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Cisco Systems, Inc. (NASDAQ:CSCO)

F2Q2014 Results Earnings Conference Call

February 12, 2014, 4:30 pm ET

Executives

Melissa Selcher - Senior Director, Global Analyst & Investor Relations

John Chambers - Chairman of the Board, Chief Executive Officer

Frank Calderoni - Chief Financial Officer, Executive Vice President

Rob Lloyd - President - Development and Sales

Gary Moore - President, Chief Operating Officer

Analysts

Jess Lubert - Wells Fargo Securities

Amitabh Passi - UBS

Subu Subrahmanyan - The Juda Group

Brian Modoff - Deutsche Bank

Ittai Kidron - Oppenheimer

Paul Silverstein - Cowen

Kulbinder Garcha - Credit Suisse

Mark Sue - RBC Capital Markets

Ehud Gelblum - Citigroup

Tal Liani - BoA Merrill Lynch

Brian White - Cantor Fitzgerald

Operator

Welcome to Cisco Systems' Second Quarter and Fiscal Year 2014 Financial Results Conference Call. At the request of Cisco Systems, today's call is being recorded. If you have any objections, you may disconnect.

Now, I will like to introduce Melissa Selcher, Senior Director, Analyst and Investor Relations. Ma'am, you may begin.

Melissa Selcher

Thank you. Good afternoon, everyone, and welcome to our 96th quarterly conference call. This is Melissa Selcher, and I am joined by John Chambers, our Chairman and Chief Executive Officer, Frank Calderoni, Executive Vice President and Chief Financial Officer, Rob Lloyd, President of Development and Sales and Gary Moore, President and Chief Operating Officer.

I would like to remind you that we have a corresponding webcast with slides on our website in the Investor Relations section. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, and cash flow statements and other financial information can also be found on the Investor Relations website. Click on the Financial Reporting section of the website to access these documents.

Throughout this conference call, we will be referencing both, GAAP and non-GAAP financial results. The matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent reports on Form 10-K and 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

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

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

John Chambers

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Frank Calderoni

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

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

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

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

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

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

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

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

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

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

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

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

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

John, I would turn it back over you.

John Chambers

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Frank Calderoni

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

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

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

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

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

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

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

John Chambers

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

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

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

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

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

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

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

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

Mel, let me turn it over to you.

Melissa Selcher

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

Question-and-Answer Session

Operator

Thank you. Our first question comes from Jess Lubert with Wells Fargo Securities.

Jess Lubert - Wells Fargo Securities

Hi, guys. Thanks for taking question. Question is on the product gross margin, which decline quite a bit sequentially and was at the lowest level we have seen in a while and you went through some of the volume and mix issue some calls, so I was hoping to touch upon the competitive environment from both, traditional and nontraditional vendors to what degree there was any change in pricing. Perhaps beyond Q3, do you think you can get the gross margin back towards the mid to upper end of the 61% to 62% gross margin ranges, volumes improve and new products ramp or should we be thinking about the lower end of this range longer-term?

John Chambers

Okay. Frank, I am going to have you handle the second part. The first part, there was nothing abnormal about this quarter's pricing trends at all. No abnormality in terms of competitors we saw, new or existing models or new startups. The field is going to go after key wins and opportunities to capture major franchises and key strategic beginning of architectural plays. I think it's good as we begin to drive for growth.

In terms of timing what we said traditionally in terms of the growth, you watch our order improvements, you watch our steady progress each quarter, which I think we have done up to this point in time and are going to do it again this next quarter and you will see as we come through these product transitions at the high end routing and switching, and as you see us began to grow our service provider strategy more together, you will see these turns up in Q4 and Q1 and Q2 in terms of momentum from an order perspective.

Frank, I am going to switch it over to you in terms of gross margin comments.

