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Cisco Systems F1Q10 (Qtr End 10/24/09) Earnings Call Transcript

November 05, 2009 | about: CSCO

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Cisco Systems (CSCO) F1Q10 Earnings Call November 04, 2009 4:30 pm ET

Operator

Welcome to Cisco Systems’ first quarter fiscal year 2010 financial results conference call. (Operator instructions) Now I would like to introduce Ms. Laura Graves, Director of Global Investor Relations of Cisco Systems. Madam, you may begin.

Laura Graves

Thank you, Operator and good afternoon, everyone. Welcome to our 79th quarterly conference call. I am joined today by John Chambers, our Chairman and CEO; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, Executive Vice President of Worldwide Operations, Ned Hooper, Chief Strategy Officer and Senior Vice President of our Consumer Business; Padmasree Warrior, Chief Technology Officer; and Blair Christie, our Senior Vice President of Corporate Communications.

The Q1 fiscal year 2010 press release is posted on US high-tech market wire and on the Cisco website at newsroom.cisco.com.

I would like to remind you that we have a corresponding webcast with slides. In those slides you will find the financial information we cover during this conference call, as well as additional financial metrics and analysis that you might find helpful.

Downloadable Q1 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. Click on the financials tab in the IR website to access the webcast slides and these documents.

A replay of this call will be available via telephone from November 4th through November 11th at 866-357-4205 or 203-369-0122 for international callers, and is also available from November 4th through January 15th on Cisco’s IR website at investor.cisco.com.

Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results and these 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 detail in our documents filed with the SEC, specifically the most recent annual report on Form 10-K and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in our forward-looking statements.

As a reminder, unauthorized recording of this conference call is not permitted.

With that, I would like now turn it over to John for his commentary on the quarter.

John T. Chambers

Thank you very much. During the opening comments of the conference call, I will focus on what I view to be the key takeaways for Q1 fiscal year 2010. First, a very candid discussion about what we are seeing in the market on a global basis relative to Q1 and its effects on our Q2 fiscal 2010 expectations.

Secondly, an update on our rapidly improving financial measurements and some interesting sequential quarterly metrics. Third, a high level summary of some of our investments and results in new market adjacencies in Q1. And finally our revenue guidance for Q2 fiscal year 2010 with the appropriate caveats.

Following my opening comments, Frank will follow and provide additional details on Q1 and then in the third section, we will focus on business momentum from a strategy, customer segment, geographic and product basis. Frank will then follow with additional financial parameters around our guidance. I will then wrap it up with some comments in terms of Cisco's momentum going into Q2 and finally our Q&A session.

From a summary point of view, I think there are a number of key takeaways from the results in Q1 and I will attempt to cover these at this time. First from a financial perspective, the quarter was very strong versus our expectations, given the challenges that are occurring in the global economy. Expanding with additional details on the strengths of Q1 from a financial perspective, almost all of our financial measurements were above or at the high-end of our expectations. Revenue of $9 billion year over year, decreasing approximately 13%, was dramatically better than our expectations of down 15% to 17%.

Non-GAAP earnings per share of $0.36 were again well above our expectations.

Expense management was very solid, with non-GAAP OpEx decreasing approximately 10% year over year, while non-GAAP product gross margins were extremely strong at 66.3%, which was the best in nearly four years.

Cash generated from operations in Q1 was approximately $1.5 billion and we repurchased $1.8 billion of stock during the quarter under our repurchase program. Non-GAAP operating income as a percentage of revenue was a very strong 29% versus Q4’s 26%.

Product book-to-bill was above 1. Services continued to outpace other parts of our business with year-over-year revenue growth of approximately 7%. Although there is always room for improvement, we were very pleased with the Q1 financial results.

The second area that I would like to discuss at this time is kind of a discussion of how our momentum has evolved over the last three quarters. The market over the last three quarters for Cisco evolved very similar to our expectations and at the high-end of our guidance. In my opinion, Q3 FY09 felt like the bottom, as each of the three months in that quarter were in line with our normal order flow, granted with very tough year-over-year results.

While Q4 showed the first normal sequential order rates in fiscal year ’09 and therefore as we said in the Q4 conference call, looking back was probably the beginning of the up-turn. This trend continued in terms of sequential order growth rates during Q1 fiscal year ’10, matching what we have seen in normal economic times. And to all of us with the appropriate caveats, this would indicate a continuation into the next phase of the economic recovery.

Another key reason that we characterize Q1 as strong is that almost all of our financial sequential measurements from Q4 fiscal year ’09 to Q1 fiscal year 2010 were at the high-end or even above the same period as the Q1s from the last five normal economic years -- that is fiscal years 2004 through fiscal year 2008.

In other words, the sequential growth for financial measurements from Q4 to Q1 was very strong versus prior normal economic times. This includes sequential product bookings, sequential product revenue, and product book to bill. It also includes non-GAAP product gross margins, operating income, net income, and earnings per share. Again, each of these in terms of sequential growth Q4 to Q1 of this year.

We saw similar trends from Q4 FY09 to Q1 FY10 in terms of revenue at sequential 6% growth. Similarly, we also saw positive indicators in our year-over-year revenue trends. The growth rates improved from minus 18% in Q4 to down approximately 13% year-over-year in Q1. But of even more interest was that from a sequential products order perspective, Q1 was very much in line with what we have seen in prior Q1s over a normal five-year period, again using the time period fiscal year 2004 through fiscal year 2008, which was down sequentially in the mid to low single digits in each of those years.

Third and perhaps of equal importance in my opinion is that we are starting to see solid indications of economic recovery in most geographies around the world. The improving economic outlook combined with what appears to be a very solid execution on our growth strategy due to our organization structure and innovative business model enabled Cisco to move into 30 plus market adjacencies while reducing non-GAAP operating expenses by 10% year over year and also reducing headcount.

In other words, in areas that we can control or influence, we are very pleased with our continued progress in Q1 and for those areas that we don’t control or influence, we are seeing very tangible results that the recovery, at least the initial phase of the recovery, is gaining momentum.

While most markets around the world are starting to show signs of improvement, we were especially pleased with what we saw in the U.S. To add supporting detail to this general comment, our overall orders on a global basis in Q1 were down in the high-single-digits from a year-over-year perspective, while the U.S. year-over-year orders were approximately flat.

To put this in perspective, product orders from the last three quarters in the U.S. declined by an average of approximately 30% year over year. Therefore, to have Q1 orders in the U.S. grow year over year at a flat rate was in our opinion a major inflection point.

Based upon our business momentum in our opinion in prior economic recoveries, this would indicate that the recovery from an initial phase perspective is well underway.

In summarizing our comments in the conference calls over the last three quarters, the market is evolving very close to our expectations. In simple terms, our Q3 fiscal year 2009 as we indicated in the Q3 conference call appears to have been the bottom with very tough year over year comparisons but with normal monthly linearity. Q4 FY09 as we indicated in last quarter’s conference call, looking back was clearly the tipping point, marking the beginning of an upward trend from a sequential orders perspective point of view.

In our opinion, Q1 FY10 results especially in the U.S. again follow our normal sequential order patterning, indicating that the initial phase of recovery is underway based upon this order momentum. While the continued strength of the recovery and eventual job creation may still be in question, we are clearly basing our decisions and our investments upon an optimistic evolution of the economy.

If we get surprised, and there is always the possibility we might, we will adjust and we have a proven track record of being able to do so when appropriate. Given our views of the economy expressed over the last three quarters, with the expanding role of intelligent networks in all forms of communications and IT, combined with our ability to catch market transitions and move into new market adjacencies, we are proud of our ability to return to our prior financial operating model so quickly after the global economic slowdown.

Our new organization structure of council boards and working groups as discussed in the last few calls is operating very efficiently and has been an important part of managing through recent downturns. These structures allow speed, scale, flexibility, and rapid replication.

We will continue to move into additional adjacencies which are currently at 30, also you should expect some consolidation and evolution within the existing 30, and of perhaps equal importance, many of our leading customers are now understanding how this highly innovative management structure and new business models can launch this many product families and move into this many market adjacencies while still maintaining focus and quality.

