes to gross margin improvements as it relates to SFA? I would imagine we're still in the early innings of Cisco leveraging its skill and working on the supply chain improvements. Longer-term, can we get to a blended level of around 67% to 68%?
Mark, I think that the guidance that we gave of seeing a reduction in our blended rate of about 2% is what we ought to be looking for. On the other side, remember that Scientific-Atlanta also has lower operating expense as a percentage of revenue. So that impacts us on the positive side by about 1%.
So when you look at the bottom line of operating margin, the impact is around 1%. I think that there's some things that we can do to work on closing that gap a little bit. I don't think it's just in the gross margins.
Our next question comes from Subu Subrahmanyan - Sanders Morris.
Subu Subrahmanyan - Sanders Morris
Thank you. My question is on the carrier opportunities that you have mentioned. John, when you look out late fiscal '07, early fiscal '08, are there important next-generation architectural designs being made U.S. versus international? Can you talk about how you are positioned? Are there any important pieces that you don't have when you look at selling into those markets or the solution you would like to provide?
Yes. Jim, I want to ask you to make a couple of quick comments here as well. But if I were looking at the key build outs, there's a lot of exciting things going on in Japan. Clearly, we're letting Japan set part of our service provider strategy. We've bet a fair amount of our resources on doing that and it looks like the product requirements they are helping us look at and the direction looks very solid.
I've actually seen the U.S. service providers get more aggressive in the last two years and really think about this from an architectural perspective. Jim, I'm going to ask you to comment a little bit in terms of service generation and how you see that moving forward.
But to the last part of the question, yes, if you look architecturally how we want to go after the service provider marketplace, there's probably two areas that over time we want to fill in. I'm not going to comment on those at the present time for obvious reasons.
But you're right, Subu, I think it's fair to assume that we are going to continue to expand our architectural play in service providers. Jim, a general theme in terms of what you're seeing here?
If you look at architectures, what you really have is three different wireline architectures being deployed right now. You have AT&T, which is basically deploying fiber to the node. Twisted pair inside to the home. If you look at Verizon, they're basically deploying fiber all the way to the side of the house or the ONU and using the coaxial cable in the house. If you look at traditional MSO architectures, you have fiber to a node, but then you have a coaxial cable going out.
So you really have three different architectures that people are pursuing and each of those architectures offer us quite an opportunity to participate in it. Of course, the devices you hang on the end of these architectures are all a little bit different. Then of course, what our customers often want to do is pursue integrated services across those architectures.
So I think what you find is fiber runs out to the node. It may run to the side of the house, it could be terminated in twisted pair or coaxial cable, and all three of those represent a significant opportunity for us not only in the network, but in the devices and in the services that go on top of that.
If you look internationally of course, what you find is you have shorter loop links in terms of DSL technology. So the fiber to the node will actually produce you more bandwidth as you look into the international opportunities.
So I think as you look at it architecturally internationally, the fiber to the node strategy plus the twisted pair going into the house offers a significant opportunity for us to grow our international business to deliver video. So we're focused on all three of those, and of course the fourth one obviously is a wireless technology which we participate in as well.
Our next question comes from Paul Silverstein - Credit Suisse.
Paul Silverstein - Credit Suisse
One question and one quasi-housekeeping question. John, I trust you were alluding in your previous response to edge routing among one of the two areas. Can you give us some sense for how much better business could have been but for maybe some challenges in that product space? You mentioned your strength in core.
And then my other question is, in terms of pricing and margins, can you give us some insight as to what's going on in terms of the increase in the improvements both for products and services in what would otherwise seem to be a challenging macro?
Sure. In terms of the overall approach, we obviously are gaining market share now very rapidly at the high end, and we've really turned the corner on the CRS and the volumes were really outstanding.
In the access segment, we have always done very well. The edge, very solid. It's an area that I think we have the most opportunity to gain our market share back comfortably above 50% at the present time. If you look at the GSR this last quarter, its growth rate was if I remember right, in the high 20s. So a little bit of comment?
That was due to a large extent from success in the GSR now on the edge. So just to be direct, Paul, no, we don't expect to go outside to improve our performance in edge. We expect to do that internally through our own efforts and we believe we're already starting to see the fruits of that.
I think it's fair to say that the competition got us (a) in a product transition, and (b) with a reclassification of their own products for the purpose of reporting their market shares. But we're going to get that back. So that's it.
On the margin question though, no unusual margin pressure. In fact I think, Dennis, our actual product margins edged up just a hair on Cisco-only products.
They did, and also on Scientific-Atlanta. So we've been able to continue the model of what we are going to see over time over the life cycle of products that pricing will come down or price performance will go up. But at the same, we've been able to offset those with cost reductions so that on a net basis, we've actually improved our margins quarter-over-quarter this year.