Frank Calderoni

Jess, as I mentioned, we came in at 61.3% within the range of 61% to 62%, and provided the guidance in the range of 61% to 62% for the next quarter and saying it's at the low-end of that range, primarily in Q2 as well as Q3, the issue is volumes, so to answer your question and that's driving both, most of the cost as well as the mix that I talked about, so as volume does improve that gives us the ability to also improve the gross margin.

When I think about it from a long range perspective, we talked about 61% to 62% for some period of time as volume improved and we get into a more growth scenario from a topline perspective that enables us to be at the high end of that range or even above that range.

Jess Lubert - Wells Fargo Securities

Great. Thanks.

John Chambers

When you rethink about it, Jess, we have control over our pricing, our expenses and gross margins and we are managing these as levers. As volumes come back as Frank said, and I believe very firmly they will, you will see the gross margins improve as well, but reminding everybody for the last couple years, I have been saying gross margins will be in the 61% to 62% range and plus or minus 1% or 2%, and I think the last time we said very openly was impact in 2012.

Melissa Selcher

Thanks, Jess. Operator, next question?

Operator

Our next question comes from Amitabh Passi with UBS.

Amitabh Passi - UBS

Hi. Thank you. John, what is the risk that you have yourself to spread across to many areas where you are fighting multiple battles on multiple fronts we have just a massive rate of flux in each of the markets. The reason I asked you as I am little surprised with these service provider segment for you continues to remain relatively weak. NCS has been off for some time, so I am surprised we are not seeing any traction there, so we would love to get your thoughts in terms of the portfolios there, room for further rationalization…

John Chambers

First, the answer is no. If you are a single product company in today's market, you are going to have a real tough time competing against a number of different competitors, and differentiating yourself. We saw these trends coming and we have articulated for four, five years the importance of architectures where you combine products that combine '13 products that are number one in their field, four products that are number two in terms of market share and two product areas that are number three. You combine these into architectures with services and partners that very quickly bring you to solutions and dramatic differentiation and that is what you are seeing them play very strongly in the U.S. commercial and U.S. enterprise as proof points.

The second part of your question in terms of service provider, we basically are again going with an architectural approach. We are literally saying how do you influence the key issues that are most important to the service provider from mobility to video, to cloud, to speed of services delivery, so reducing OpEx and CapEx and say how you approach these with an architectural approach. So I think this will be an industry where architectures will win and I think we are very well positioned versus our key traditional IT players and future challenges.

Melissa Selcher

Great. Thanks, Amitabh. Next question, operator.

Operator

Thank you. Your next question comes from the line of Subu Subrahmanyan with The Juda Group.

Subu Subrahmanyan - The Juda Group

Thank you. My question is on the product transitions you are seeing. Is there anyway to quantify the impact of data center transitions and core routing product transition in this quarter? And John, as you look at the recovery in these, is there a timing expectation? Which one will rebound first between these two?

Frank Calderoni

As you look at it, let's go to the data center and let's go to switching. If you watch and you see the Nexus 9000, as an example, our product pipeline is up to 522 customers. That's almost a 2.9% increase quarter-over-quarter. Our win rate is extremely good versus traditional players and new challengers. You will see us over the next four to five quarters go by, some of the early startups in this area and if you look at the transition I think you watch our orders in Q4 and Q1 in this area and we are going to follow a path very similar to what we did in UCS. A similar game plan that this team has done so many times before from a technology perspective. We will put in place our steps in terms of how we identify the top customers, how we get the close rate, how we amp the volume and at the same time tie that to what we do in the Nexus 7000 and below in terms of the data center.

In terms of the routing, the routers are a little bit longer sales cycles. As you know when you put these routers that has such tremendous capability and function where you can really transfer the whole Library of Congress in a second or the Netflix library in a second, you basically are talking about tremendously powerful capabilities with the NCS and the CRS-X. That will take a little bit longer. I would watch our franchise wins in Q3 and then you should begin to see orders pickup in Q4 and Q1 on those. A little bit longer sales cycles in terms of implementation.

Melissa Selcher

Great. Thanks, Subu. Operator, next question.