Just to give you an idea of how our organizational structure translates into speed, scale, flexibility and replication, let me use the last month as an example. We announced intentions to acquire four companies, two of which were $3 billion transactions. A strategic partnership to drive the market transition around virtualization, launched a new product, the IGISRG2 that provides five times more performance, video ready capability, and the richest set of virtual services with the lowest cost of ownership in the industry, all while executing on a strong quarter.

And just using myself as an example, but the same is true for our entire executive leadership team, we did all of the above while each of us, and again using myself as an example, maintained our normal pace and during this quarter I -- I’m sorry, during this month I met with over 100 customers.

This is business as usual at Cisco, given our collaborative structure of councils, boards and working groups to be able to effectively execute on multiple fronts. Time will tell if we are right but the tangible results indicate that the business models based on collaboration may be the most effective way to drive a successful global business today.

We exit Q1 with a compelling financial position and an innovation engine from both a products and business model perspective that should position us to expand our leadership in the marketplace. Our internal start-ups, partnerships, and acquisitions continue to fill out our architectural strategies. For example, our video strategy from the home to the service provide to the enterprise is described by many of our customers I talk with as world class innovation and execution. The pure digital acquisition combined with both our announced intentions to acquire [Tamberg] and [Cera] Networks continues to drive home to many of our customers how we believe our architecture will play out across all of our customer segments.

We continue to believe that the video architecture is the most important web 2.0 next generation play and is one of our key competitive advantages versus our peers.

The virtual computing environment coalition announced yesterday between Cisco, EMC, and VMWare illustrates our continued ability to innovate and partner and acquire and combine these to catch key market transitions such as virtualization and cloud computing.

As we all understand the vast majority of acquisitions fail and truly meaningful strategic alliances have an even poorer success rate. However, Cisco and EMC’s track record on acquisitions, strategic partnerships and customer driven strategy is among the best in the industry. Time will tell but I believe this coalition announcement will mark a clear inflection point in the future of next generation data centers and multiple phases/generations of cloud computing enabled through virtualization.

With over 20 years of working together with Joe Tucci and over a decade of working together with EMC, I believe this will be one of the most strategic coalitions to occur in the industry over the last decade.

I also believe that more of our customers are beginning to understand that the market adjacencies will in our view at first loosely and then tightly be coupled together from a technology and business architectural perspective, enabled by the common theme of the network becoming the platform for all forms of communications in IT. If the market adjacencies play out the way we expect, it will be very similar to what we saw with advanced technologies being viewed as standalone and then over time become loosely and then tightly coupled.

The EMC/VMWare/Cisco coalition allows our customers to understand how our innovation engine of internal start-ups, partnerships, and acquisitions brings together product families such as unified computing, unified fabric, and the Nexus family.

It is combined -- it is this combination of internal innovation, acquisitions and strategic partnerships which really allows Cisco to bring virtualization to life.

We clearly have been very focused on catching market transitions around virtualization, combining the network along with the server, storage and applications for over three years now.

For those areas that Cisco can control or influence, we feel that we are doing very, very well. The key market transitions relative to collaboration, virtualization, and video networking which will drive productivity and growth in network loads for the next decade are continuing to evolve even faster than we thought just several quarters ago.

While we attempt to be very transparent with what we are seeing in the market and have established a good track record in terms of seeing trends early, our views do not tend to change every month or quarter, and even when they do evolve, to change dramatically is really the exception. It is this consistency of staying focused on the long-term while not getting distracted by short-term market activities that drives our strategy for future success.

We believe that given that the recovery is now occurring, no one knows for sure how strong it will be, how long it will last, or the extent of new job creation. But as we said in prior quarter conference calls, we are going to continue to be very aggressive to position ourselves for the inevitable up-turn by continuing to maintain tight financial management and aligning our resources to new opportunities.

I believe Q1 was a very positive proof point that both our vision and strategy for the industry is evolving as expected, and at the same time our ability to execute on the vision and strategy is showing results.

Given our belief that the market is beginning to accelerate is probably not a surprise to anyone that you will now see us slowly starting to grow expenses, while still being very aggressive in both our own internal innovation commitments, as well as our partnership and acquisition strategies. For those Cisco employees listening, this growth in headcount will be very targeted, with focus on productivity improvements and movement into new market adjacencies.

Also as we said in conference calls over many years, Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors, potential issues affecting our suppliers, and our ability to execute or not on our strategy and other factors as discussed in our SEC filings. For purpose of our long range goals as well as our quarterly guidance, we are also assuming that our vision of how the industry and the market will be accurate and we will effectively execute on that vision.

With all this in mind, we will 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.

In fact, I would encourage each of you to consider following our lead of breaking fiscal year 2010 into two halves, both from a planning and an expectations perspective. We clearly had a strong Q1 and will provide guidance for a strong Q2. However, I would encourage you to wait until our Q2 quarterly conference call in early February before extrapolating these results and guidance into your projections for our fiscal Q3 and fiscal Q4. This is exactly what we would do with our own expense budgets and our internal plans. Given all the uncertainties regarding the strength and shape of the recovery, concerns about the recovery faltering and the unknown extent of job creation, we encourage you to wait for additional quarterly data before becoming too optimistic. This is what you would expect of Cisco and what I would encourage from our shareholders.

With this in mind, our revenue guidance for Q2 fiscal year 2010 and including our usual caveats as discussed earlier and in our financial reports, is for revenue to increase in the 1% to 4% range year over year.

As you would expect, during economic transitions we will continue to track sequential improvement quarter to quarter. To put this year over year revenue guidance into Q1 to Q2 sequential revenue growth terms, it would be in the 2% to 5% growth sequential range. Over the last five normal economic years, fiscal year 2004 through fiscal year 2008, the sequential revenue growth has averaged approximately 3% from Q1 to Q2.

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 entering 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 hierarchies and the expertise -- product architecture, sorry about that -- and the expertise to help our customers in the implementation of these collaborative capabilities from a technology and a business perspective. We will also share with our customers how we have done this internally.

In short, we are going to attempt to execute a strategy over the next decade that is similar to what we did in the early 90s and as we said before, have [pared] our growth for an entire decade.

Now I’d like to turn it over to you, Frank, for additional comments on Q1.

Frank A. Calderoni

Thank you, John. I am pleased with our strong results for Q1 fiscal year 10 which demonstrates our ability to execute on our innovation and operational excellence priorities within our business model. As demonstrated this quarter, we are also using our strong financial position to invest in and accelerate growth opportunity for Cisco while continuing our internal focus on productivity.

Total revenue for the first quarter was $9 billion, a decrease of approximately 13% year over year, above the range provided last quarter of minus 15% to minus 17%. This includes an approximately $50 million benefit related to the adoption of new revenue recognition accounting guidance, which I will discuss shortly.

Total service revenue was $1.8 billion, up approximately 7% year over year. Total product revenue was $7.2 billion, down approximately 17% year over year. Switching revenue was $2.9 billion, a decrease of 21% year over year. Modular switching revenue is down 19% year over year, while fixed switching revenue declined 22% year over year.

Routing revenue is $1.6 billion, down 17% year over year, representing a decrease of 15%, 19%, and 20% year over year in high-end, mid-range, and low-end respectively.

Advanced technologies revenue totaled $2.3 billion, representing a decrease of 15% year over year. We saw declines in unified communications of approximately 10%, video systems of approximately 29%, and security of approximately 9%.

Other product revenue totaled $481 million, an increase of 9% year over year. Growth year over year was driven primarily by the inclusion of our acquisitions late last fiscal year of Pure Digital along with strong growth in [tele-presence]. We remain very pleased with the growth of the [tele-presence] year over year.

Sequentially, our total revenue was up 6% quarter over quarter. We saw sequential revenue increases across most product categories with good performance in modular switching up 11% quarter over quarter, mid-range routing up 9% quarter over quarter, wireless LAN up 32% quarter over quarter, and security up 16% quarter over quarter.

We experienced a decline in total revenue across all geographic segments on a year-over-year basis with the exception of Japan. Year over year revenue ranged from a decline of 30% in emerging markets to growth of 2% for Japan [theater], with revenue in U.S. and Canada theater down 10%, Asia-Pacific down 6% and European markets down 15%.