A good execution quarter. They won't all be this good, but this one was good.
Our next question comes from Samuel Wilson - JMP Securities.
Samuel Wilson - JMP Securities
Good afternoon, everyone, just a simple question. When you look at lead times and backlogs, you're obviously carrying good backlog going into the first fiscal quarter. Would you expect to bring down lead times, and correspondingly, bring down backlog as you work through in the first quarter, maintain growth? What is your thought process there?
Sure. I like backlog. It allows us to run the business more effectively as I alluded to earlier. Q1, you almost always bring down backlog by definition in terms of the quarter. You go into it with good order positioning, et cetera, and that's what we've done in prior quarters as well. That's what we alluded to from the perspective overall.
But no, I like backlog. As long as you're able to meet your customer lead times with the flexibility which is really Angel Mendez's key challenge and what Randy and I have challenged Angel with, is give us the flexibility for maybe as many as 40% of our orders being exceptions within it. So that's kind of how we approach it. Thank you.
We have time for one last question.
Our final question comes from Inder Singh - Prudential.
Inder Singh - Prudential
Thanks very much, congratulations on a solid quarter and I must say the very clear guidance for October at this time. We appreciate that.
Thank you, Inder. We're a learning a little bit, but it was easier to give perhaps this time too.
Inder Singh - Prudential
You're sounding very confident, obviously in the midst of some economic and macro issues, and we have seen some of your key competitors really falter and guide a lot more cautiously than you have. Obviously you feel that you're taking share. I want to ask you a couple of questions, well one question two parts.
In the carrier market, we saw, for example, Sprint go after the WiMAX space today and really start to invest in that market. You've not invested in carrier wireless before. Do you see new markets potentially opening up for you where you can take some additional market share, WiMAX being one for example? You went after WiFi pretty aggressively a few years ago.
Just within carrier in the IPTV space, you've integrated SFA, you've done well there. What is next with that? When do we start to see the IPTV wins sort of start to roll out?
First, Inder, I think the last quarter we shared with you our caution, which I think many people had not really considered as much. I think we see the market very similar to what most people see it today. We were obviously very pleased with how we held up this quarter, which included one month longer than our peers did in this marketplace. Again, we had a solid, very solid July in terms of the momentum.
The second reason for our optimism is our architecture's winning. It isn't just a balance issue anymore or a product breadth, it's an architectural play and it's the value we bring across Service Provider and Enterprise and Commercial. While we're in no way immune from challenges or downturns, I don't mean to imply that we aren't, we begin to see more and more of both market share gain and opportunities, the value in terms of the strategicness of the players, as you alluded, to the service provider marketplace.
Service provider is probably the area we've made the most progress in terms of results, Charlie, this last year, and it's Scientific-Atlanta, but it's also learning how to be a better business partner with them to focus on their revenue streams, listening to their requirements and we're positioned extremely well in the wired incumbent players, the new challengers in the cable marketplace.
It isn't just the U.S. or Japan or Asia, it's also with the BT’s of the world and the Telecom Italia’s of the world, et cetera. So I think you will see us win a number of IPTV announcements over this next year. Like many of our peers, we're not in any hurry to announce if we win. My view is that if the other side is very good, the minute you announce that on your call, then the other side focuses on you. Our definition of a minor objection is when we've been told we lose.
So we have a sales force that is really good and doesn't wear down and keeps coming back. But I think we're in good shape on IPTV side of the house.
In terms of the wireless side of the house, I think it's perhaps an area that is one that we could expand in and ought to look about being even more aggressive. Just using Sprint as an example, we have a great relationship with that leadership team. They're a very good business partner for us. So what you are seeing is more or where that might have been an exception two years ago, it's becoming more commonplace.
So Inder, I hope that answered the question. In certain parts, direct enough and in other parts vague enough to not share too much of our product strategy and appreciate the nudge in terms of the wireless space. So Blair, with that, let me turn it back over to you. Congratulations on keeping us on time for the first session, and it's yours.
Thank you, John. Our next quarterly conference call which will reflect our first quarter fiscal year 2007 results will be on Wednesday, November 8, 2006 at 1:30 pm Pacific Time, 4:30 pm Eastern Time.
Again, I would like to remind you that in light of Regulation FD, Cisco plans to retain its long-standing policy not to comment on its financial guidance during the quarter unless it is done through a public disclosure.
As a reminder, this year's Cisco’s Investor and Financial Analyst Conference will be held on September 6th in New York City. For more information about the event and the live webcast, please see our investor relations web site.
As always, please call the investor relations department with any follow-up questions from this call. Thank you for your participation and continued support and this concludes our call.
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