Operator

Your next question comes from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank

John, hi. Switching to the Nexus 9000 order ramp. Will you see that this quarter? Our checks continue to get more evaluation phase in the products still. Will we start seeing that ramp this quarter? Will that help get switching back in the positive territory heading into July and into fiscal '15? Can you give us an update on campus switching and how that's doing? Thank you.

John Chambers

Sure. Again, Rob [ph], I am going to give you the campus switching piece. Let me go to the Nexus piece. Literally, I review almost every other week with the team where we are on this, reminding everyone this team has never missed in terms of our telephony approach, our combination of storage with the network with processors that really made us a major player in the data center and now what you watch on this when you are going to see a steady ramp to grow where we would just pick up momentum in key accounts and we are tracking these key accounts. The volumes are small. We won one, for example today.

That is a huge opportunity but it was the first opportunity but it was the first opportunity to get the door in the foot. So we deal with first getting the pilots in and then scale that this is a product that is extremely competitive and every aspect of the commitments they made on the product are on schedule on the quarters that they committed to. So I feel very comfortable with the product ramps on this and as you begin to see the Nexus 7000 and 9000 both available market then you will move through perhaps a little bit of pause where a customer is saying which way I would go and I have a hesitation here. Rob, additional thoughts on campus?

Rob Lloyd

Yes, John. In addition to the data center, I think that the entire two big transitions which are from 1Gig to 10Gig and now from 10Gig to 40Gig are playing to the strongest hand we have had in terms of our portfolio. So we have a product for every part of the market right now and you covered some of the data center technologies. We haven't talked about the new 40Gig uplinks our Nexus 5000, an important part of the product and of course the 10Gig and 10Gig links on the campus switch which is a 68000. So right across the board, great portfolio strength and you mentioned it, but we give the pedal to the metal on the 10Gig to 40Gig transition and I think you are going to see some good market share movement in the quarters ahead.

John Chambers

Yes, I think the market share gains on that are going to be dramatic.

Melissa Selcher

Great. Thanks, Brian. Operator, next question.

Operator

Thank you. Your next question comes from the line of Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer

Thanks, guys. John, I want to focus on two specific segments, the wireless and the data center. Both, for a couple of quarters, have now either completely flattened out or in the wireless case, have declined on a sequential basis. I am trying to understand, I understand I would assume that some exposure there relates to emerging markets and that's probably one of the sources of the weakness, but nevertheless for you those are very hard growth opportunities, especially on the server side and on the wireless. Many of the competitors are still growing at very cliff, so I am trying to understand if there's something going on in those two businesses that's not related to the macro issue you have been discussing.

John Chambers

Okay. First on the data center, the answer would be no. If you watch the rate at which our orders come in. As I said in the script, the order rate was in the mid-30s and this is more of the time and the shipments, book to billed across most of our product lines you can do the math quickly as I can, all of them were in good shape in terms of book-to-bill. We clearly built backlog in many of the categories and I would be very surprised if you don't see the numbers up in the 30% range this next quarter with all the appropriate caveats. That momentum feels good. We are very, very well positioned versus competition.

On the wireless side of the house, there were areas such as Meraki that was just very, very good for you going with solutions and position it. Some of the other wireless decisions on very large service provider decisions are long sales cycle such as the Small Cell SP WiFi etcetera on it and I think you are going to see as we brought out some additional product functionality that just came out with our wireless LAN capability, Rob, you will see the orders in that category that backup as we look out over the next couple quarters.

On the data center, we are going to win that one and I think you see tremendous position of momentum there and we have no fear there. That really feels good. Then in terms of wireless, there are couple of areas that we need to pick momentum back on.

Rob, I think we know what we want to do on that. You talk to that group the other day, I think.

Rob Lloyd

I talked to them the other day and again this morning, so we have got some actions in place.

Ittai Kidron - Oppenheimer

Sounds good.

Melissa Selcher

Thank you, Ittai. Operator, next question?

Operator

Thank you. Our next question comes from Paul Silverstein with Cowen.