We did see sequential improvement in all geographic segments except for Asia-Pacific which was down less than 1% sequentially.

Q1 FY10 total non-GAAP gross margin was 66.3%, up 1 percentage point quarter over quarter and 0.7 percentage points year over year. For product only, non-GAAP gross margin for the first quarter was 66.3%, up 1.6 percentage points quarter over quarter. For the quarter over quarter comparisons, lower discounts, increased cost savings and shipping volume were partially offset by product mix.

While we were pleased with our overall performance in gross margins this quarter, we recognize that variability in product mix will impact gross margins. On a year-over-year basis, non-GAAP product gross margins were relatively flat.

Our non-GAAP service margin for the first quarter was 66.3%, down from 67.5% last quarter and up from 62.4% in Q1 fiscal year 09. The service margin decrease quarter over quarter was primarily driven by increased investment in certain projects, partially offset by volume.

The increase in service margin year over year was due to strong margins in both technical support services and advanced services, driven by cost improvements and overall volume.

Total gross margin by theater ranged from approximately 62.8% for emerging markets to approximately 72.6% in Japan. With the exception of U.S. and Canada, gross margin improved on a quarter over quarter basis in all theaters primarily due to stronger cost improvements, lower-than-expected discounts, and higher volume.

Non-GAAP operating expenses were approximately $3.3 billion in Q1 fiscal 10, relatively flat quarter over quarter and down 10% year over year. Non-GAAP operating expenses as a percentage of revenue was 37% in Q1 fiscal year 10 versus 39.2% in Q4FY09.

GAAP interest and other income was $115 million, which also includes a $42 million mark-to-market impact related to transactions to hedge a portion of the foreign currency consideration for our announced pending acquisition of [Tambur].

Non-GAAP interest and other income was $73 million for Q1, reflecting higher than normal realized gains of approximately $40 million from the sale of a privately held investment.

Our Q1 FY10 non-GAAP tax provision rate was 22%.

Non-GAAP net income for the first quarter was $2.1 billion, representing a decline of 15% year over year. As a percentage of revenue, non-GAAP net income was 23.5%.

Non-GAAP earnings per share on a fully diluted basis for the first quarter were $0.36 versus $0.42 in the first quarter of fiscal year 2009, a 14% decline year over year. The higher investment gains on the sale of a privately held investment and the adoption of a new accounting guidance for revenue recognition combined to contribute approximately one penny to our GAAP and non-GAAP earnings per share this quarter.

GAAP net income for the first quarter was $1.8 billion as compared to $2.2 billion in the first quarter of fiscal year 2009. GAAP earnings per share on a fully diluted basis for the first quarter were $0.30 per share versus $0.37 per share in the same quarter of fiscal year 2009.

Now moving on to the balance sheet, our balance sheet continues to be strong, providing us with significant financial flexibility. The total cash, cash equivalents, and investments for the quarter was $35.4 billion, up approximately $400 million from last quarter. Of this total balance, $4.7 billion was held within the United States at the end of Q1 fiscal year ’10.

During the quarter, cash flow from operations was approximately $1.5 billion.

Moving on to accounts receivable, our receivables balance was $3.2 billion at the end of Q1.

At the end of Q1, days sales outstanding, or DSO, was 32 days, compared to 34 days in Q4 and 29 days in Q1 fiscal ’09.

Total inventory at the end of Q1 was $1.1 billion, relatively flat quarter over quarter. Non-GAAP inventory turns were 11.3 this quarter, flat compared to last quarter, and down three-tenths of a point from Q1 of last year.

Inventory purchase commitments at the end of Q1 were $2.8 billion, an increase of approximately 30% from the end of Q409 and a decrease of approximately 2% year over year.

Similar to what is happening in the industry, we are seeing some product lead time extensions stemming from supplier constraints based upon labor and other actions taken during the downturn. Please know that we continue to build upon our strong relationships with our suppliers to proactively manage our supply chain and minimize any potential impact to our customers.

By focusing on what we can control and influence, we believe we will be well-positioned for an up-turn in the market.

For the quarter, we repurchased $1.8 billion of common stock under the stock repurchase program, or 76 million shares at an average price of $22.99 per share.

Per our press release, our board approved an increase to the repurchase program of $10 billion. The remaining approved amount for stock repurchase under this program including the additional authorization is approximately $13.1 billion.

Deferred revenue was $9.3 billion at the end of Q1, an increase of approximately 5% compared with Q1 fiscal year ’09. Deferred product revenue was $3.1 billion and deferred service revenue was approximately $6.2 billion, increases of approximately 7% and 4% year-over-year respectively.

At the end of Q1, our headcount totaled 63,756, a net decrease of approximately 1,800 from last quarter, primarily as a result of tight hiring constraints combined with prior quarter limited restructuring actions.

In Q1, we adopted two new accounting standards which impact revenue recognition for Cisco, EITS08-1 and 09-3. We are pleased that these standards which provide guidance on the accounting for multiple element arrangements were approved by the financial accounting standards board in Q1. The impact of the new standards in Q1 was an increase to revenue of approximately $50 million and a half-penny benefit to earnings per share.

We do not expect the new standards to have a material impact on our financial results in Q2. We do anticipate the new guidance will result in improved operational alignment of the accounting with new product offering, including products from acquisitions and related go to market strategies, particularly in our product and solution areas of collaboration, tele-presence, and securities.

In closing, from a financial perspective, we are very pleased with our Q1 results and the strong foundation from which we can continue to focus on growth and capturing market transitions in our industry. Our ongoing efforts to improve efficiency and productivity have allowed us to deliver strong performance in the current quarter but also position us well for the future. We will continue to make investments in innovation, operational excellence, and our key growth opportunities.

I will now turn the call back over to John.

John T. Chambers

Thank you very much. Now moving on to the next section dealing with strategy, customer segment information, geographic and product review. Q1 continued the trend of balance between innovation and operational effectiveness in almost every aspect of our business. The continued pace of Cisco's innovation and execution has never been broader and in our view more successful, ranging from product announcements, technology architecture expansion, acquisitions, and rapidly evolving business architectural leadership in our customers’ minds.

Cisco has had a continued explosion of collaboration enabled by network web 2.0 technologies in every aspect of our business. I always listen carefully to our customers and in many ways feedback from our leading edge customers about the collaboration trends in Q1 was pivotal. Q4 fiscal year 09 appeared to be the first major inflection point in terms of both customers understanding and in many cases there commitment to next generation intelligent networks becoming their platform for productivity, standard of living, and global competitiveness.

While Q1 really added the meat on the architectural and execution side, the major results and commitments to virtualization, video, and collaboration were more evident in almost all phases of our focus on market adjacencies as the network becomes the platform for all forms of communications in IT.

In last quarter’s conference call, we had a detailed discussion about our general goals and our focus on moving into market adjacencies and the importance of our new innovative organization structure and business models to enable these moves. We also discussed the discipline process that is required to allow our entire Cisco workforce to execute across these opportunities with speed, scale, flexibility, and replication. In the last conference call, we also provided an update on three market adjacencies that included smart plus connected communities, small business, and smart grid.

Continuing the trend of discussing several market adjacencies in each conference call, I would like to cover three additional market adjacencies in this call, those being virtualization, video, and collaboration.

Virtualization in terms of our data center portfolio offering, we are seeing solid momentum by our Nexus 5000 and 7000 families, both growing in triple digits year over year from an orders and a revenue basis in Q1. Over the last quarter, we added 250 customers for a total of over 1,000 customers for the Nexus 7000. UCS is also experiencing solid market reception with a very good initial ramp and order pipeline.

Yesterday, as we discussed earlier, we announced the virtual computing environmental coalition formed by Cisco, EMC, with VMWare which represents a major breakthrough in the way that IT is delivered and consumed by customers. The key industry transition happening is the movement from the current data centers to next generation data centers and the journey to private clouds. It is really about bringing IT as a service to life.

With these industry trends in mind, this announcement represents an unprecedented level of collaboration in development, services, and partner enablement to deliver the industry’s first completely integrated IT offering that combines best of breed networking, compute storage, security, and management technologies with end-to-end vendor accountability. This move clearly signifies our focus on capturing the market transition around virtualization and private file infrastructures.

The second market adjacency I’d like to talk about is video. As we have said many times before, I believe that video is the killer application that will drive next generation productivity and innovation. To give you some additional color on our progress in this area, we talked earlier about tele-presence revenues once again growing in excess of 100% year over year, a proof point that our customers truly understand productivity and value that video delivers internally and with their own customers and partners.

In Q1, we conducted 77,000 Cisco internal meetings, had another record quarter in terms of units old, selling over 570 systems and adding approximately 85 new customers. We just recently celebrated our three-year anniversary since launching tele-presence and since that time, we have conducted more than 0.5 million internal hours of meeting and 427,000 meetings, to be exact.

These are staggering figures and our customers are also experiencing a high usage patterns. Today we have over approximately 500 customers and almost 3,200 systems sold to date.

You have also recently seen us make strategic announcements around Tamburg and Norway, digital video networks in China, pure digital early this year in the U.S. We believe we are well-positioned to take advantage of this major market transition as network plays a key role in transforming how we communicate and collaborate. Video is very much an art as well as a science and media net is our architectural solution to enable access to any content on any device on any network. Media net can adjust real-time, change aspect ratios, bit rate and file formats to optimize traffic and the users’ experience. This is something that plays to Cisco's core strengths and we feel we are well-positioned with our service providers and enterprise customers to take advantage of this unique market transition.

The third market adjacency I would like to discuss today is collaboration. We believe that collaboration is driving the next waves of business growth, innovation, and productivity. The future of work is changing and organizations are working for new ways to address their challenges. There are four key trends that are critical to customers that are driving collaboration -- consumerization of IT, global value chain, worker mobility, and information overlay. Cisco is delivering on these experiences to transform the way that we collaborate with real-time voice and video interactions as we enter new markets in this area.

As much as it is about video, our intentions to acquire Tamburg is also about the integration of video into a broader $30 billion market for collaboration. By acquiring Tamburg and extending our video in-point product line, we hope to grow business interest in video as part of how enterprises communicate internally and between businesses.

Similarly, our interest in [Cera] is based on the floating use of mobile devices by consumers and businesses in innovative ways where entertainment, social networking, collaboration, and business productivity.

Through our intent to acquire [Cera], we are focused on offering rich quality multimedia and experiences to mobile subscribers. Cisco and [Cera] are bringing complementary technologies and capabilities to design to accelerate this transition to the rapidly growing mobile Internet, where the network as a platform to enable service providers to launch, deliver, and most important monetize the next generation of mobile multimedia applications and services.

Now moving on to customer segments and geographies, where the discussion on a global basis will be measured by both orders year over year and sequential orders.

As a general statement, our position in terms of both technology partners and a business partner to our customers in service provider, enterprise, and government is continuing to expand in a very positive way. On a global basis, our total product orders year over year were down in the high-single-digits, which was a major improvement from fiscal year 2009 Q4 year over year total product orders, which were down in the mid-20s.

I want to also use this chance to talk about the U.S. I might have made a mis-statement. When I talked about product orders the last three quarters in the U.S. declined by an average of approximately 20% year over year, and I might have said 30, so if I got that wrong, please forgive me.

Now moving back to continue the discussion, our enterprise business on a global basis in terms of product orders was down in the mid single digits. Our public sector was up in the mid-single digits. Service provider and commercial were down in the low double-digits and consumer was up approximately 20%.

First in terms of the U.S., it was a strong turnaround from Q4’s fiscal year ’09 negative order growth of approximately 20% year over year to Q1 fiscal year ’10 flat year over year growth.

Enterprise led the way with over a 30 point sequential quarter swing with negative Q4 growth in the 20 to approximately 10% year-over-year positive growth in Q1.

U.S. public sector continued to be solid with growth in the high single digits year over year while service provider was still down year over year in the high single digits. However, service provider, this was a significant improvement from being down over 30% in the U.S. year over year in Q4.

Commercial showed improvement as well, down in the mid single digits in Q1 versus down in the mid 20s in Q4 year over year.

While the U.S. clearly led the way in Q1 in terms of geographies and customer segments, there was also very solid improvements in Japan, Asia-Pacific, and even in parts of Europe, while our emerging markets which we will exclude China and India from in our discussion, continue to be challenging.

Second, Japan continued to show solid improvements with positive order growth rates year over year in the mid single digits, with good balance across enterprise, public sector and service provider. Public sector was up the most year over year in Japan with order growth of about 40%, while commercial continued to be challenged, decreasing in the mid-teens year over year.

Asia-Pacific overall was down in the low single digits, with the public sector up over 30% year over year while other segments were down between mid-single-digits and mid-teens.

The emerging markets not including emerging countries in Asia continued to experience challenges, with overall year over year orders decreasing in the high 20s. The challenges spread equally over all customer segments.

Europe, speaking very candidly, was a pleasant surprise with orders year over year down in the low teens. Public sector was down in the low single digits and the other major segments were down in the mid to upper teens year over year.

Now moving on to product, product numbers for Q1 will be in terms of revenue year over year. As you would expect, given book to bill was above 1, product orders were down in the high single digits, while product revenues were down approximately 17% year over year.

Switching revenues were down approximately 21% year over year. However, as you might expect given the positive trends discussed in the enterprise markets, product orders for the enterprise business, including public sector from a switching perspective were relatively flat year over year, obviously a major improving trend.

Routing revenues were down approximately 17% year over year and total advanced technology revenues were down approximately 15% year over year.

In terms of advanced technology, UC was down approximately 10%, wireless showed an improvement, and a positive 7% growth. The network home was down 18%, security was down 9%, and storage was down 19%. Video was down 29% year over year, although orders year over year were down less than half of that amount. Applications and networking systems were down 25% year over year.

Other product areas that may be of interest to you from a revenue perspective including tele-presence had increases over 100% and we added approximately 85 new customers in Q1. Pure Digital’s [Lift] had revenues of approximately $50 million and CRS revenue was up approximately 7% year over year.

From the vision, strategy and execution perspective -- in summary, although we would all like to avoid the downturns, our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe our differentiated strategy is also achieving the benefits to both Cisco and our customers that we thought were possible. And finally, our execution is on target in terms of results as measured from a customer partnership perspective, market share, and share of our customers’ total communications and IT expenditures as the network becomes the platform for delivering these capabilities.

Now Frank, let me turn it back over to you for additional financial detail.

Frank A. Calderoni

Thanks, John. Let me remind you again that our comments include forward-looking statements. You should review our recent SEC filings that identify important risk factors and understand that actual results could materially differ from those contained in these forward-looking statements.

The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP.

As John indicated while we are cautiously optimistic about the recovery of the economy, the variability that still exists within the marketplace makes it difficult to predict demand in other related matters beyond a quarter at a time. As such, we will only be providing guidance for our second quarter at this time and are approaching the second half of our fiscal year outlook with the realizations that there remains an unknown level of sustainability.

We would encourage each of our shareholders to be equally careful and to reflect this uncertainty as they model the second half of our fiscal year. We will continue to provide updates and further guidance each quarter.

For Q2 FY10, we anticipate total revenue for the second quarter to be up approximately 1% to 4% year over year. From a sequential perspective, we expect to see approximately 2% to 5% growth.

At this point, let me remind you that in light of regulation FD, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Now let me give you some additional details on the Q2 financial guidance. As we have said in the past, forecasting gross margins has always been challenging due to various factors such as volume, product mix, variable component costs, customer and channel mix, and the competitive pricing pressure. That being said, we believe total gross margin in Q2 will be approximately 64% to 65%, reflecting the revenue guidance I just shared with you. With recent acquisitions and our entry into some lower margin markets, gross margins could be negatively impacted by product mix.

We believe Q2 operating expenses will be approximately 37.5% to 38.5% of revenue. We expect interest and other income to be approximately $25 million in the second quarter. Our tax provision rate for Q2 is expected to be approximately 22%.

Going forward, due to the immaterial difference between GAAP and non-GAAP share count, we will use one share count for both GAAP and non-GAAP earnings and are modeling share count to be down approximately 50 million shares 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 second quarter of fiscal year ’10.