Paul Silverstein - Cowen

I am hoping through this is clarification, but let me give it a shot. Going back to gross margin I just wanted to confirm something. With respect to the pricing environment, I think so and if I go back to the previous quarter you were fairly assertive in your commentary about the healthy pricing especially with the new products that they were coming consistent with your current margin structure to returning to this quarter is it essentially volume issue or we when we look at pricing, when we look at the new platforms has there been any change in terms of the margin profile, those new products in particular and more generally all in terms of the overall product portfolio. I heard you response on a call previously, [issue] but I just want to clarify to what extend is this a volume issue or is there something more?

Frank Calderoni

Paul, great question. It allows me to expand a little, bit it's purely a volume issue. If you look at cost, you look at mix, you look at pricing et cetera, those to come together. Volume is what is driving each of the areas. The area that you are being very general with me on as you are saying all right John if you see an unusual things and switching is that going to surprise.

Even within the switching segment our gross margins are remarkably stable even with lower volume, so we are not seeing anything unusual in the switching at all. We are very, very competitive and as we mentioned before, Paul, these new products which were just now begin to get out and enhancing the effects on gross margins are all coming in gross margins that are very typical of our high-end gross margin. That a much better job than ever done when high-end products, where usually you bring them out in the low 50s and over literally almost 2 years bring it back up to more traditional margins, so I feel good with that, so it's volume and volume ties to what the cost, what the mix and what you see overall in terms of pricing in the field. Pricing the field is a little bit up versus what we seen before, but with well within the range of what we see, a point plus or minus or half point.

Melissa Selcher

Thanks, Paul. Operator, next question?

Operator

Thank you. Our next question comes from Kulbinder Garcha with Credit Suisse.

Kulbinder Garcha - Credit Suisse

Thanks. Just a question on the services side, I think Frank mentioned earlier on the call that service should follow a product revenues and I guess what we are seeing product revenues of declining new self-service offset dollars at risk the two quarters out about maybe quite how should we think about the dynamic.

Then just one further clarification on gross margin if can. Are you saying there is no real change to the pricing environment? It's all volume-driven. The reason why I ask is, you guys knew that revenues were going to be weak this quarter and your guiding for low gross margins will weaken in front of this quarter. They are going to be relatively weak next quarter, so why aren't the cost issues is coming through more long. Any point on that would be helpful. Thanks.

John Chambers

Gary, do you want to take the service. I don't know if you could hear it or not.

Gary Moore

I think, I do, John. So, Kulbinder, on the services. The services business is tightly tied to product but we have added a number of services that John mentioned during the call earlier and those are ramping up and the fact that our product decline has been what it's been, those services aren't coming up as fast and offsetting that. But we are very happy with the way we have been able to drive continued growth in the services business as well as continuing to drive the margin that we have had.

Kulbinder Garcha - Credit Suisse

In terms of the gross margin comments?

Frank Calderoni

As far as the gross margin, just to reiterate, so as far as the guidance that we gave last quarter 61% to 62%. That said, we came in at 61.3%. So we did assume the lower volume when we gave guidance and then also assuming the lower volume for Q3 in the guidance that we just gave for the coming quarter. As far as the volume and the cost impact, so when you take your volume down we have a fixed base within a manufacturing organization, things like logistics center, things like the data center that supports WebEx and things like that. When you have lower volumes, you are spreading that fixed base over those lower volumes and therefore you don't get some of the magnitude of cost-benefit that we have seen in prior quarters. So some of initiatives that we are driving like value engineering will continue to drive those. We don't see the full impact when the volumes are down because it's offset by the fixed cost piece of it. So as I said before, if the volume improve back to, let's say, normal levels then you can definitely start to realize those deficiencies from a cost and then also from a mix standpoint as the volumes improve in switching and routing, that was one that basically had the most cell sales on a quarter-on-quarter basis which tend to have higher margin that's going to overall affect the mix in a positive direction. So we are having those impacts in periods when the volumes are lower and as the volumes improve they should be offset.

John Chambers

Very simple, if we were seeing major pricing pressures, we would just tell you. The switching is the prime example where even in the product transition time period, the margins are remarkably stable on that. So we control the pricing, we control the expenses, control the gross margins and we think we are positioned very well versus the changes in competition at this time.

Melissa Selcher

Great. Thanks, Kulbinder. Operator, next question.

Operator

Thank you. Your next question comes from the line of Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets

Thank you. John, I am sorry for the background noise. (inaudible), so I guess the bigger the better in your (inaudible) architectural approach, yet some of your assets are past their peak cycle and having a negative impact o your financial model. So on the other point that Cisco has to choose between customers and margins and Cisco actually proactively looks at the corporate ecology so that we can actually have margin, customers happy and investors happy as well.

John Chambers

I think I got part of the question. The question is, do we have to choose between customers and margins. I would say the two actually come very tightly together and this is something that I think we need to both articulate and give you a feel for the examples. When you begin to look at an architectural sale and I was just at that World Wide Tech this last week, WWT, technologies and they this last year did about $2.8 billion as a partner reselling for us growing in the high-20s year-over-year. They align completely with our architectures and they align completely with us as we make the transition into the Internet of Everything.

Now bear with me as I walk through this so you understand why I am sharing this with you. They standardized on Cisco and they are rally building their labs, the architectures, instead of interfaces customers with white papers or slides, they basically say here is what you can do to architectures and it is why you have to have all of these 18 different product areas to be able to get the result that you want when you combine it with services to get the outcomes much faster. They already show that in each of their labs with the capability to bring it to life. So you see the growth, you see the realization on it. On the Internet of Everything, they are almost ahead of us there in terms of, they are already talking to areas like in mining where you connect the sensors to all of the equipment in a major mining operation.

They just feed, as you can imagine, probably 10,000 sensors feeds per second. It goes into six or seven different databases applications. As you begin to think about the Internet of Everything and as they show that architecturally, you almost can show by doing this how you can make the decisions with people, process, data and things much quicker, get the right information at the right time to the right person or device or machine to make the right decision.

So this is why you have to be in these various product areas. This is why when you bring those together your gross margins come up, because you are delivering the results. This is why you don't want to be a single product group like a router or a switch or a wireless capabilities et cetera.

You can get caught in a huge squeeze as you move forward and if that combination that provide gross margin capabilities. If you are in service providers and of course we look at the analysis as we go forward. We are very much committed to the video side of market, because video mobile is the number one application area that they really see differentiation and two thirds of the load on mobile devices and just a year will be video, so you have to be in these areas where you can tie up together. Does that make sense?

Melissa Selcher

Thanks, Mark. Operator, next question.

Operator

Thank you. Our next question comes from Ehud Gelblum with Citigroup.

Ehud Gelblum - Citigroup

A couple of clarifications and a couple of questions, clarification were that if you can give us, Frank, maybe because you are buying back so much stock, what the ending quarter share count was that would be helpful. Then a comment on linearity if you could.

Clarification on the services business I thought, because at your Analyst in December you took 80% of your services as maintenance. I had thought it was more a function of your installed base that on quarter-by-quarter product revenue, so if you can just clarify that.

Then another question is about service provider. Service Provider Video, obviously continues to fall is there a bottom just a spot the calculate and kind of look it and you touch for ways when that kind of bottoms out and you should be modeling that and then core routers, you have got a cyclical funk that we are in right now in core routing?

John Chambers

You so many questions, I can even write them down quick enough. Let me stop right now quickly and see if we go through it. I am going to take the take the linearity question. The quarter was very linear, no surprise on that at all, and played out much in the range that we do with the first month being a little bit average and 25%, let's say, let's say second a little bit more in third month in the 40% to 45% range depend on which quarter you are in?

This quarter was very, very, much in line with what we traditionally see Q2s, I want to say so that nobody understands this. We exit the quarter with the best booking backlog in terms of weeks that that was in 10 years in Q2, so the number of weeks of backlog we had was very solid coming out of the quarter. Frank, I will give you a minute to look up to share count.