While we expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. As a point of reference, a $1 movement in our average share stock price would change the calculated shares outstanding for purposes of determining earnings per share by approximately $17 million.

Regarding cash flow from operations, we would expect to generate $1.8 billion to $2.1 billion during the second quarter. For the Q2 FY10 GAAP earnings, we anticipate that GAAP EPS will be $0.06 to $0.08 per share lower than the non-GAAP EPS, primarily due to stock compensation expense and acquisition related charges. Please see the slides that accompany this webcast for more detail.

Our GAAP guidance could vary significantly depending upon the potential positive or negative mark to market fluctuations relating to our transaction to hedge a portion of the foreign currency consideration for our announced pending acquisition of Tambur.

Other than those items noted above, there are no other significant differences between GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant.

I will now turn the call back to John.

John T. Chambers

Frank, thank you very much. The following is a summary of my views of Cisco momentum and opportunities entering Q2 of fiscal year 2010. It is a pleasure for the first time in over a year to say that our optimism implies as you would expect not only to the areas that we can control or influence but also with all the appropriate caveats for those areas that we cannot control or influence. It appears that things are headed in the right direction. While no one knows for sure the strength of the recovery, job creation opportunities, and the possibility of another downturn, we will set our strategy and execution assuming an optimistic view on the economy and our execution capabilities. If we get surprised, we will simply adjust and I think that most of you would agree we can do this effectively if necessary.

In our opinion, in most of the areas that we 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 also our customers are rapidly expanding their views as to Cisco's role in helping them to achieve their productivity, revenue growth, and differentiation versus their peers in the global market. This was especially true in the service provider and enterprise market as illustrated in our key customer meetings and group meetings throughout the quarter, such as the ITU UN meeting in Geneva where we met with over 22 of our top service providers and our own CIO conference.

As we said before, even if the market slow down was to occur, we don’t see this changing our long-term growth opportunities. If we execute the way we have in prior slow downs, and assuming that the global economy continues to recover to GDP growth rates similar to those in the middle of the decade, as we move into Q2 assuming the current trends continue, we plan to aggressively invest in new and adjacent markets for the longer term.

On a global and U.S. basis, while we saw improvements and at times dramatic improvements in many areas, we also continue to see the same challenges and uncertainties from an economic, job creation, political, and capital spending perspective that many of you continue to witness.

However, on a global basis, we are starting to see positive trends in Asia-Pacific, U.S., Asian countries in emerging markets, Japan, and even some early signs of improvement in Europe.

Again, I want to thank the Cisco family for working together as a team to ensure that our company is in a solid position to not only weather the challenging economic environment but even more importantly to be ready to continue to accelerate our investment, assuming that current trends continue.

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.

As we continue to aggressively invest, we will also continue to maintain our focus on our financial models. Once again, with our usual caveats as discussed earlier in our financial reports, our Q2 fiscal year 2010 guidance is for year-over-year revenue to increase in the 1% to 4% range.

We believe our long-term growth opportunities remain in the 12% to 17% range, again assuming our usual caveats and normal global GDP growth.

It is clear in our opinion we saw a tipping point in Q4 and Q1 was very strong sequentially, although still challenged from a year-over-year perspective. Our sequential growth in Q1 and our expectations for year-over-year growth in Q2 confirms that the market is recovering with all the appropriate caveats.

However, it is simply too early to know what the rate of recovery and the extent of job creation which is required for sustainable recovery will look like throughout 2010. This makes it challenging to forecast our own business beyond next quarter.

While we are currently going to be aggressive, we will build our plans off of the first two quarters of fiscal year 2010 and then we will revise it based upon both our business momentum as well as what the economy looks like as we enter the second half of our fiscal year. The picture should be much clearer during our February Q2 conference call.

While we expect a continued recovery into next year, it is important that expectations do not get ahead of market realities. We can see economic growth bounce up and down in the next 12 months and we strongly urge our investors not to dramatically change your model in the second half of our fiscal year.

In other words, we would encourage you to follow our model similar to our own planning and model our own business in two stages, anticipating the visibility in the second half of the fiscal year will be better by the end of January.

We will continue to share with you what we are seeing in the market and our own expectations for our business as directly as we can. 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, market adjacency opportunities, or economic.

In summary, for those areas that we can control or influence, we believe our vision, strategy and execution are in great shape and producing results.

We were very pleased with our Q1 and saw a number of positive signs this quarter in the economy and in our business, especially compared to the sequential financial results and improvements, and especially in those in the U.S. from Q4 to Q1.

If we continue to see those positive trends for the next one or two quarters, we believe that there will be a good chance we will look back to see that Q3 was in fact the bottom, that Q4 was the tipping point, and the recovery started aggressively in Q1 of fiscal 10.

To briefly touch upon a topic important to us all, last night Cisco was honored to receive the Corporate Secretary magazine’s best overall governance, compliance, and ethics award.

Our cross-functional working groups driving these programs included integrating clients and governance across all aspects of the business worldwide, moving well beyond a simple check the box approach to regulatory considerations to become a true function within Cisco.

Trust, transparency, and a commitment to stakeholder engagement are fundamental to our values as a company. Congratulations to the team as we continue to move the bar in this important area.

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 challenging economic times.

So Laura, it’s a pleasure to turn it over to you. It’s a good time for you to be starting and taking over from Blair in part of these conference calls and it was a good quarter, so let’s open it up for questions and see what is on many of the key analysts minds.

Laura Graves

Thank you, John. Operator, we are about ready to open the floor to questions. We respectfully ask that the sell side analysts please ask only one question. Operator, go ahead with our first person, please.

Question-and-Answer Session

Operator

Our first question comes from Brian Modoff with Deutsche Bank.

Brian Modoff – Deutsche Bank

Can you talk about UCS in terms of its implications going into next year as a growth driver? You’ve alluded to a number of trials, some of which we heard have been very successful for you. Is this going to be material in 2010 or is it more of a 2011 event?

John T. Chambers

I wanted to give one more quarter before I answer that one, Brian, directly. In terms of the early customer acceptance, our own internal use of the product, the number of customers who will watch the first wave and if it goes well, and consider putting it into their business model but I think when we do our next quarter conference call, I will make it a specific topic for you on that conference call to give you an update because I will have a lot better data as opposed to initial pilots.

Initial results look very solid. There are very few accounts in the world that won't take a hard look at this, and so the key is can we translate those pilots and can we translate the initial systems into those accounts into real meaningful, measurable volume.

We clearly view that positioning with the -- with virtualization and cloud position us well for the future, so I will give you a chance for a second question, since I indirectly answered the first one.

Brian Modoff – Deutsche Bank

Just on the ASR router product line, we’ve been hearing about some meaningful wins for you in that platform against your competitors with the carriers. Can you talk about how ASR is doing and specifically how order trends are with the carrier segment of your business? Thank you.

John T. Chambers

The ASR 1000 is off to a great start. If I remember my data, I’ll have somebody check it as we go, I think we got over 1,000 customers for the ASR 1000 already and for the ASR 9000, the number of customers more than doubled during the quarter. And so both of them are off to a good start.

As you know, like with ASR 1000, it takes a while in pilot situations before you begin volume, so it will probably be a couple of more quarters before you see the ASR 9000 volumes be meaningful in terms of direction.

So in summary, ASR 1000 bookings were probably over $100 million and that obviously indicates a pretty good trend, probably in the $0.5 billion range for the fiscal year and a growth year over year obviously in the 100% plus type range. ASR 9000, we are off to a good start but I will probably have better day for you in one more quarter.

Operator

Your next question comes from Jeff Evenson with Sanford Bernstein.

Jeff Evenson – Sanford Bernstein

I am hoping you can give us a bit more insight into your fourth quarter revenue guidance by maybe talking about your assumptions on budget flush and the impact of any of the larger acquisitions that you have announced recently.

John T. Chambers

So the larger acquisitions, Ned, keep me honest here, I don’t think will be closed during the fourth quarter, so that will not be --

Laura Graves

Are you talking about fourth quarter, Jeff or --

John T. Chambers

Calendar fourth quarter.

Jeff Evenson – Sanford Bernstein

Calendar fourth quarter.

Laura Graves

Okay. Thank you.

John T. Chambers

So Jeff, I understood you clearly. You must have been speaking through a Cisco IP phone. A little bit of humor there -- [inaudible] but in terms of those, they will close in the first half of next calendar year and we will probably give you more specific data as we get closer in.

In terms of the fourth quarter activity on budget, I think you are going to see some companies and we want to watch this very closely and we will make sure that we have the availability for them to spend in the fourth quarter and we absolutely put that into our projections. So I think you are seeing many companies start to look a little bit more optimistic but with appropriate caution and you are starting to see them invest and to me, the key takeaway -- if you were to say all right, John, what is the number one indication of that? It was clearly enterprise. Enterprise was the first one in to slow down. It was down even last quarter, 20% year over year and yet this quarter it was up 10% in the U.S. So just like the major enterprise accounts were the first one in, followed by service providers, followed by medium-sized business, followed by small, we think the trend will come out the same way.

The stimulus package is starting to have an effect. You saw that in government spending around the world and I think you will see some stimulus spending that will have some -- this Q4 calendar year implications attached to it, and service providers. While the numbers are still down year over year by a fair amount, you saw a very positive trend form Q4 to fiscal year Q1, so that’s a nice way of saying yes and yes, Jeff, we did factor it into our forecast.

Jeff Evenson – Sanford Bernstein

Thank you.

Operator

Your next question comes from Jeff Kvaal with Barclays Capital.

Jeff Kvaal – Barclays Capital

I was wondering if you could spend a little bit more time in telling us how not to extrapolate in the second half of your fiscal year -- I mean, you are doing a little bit better than seasonal here in the fiscal second quarter therefore we should be modeling seasonality in the second half of the fiscal year, is that the idea?

John T. Chambers

No, I would just wait to see. We clearly are ahead of most of our peers in seeing the activities in terms of growth. Q4 from Q3 was up a little bit over 10% in terms of sequential orders. Q1 was in a period that is normally down in mid single digits or low single digits right in the pattern. Our revenue sequential growth was good. This next quarter looked strong.

I just don’t want to get ahead of ourselves and you know, we are just saying wait another quarter to let us get the data because there are a lot of caveats around job creations, sustainability, so it was a very strong Q1. We are projecting a strong Q2 and I would just encourage you to do exactly what we are doing at Cisco -- let’s not get Q3 and Q4 modeled until we get further into that time period.

So I’m just doing what I would do myself in terms of the direction. Frank, you [inaudible].

Frank A. Calderoni

John, as you mentioned, we’ve been modeling our year as far as looking at the two halves because of the situation that has gone on in the economy, as you mentioned. So we’ve developed a plan really for the first two quarters and after we finish this next quarter, we will then look at our plan for the second half of the year and invest accordingly.

John T. Chambers

I think that’s the better part of optimism. We are being about as optimistic as I think you could be given the challenges that are going on and backing it up with very specific data with it, but I’d wait another quarter before I would model Q3 and Q4 up off your current levels.

Operator

Your next question comes from Ittai Kidron with Oppenheimer.

Ittai Kidron – Oppenheimer

Congratulations on the good numbers.

John T. Chambers

Thank you. It’s nice to say that for a change. You could say that one more time, if you wanted. It’s been a number of quarters.

Ittai Kidron – Oppenheimer

I say that every quarter and I am happy I am not the last question around this time, so I am definitely moving up. A quick question, two questions on the cost side, one with regard to the gross margin. Frank, we could go a little bit more detail on the guidance -- why do you expect that big step down sequentially? What is it about the mix that you expect to change, whether it be geographic or product wise that will get you into that range? And then on the operating expenses side, just extrapolating from your guidance, it looks like a $200 million sequential increase. Maybe you can give us just a little bit more color where you intend to spend it.

Frank A. Calderoni

Let me just start and talk about the --

John T. Chambers

By the way, both those numbers are exactly [inaudible].

Frank A. Calderoni

Let me start with the first part of the question on the gross margin, so just looking at even some of the drivers from a Q4 to Q1 perspective, especially with the guidance that we provided last time, so we did see overall better volume and higher revenue as you can see. That does generate a portion of the higher margin that we saw. Again, we had several hundred million dollars of higher revenue than we anticipated.

The other driver is we did see lower overall manufacturing costs than we had expected, really driven by a lot of the strong operational efficiency that we had been working through the manufacturing organization. Effective inventory management, value engineering, process efficiencies, and so forth.

And then the last point is our service margins -- although they were down quarter on quarter, they were better than we anticipated, primarily on the stronger revenue but also from the standpoint of the ramp of our resources. We have been increasing that ramp because we do see opportunity for us to invest in services but it’s not happening as fast as we would anticipate.

So going into the second quarter, the major change from where we are at the end of Q1, one is the service piece that I just talked about, so we are anticipating our service margins to drop primarily because of the investment and we think that is good because we do see the opportunity for the advisory services to continue to provide growth opportunity for Cisco.

And then the second piece has to do with the product mix. Now, we are going into the holiday time frame for November/December -- therefore we are anticipating a higher percentage of our business in the consumer --

John T. Chambers

-- you can raise your forecast anytime.

Frank A. Calderoni

And then we also have mix, lower mix gross margin impact driven by the UCS product that we talked about as that starts to ramp. And then also with our set-top box business, which does have lower margin.

So mix does have a play as we move forward. It’s something that if we model over a longer period of time, it’s that which we have to take into consideration and it’s part clearly of what we are looking at in Q2 as part of that 64% to 65% range that we provided.

It is higher than we had guided coming into Q4 -- sorry, into Q1, so we’ve taken some of the benefit that we saw in Q1 into consideration.

Now on the OpEx, yes --

John T. Chambers

One more comment on that, Frank -- also you saw our numbers in emerging markets. The competition there on price is brutal and developed markets, we can usually -- are in the premium because of our ability to help them drive productivity and transform industries and emerging markets, it is a very tough price game and probably in hindsight if we had been a little bit more aggressive, we could have picked up more business there and I -- it’s a nice way of saying we will probably be more aggressive in the next quarter or two in emerging markets in terms of pricing.

Frank A. Calderoni

And then moving on to the operating expense, clearly we’ve done a very good job over a number of quarters dealing with the challenges in the economy. We came into Q1 at a very low rate from an expense perspective. We are as both John and I just mentioned as part of the call planning to make selective investments in addition to supporting the market adjacency opportunities that we see.

I think if you look back at Q1 and how aggressive we were with some of the announcements that we’ve made, we want to continue to be aggressive and take advantage of the momentum that we are seeing in the marketplace and the position that Cisco has, so we feel that making that investment in the second quarter, increasing our expenses is going to pay back in the long-term.

Ittai Kidron – Oppenheimer

Can you be more specific --

John T. Chambers

-- shoulder motioning to move faster on it, so I’ll try to keep my answers tighter, Blair.

Operator

Your next question comes from Jason Ader with William Blair.

Jason Ader - William Blair

My question is on the supply constraints that you talked about in the quarter -- how much did supply constraints factor into the revenue first and bookings first and foremost? And secondly, do you have more visibility now than normal just due to the lead time issues? It seems like lead times were an issue in the quarter and therefore maybe you just -- I’m guessing you are feeling pretty good about visibility.

John T. Chambers

Yes, but not for the reason of lead times. If you watch, many of our peers saw a problem in the supply area and as Frank alluded to in his comments, we clearly are taking pretty aggressive actions to make sure with inventory, et cetera, that it will not be a problem as we go through this next quarter.

In terms of the quarter, we made good progress during the quarter on our lead time issues and we need to bring them down further this next quarter, and it varies by product category. Actually it’s the reverse -- the longer lead times are, the less good indications it is in terms of order rates. And so when it’s at the current level, it’s still reasonably good indications but -- and I think Rob, you and I would both rather they be down to a week or so in terms of getting some of the trends right in terms of direction.

To your indirect part of your question, did that contribute to the bookings in a meaningful way, we don’t think so but it does encourage people to order earlier and that does help us a little bit in projecting the quarter, at least in the short-term.

Jason Ader - William Blair

Thank you.

Operator

Your next question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski – Goldman Sachs

I just wanted to ask you a question on M&A because obviously this was a big M&A quarter for you guys. As we kind of step back and look at your strategy here, you have obviously chosen to buy in certain areas, you are continuing to build in a lot of areas and then you chosen to partner in some. Can you just delineate against for us, for example, given the decisions that just got made on [inaudible] and Tamburg and EMC, what drives you to buy versus partner? So for example, I can think of size being the determinant factor here vis-à-vis EMC, or is there any other factor in consideration?

John T. Chambers

Sure. Ned, why don’t you take a crack at it and I’ll summarize it after you finish?

Ned Hooper

Okay, John, thanks and Simona, thanks for the question. So first of all, we have been very focused on a strategy, as John articulated, in his comments where we see the opportunity to take our strength in networking and the intellectual property and competitive advantage we have there and extend it into the major market transitions and specifically as we look at video collaboration and data center, and -- excuse me, video collaboration and then data center and virtualization, when we look at build by partner, we look at a combination of factors from what we see as core versus context for our business, and where we see the greatest opportunity in terms of providing success for our customers on a rapid basis, and we drive from there.

So as we looked at the opportunity with [Starent], [Starent] truly extends our network as a platform capability into the mobile space. It brings an outstanding team and key intellectual properties to extend our networking expertise, product line, et cetera, and that’s obviously very core to our business and extends us forward.

As we look at the partnership that we announced yesterday with EMC and VMWare, EMC and VMWare both bring very complementary products and skills as well as market reach to the table in a way where we felt that it was much more effective for our customers to bring together a coalition than to try to integrate and try to imitate an integrated end-to-end solution versus a best-in-class, best-of-breed opportunity for our customers.

John T. Chambers

So in summary, if you look at it, our general guidelines haven’t changed. Ned, I want to congratulate the team -- four acquisitions in a month was amazing and what was fascinating, this speaks to our speed, skill, flexibility and replication, is I talked about myself not really changing my schedule during the month with all these activities going on -- Ned, you did the same. You did your consumer reviews, you did your product plans, you made your customer calls and this really speaks to the power of this organization structure, where before with [webX] two years ago, I think it about killed us both but especially you when we announced at the time we delivered it was probably 24 by 7 for seven days and it speaks to how effectively as we do each of these acquisitions or market areas you know, and Rob, you, Gary, and Ned took the lead with EMC. In VMWare, we had Martin Deboer and Charles take the lead in terms of the movement in terms of Tamburg; we had [inaudible] and Hilton take the lead in terms of what we did with [Cerin].

And so you see the structure really begin to have legs and interactions, but the basic [inaudible] haven’t changed. General rule of thumb, partner big to big, acquire big to small. When you move into a market, you’ve got to get it before the market is obvious, if you are going to do it with internal development. Once the market starts to take off, you acquire one of the top five players, ideally one or two, and you don’t move into a market where you don’t have a reasonable probability of becoming the number one player, ideally with 40% plus market spend.

So those rules haven’t change, and thank you for the review, because it does keep all of us kind of on the straight and narrow of what we try to do.

Simona Jankowski – Goldman Sachs

Thanks, John.

Operator

Your next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos – UBS

I wanted to get back to an earlier question I think Jeff Kvaal asked it on the second half commentary. I’m a little confused because --

John T. Chambers

That’s the nice way of saying you are going to push me to be more aggressive, I got it.

Nikos Theodosopoulos – UBS

No, no, I’m looking for clarity here because -- I mean, the way I look at it is first half this fiscal year, the October, January quarters your sequential rates are higher than historical averages and that makes sense because we are coming off the bottom and you would expect that. When we get to the second half, why would we just assume normal seasonal sequential trends? I mean, the way I heard the question before, it was like keep your numbers the same but current consensus revenue number for the April quarter would be down sequentially from January. That doesn’t make any sense at all, so what would be incorrect in just assuming normal historical sequential seasonality for the April and July quarter?

John T. Chambers

I don’t think there is a correct or incorrect way to do it but here is our thought process. First is with those of you that might be saying tell us again, John, why your Q2 numbers are where they are and then let me go to Q3 and Q4 is if you look at our revenue growth in Q2 sequentially from Q1, it was all the way back in 2004 before it was more than 3% year over year. So this is exactly how it normally folds out in terms of sequential numbers, even in good years and for those of you who follow us real closely, you know that the federal business in Q2 dropped from Q1 to Q2 even with good year-over-year numbers, falls sequentially $300 million, so Rob has to in his forecast to us absorb the $300 million.

And the second half is just we don’t want people modeling in a normal year yet -- it’s too early. There are too many of our peers not seeing the turn and too many of our customers and you are coming off of a lower base, so not saying if I implied don’t change a forecast to say versus what you are seeing in Q2 that you are going to be modeling down but at the same time, don’t model in the normal year yet. I think that’s just taking a little bit too much risk at this time.

So we are modeling our own business this way. We think that’s a better part of prudence and the numbers are up pretty healthily in Q1 and Q2, as you said.

Nikos Theodosopoulos – UBS

Okay, thanks for the clarification.

John T. Chambers

I don’t mind the challenge either. I clearly hear the challenge that goes with it. I hope you are going to be very right on that and at the Q2 conference call, I’ll be saying Nikos was right, now we are comfortable with raising it the normal sequential growth for Q3. But I’d like to get closer. There are too many people I respect that aren’t as optimistic as we are about the economy or aren’t seeing the improvements yet in their business trends, or things that could happen on the political front that we all worry about that could cause us to misstep.

Operator

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

Mark Sue – RBC Capital Markets

John, as your CEO and CIO survey indicating a renewed commitment to upgrade enterprise networks directionally is your confidence increasing that customers network utilization rates are high and they are planning for more than one quarter at a time, implying continued order linearity and visibility? And I ask this by simple math you get to 17% year over year growth very quickly by the time April comes around.

John T. Chambers

Well, a series of related questions so let me try to tie them together. You are right that customers’ networks are running hotter than they normally would and you are seeing that both in the service provider and to an extent in the enterprise where there were not large employment numbers going down -- some of the enterprise clearly did some pretty major restructuring but as a whole, the networks are running with heavier loads within that.

Secondly, no, CEOs are running their business exactly like I just indicated to Nikos. They are making their decisions, they are getting the foot perhaps off the brake, some of them are starting on the gas pedal but very few are doing what Cisco is doing, which is putting the gas pedal all the way down. So I do not think that you can call it linearity in terms of their decision to spend yet and I think that’s what the CIOs would say in our meetings, et cetera. And only about half the CEOs would be even saying we are comfortably into an economic recovery, so I believe that the numbers and as you know, I tend to be very analytical, Mark, are indications that have always in the past been right so I put pretty high odds on them being right at this time, but there is just a lot of uncertainties about how will the holiday season go, how will job creation follow because job creation is clearly not going to be there for a couple of quarters until after you start to get this recovery, companies will initially drive up productivity just like you saw us do and then very selective hire.

So that’s kind of how I look at it. I do think you are seeing an increasing movement of top enterprise and service provider customers begin to think let’s start to spend. You are seeing stimulus programs start to have an effect, especially in government spending, but it is too early to say other than network loads, which you are right on the assumption, that anybody is extrapolating out more than one quarter. I think they are going to watch how this year-end ends up, then they are going to budget and that’s why I would wait until we talk in February before I would dramatically increase your expectations.

Mark Sue – RBC Capital Markets

Okay. Thank you.

Laura Graves

Thanks, Mark. John, we have time for about two more questions, please. Operator, go ahead.

Operator

Your next question comes from Samuel Wilson with JMP Securities.

Samuel Wilson - JMP Securities

John, a quick question for you, and congratulations on a great quarter -- on video, you called it as much art as science. I wanted to know what you thought the next steps with Tamburg specifically are and how important strategically do you view that acquisition?

John T. Chambers

Okay, so as you know, whenever you do an acquisition, whatever you want to share in terms of product plans or thoughts, you can't share. And so we have to wait, Sam, until we combine the companies but I think the comments that we made at the beginning of the acquisition when we were in Norway would be very appropriate. We view tele-presence at the high-end to be extremely effective for Cisco and make no mistake about it, we have caught the imagination of both enterprise leaders and service provider leaders on what this can mean. You are now seeing companies like Procter & Gamble and GE really be able to take that concept down though not just for executives or not just for communication but completely changing business models, supply chains, productivity, how instead of workers going to where the work is you bring the work to where the employees are located. So you are seeing that market transition.

Where we were missing was at the mid level and at the desktop level and some of the open architectures, so they are a perfect match for us in terms of the combination of the two.

In terms of our overall approach, the indirect part of your question, I believe that we will get this transaction closed. But at the same time, as you also know, that we have already walked away from a couple of deals this year where we could not get the right pricing -- pricing is important to us and the premium that we put on versus prior to rumors going on in the market in early July is a 38% premium. So we think we have a healthy premium on that.

Ned, would you add anything to it?

Ned Hooper

John, I think you did a good job of covering it and we’ve obviously been clear on this that week that we when we look at acquisitions look at and have a great track record around generating strong financial results both for the shareholders of the company being purchased as well as for Cisco. And it’s absolutely critical to us to ensure we can balance that.

And in acquisitions, it’s always clear that the target company shareholders get returns. Most companies are less good at that, John, in generating returns for their shareholders but part of that is ensuring that we are balancing the risk against the expense and we are very comfortable taking that risk on. But we feel that it is a very sound offer, a very fair offer, it generates outstanding returns, over 100% 12-month return for their shareholders and we expect to continue to work with shareholders to get this transaction closed.

John T. Chambers

But to answer the question in summary on video, I think it is a killer app and you are going to see us move across the board. It isn’t just about changing communications -- it’s changing business models, how you deliver workers to where the jobs are, virtually how you build the cities of the future and so it is a key part of our overall strategy. You will see us move in video in many areas and don’t underestimate our view of how important media net is to the fabric of [being able] any device to any content in a format and then being able to not only search off of it but push it to its communities of interest.

Laura Graves

One more question, Operator, please.

Operator

Thank you. Our last question comes from Simon Leopold with Morgan Keegan.

Simon Leopold – Morgan Keegan

Thank you. Glad I could sneak in last again, appreciate it.

John T. Chambers

Simon, they are writing the names down and I am reading them sideways as your question comes in and who the next one is, so I knew you were there about 10 seconds before you did. Go ahead.

Simon Leopold – Morgan Keegan

Great. Well, thank you, I’m glad for the opportunity. I wanted to drill down on the topic of the U.S. government. You made a reference a little bit earlier, John, about federal trends and what I am looking for is really big picture, what is the trend going on federal in the current quarter? It sounds like a number of companies experienced better federal trends and if you can extrapolate to how you see overall stimulus programs affecting your business, because clearly it is not just broadband stimulus for you but multiple programs, so near-term, what was federal and then take that out to the future with stimulus. Thank you.

John T. Chambers

Federal did see a very good quarter year over year. Rob, I’m going to ask you to expand on that a little bit in a moment and talk about it in a fair amount of detail but federal from Q1 to Q2 is always down even in very strong year-over-year growth periods in excess of 50%. So we do see the federal stimulus packages having an effect both in the U.S. but candidly around the world. You saw public sector in many areas picking up in terms of direction.

In terms of federal programs, we are seeing them begin to drive some very creative areas and that relates to healthcare, it relates to broadband build-outs, et cetera, which play right into our sweet spots which Rob, you can expand on a little bit as well.

We are encouraged by what we are seeing from people out of the administration like Valerie Jarrett listening to business on what are the key issues on tax policies outside the U.S., which could have a very challenging effect on job creation in the U.S. if done wrong, and with Julius Jenakowski as an example of the FCC really listening to all sides and starting on the issue of net neutrality kind of in the middle of the page, which can have a lot of impact on many service providers and many high tech companies.

So I think you see a group that is listening and in the areas that relate to high tech, regardless of political party in terms of its direction.

To come specifically to federal, Rob, maybe you’ll comment both on what you are seeing but also it was really your idea on how to position our focus on federal both in this country and around the world, if you could expand on that a little bit.

Rob Lloyd

Sure, John, and it was actually about a year ago we started to ship some of our sales coverage to public sector teams around the world. I think that’s turned out to be a good investment. You mentioned the public sector grew around the world and was our strongest vertical.

Specifically in the United States, we have been tracking the linkage of stimulus funds to key verticals and I will tell you where we do see the pipeline building -- we are clearly seeing the pipeline building in education, especially in advanced education. We have a number of projects that are being driven as wireless and digital security projects are funded for infrastructure upgrades. We expect in the next few quarters we are going to see some of those broadband projects come to bear and we are all seeing investments being made into the healthcare space that we think will emerge in calendar 10 that may be picked up in the private sector as spending gets placed in different ways but it will be subject to funding.

We are encouraged, John, as well by the resonance we are getting around our smart and connected communities messaging --

John T. Chambers

That’s been exciting.

Rob Lloyd

Safety and security, public transportation systems, smart and connected buildings, especially for government, are very relevant today, and we are seeing education and healthcare I think as our two key verticals.

So we are in the right spot. This is a global trend and I think in the federal, we are expecting to continue to see what’s been positive momentum.

John T. Chambers

Laura, I think that was the last of our questions.

Laura Graves

Thank you, Simon.

John T. Chambers

One question I didn’t get that I was expecting a little bit and [inaudible], you know, give you the one that really I think is most fascinating, a lot of people really don’t understand how clouds are going to evolve and how they go through phases and position really what was the -- not just movement to the private cloud [inaudible] the service that we announced with EMC and VMWare and Cisco, and with other partners, service providers and systems integrators and channel partners, but walk us through the steps as you see that if I were a shareholder, what should I be watching [inaudible] cloud emerges and since you were the one that I asked to set this direction for us over a year ago and then turned it very smoothly for you and Tony working together in the implementation, show me a little bit where we are.

Padmasree Warrior

Sure, John. I think we strongly believe that cloud is a key [disruption] in terms of the architectural shift that will impact IT over the next -- I would say over the next two to five years or so. But I think the key difference, and I think the key point that most people miss is that cloud will have both elements, on-premise and off-premise. And I think [inaudible] internal clouds or external clouds or private clouds or public clouds, and I think the important factor around our strategy is how do we help enterprises and service providers deal with the fact that we will now have applications and services that will be consumed partly from on-premise and partly off-premise. And the network obviously plays a key role in making all of this happen.

So the partnership we announced with VMWare and EMC is to address the notion of building private clouds using certain blocks that we called V Block in our announcement where the data center plays a key central role in the architecture.

Moving beyond that, we are working on elements that we call cloud networking, where the network actually provides network services in an abstraction layer. We are already engaged in proof of concept and trials with multiple service providers, both large as well as emerging service providers across the world and we hope to see much traction in the future.

John T. Chambers

You know, the exciting part is, just using service providers as an example, our view and their view is the same -- you want intelligence in the network so we naturally align in ways that candidly some of our large peers do not. We don’t compete with the service providers. We have the exact same goal on it.

So Laura, with that I am going to give it back to you and congratulations. We didn’t fumble the ball too many times under your leadership and Blair is grinning. He enjoyed watching that, so why don’t you finish it up for us.

Laura Graves

Thank you. I would like to remind our audience that Cisco's annual financial conference will occur on Tuesday, December the 8th and will be available to investors via real-time video webcast.

Our next quarterly conference call which will reflect our second quarter fiscal year 2010 results will be on Wednesday, February 3, 2010 at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. Downloadable Q1 fiscal year 10 financial statements will be available following today’s call, including revenue segments by product and geography, income statements, full GAAP to non-GAAP reconciliation information, balance sheets, and cash flow statements can also be found on our website in the IR section. Click on the financials section of the website to access the webcast slides and these documents.

Again, I would like to remind you that in light of Regulation FD, Cisco plans to retain its longstanding policy to not comment on its financial guidance during the quarter unless it has done so through an explicit public disclosure.

Please call the investor relations team with any follow-up questions from this call. Thank you for your participation and your continued support of our company. This concludes our call.

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