Frank Calderoni

The diluted share count, the average diluted share count at the end of the quarter was about approximately 5,300. As I said, it came down by approximately $100 million quarter-on-quarter related to the buyback that we did $4 billion of the buyback that we did in this past quarter.

I also noted that when you do the buybacks over a period of time, depending on the timing you won't get the full impact of the reduced share count. It takes another quarter, so we will see further reductions this coming quarter and would have other additional buyback and we do in Q3 and Q4 will then reduce it even further.

It also has offset any increase to the share count related to options and RSUs and SPV the normal increased, so we have offset that and then reduced through the buyback and our objective as we said over to the period of time is to manage share count down over the next couple of quarters and over the next several years in order to help improve the return to shareholders.

John Chambers

Yes. Frank and I always provide a good balance. We are going to be aggressive in the market. You are going to see us well above our 50% free cash flow, buyback and we have continued to be opportunistic there as much as we were in the first six months of this year.

Gary, in terms of services, let me break the question in three pieces. First, how much services is actually tied to the product side of the house? Maybe a real quick discussion the technical services versus advanced services and advanced services and that advanced services however going to move more outcome-based. Two minutes.

Frank Calderoni

First part of that is, roughly 80% and that the combination of technical support services as well as advanced subscription services those, contractors are normally one to three years and you book them and then you deal that revenue out over on equal basis over whether it's 12 monthly or 36 months, so as the product revenue and bookings have ramped down over the last several quarters, there is no new attach to that on either TS or AS.

On the business that is not what subscription the advanced services that are more advanced engineering and capabilities around support services that our project oriented when people aren't building out new networks or were not deploying large deployments then that business also comes down and that has come down fairly significantly as well over the last several quarters. We are ramping up in the areas that John mentioned around smart services, the analytics around that, as well as remote managed services, some large wins there. We are really doubling down on our capability there.

And then we have also shifted and brought together, we are building out a very architecturally oriented with technology people as well consulting services and then security and we have already delivered some of that. Those are ramping up and that's why we have this gap here. You will find us being less dependent on product as we go forward and you will see us continue to manage that business extremely well through automation and things that will allow us to drive the margins we do.

John Chambers

So two real quick thoughts, because I think unifying services really make a difference in our future. Gary and I have given us the challenge to move 50% of these event services to outcome-based capabilities. That's only about 20% today. Very important in the transition. If you look at the Internet of Everything, surely the consultancy piece over the next several years is a $1 trillion market that we can address. So you begin to look at us looking at this is a major new revenue scenario most of consultancy services but more important point through our own whole product architectures. Once again going back, there is a reason that so many people fail with Internet of Everything they do in cities. They do it one step at a time. It is complex. It has got to be able to scale. It has got to have the architectures all come in together. It has got to be mobile. It has got to be data center. It has got to be analytics at the edge. It has got to be secure. It has got to be collaborative. And you have to have a game plan to bring these customers together and just using cities or countries as an example when you bring them together with these architectures that's why you win. That's why you see a digital Israel where really our business grows in the high-teens year-after-year because of what we have done together there.

Melissa Selcher

Okay. Thanks, Ehud. Next question.

Operator

Thank you. Your next question comes from Tal Liani with BoA Merrill Lynch.

Tal Liani - BoA Merrill Lynch

(Inaudible) very much for the questions. I have just one question left which is, I am still trying to understand, in your numbers what related to the loft quarter, what's related to the next quarter? What I mean by that is, the quarter is definitely weak but I don't know if it is incrementally weaker than last quarter and what are the parts that are incrementally better? So maybe you can just go through kind of the major segments, just to tell us where did you see improvement from the previous time that you updated us about three months ago and just overall kind of the delta from the last time? Thanks.

John Chambers

Sure. Just repeating some the same things and expanding on them. The quarter played out on this exactly as we expected in terms of the three areas that were challenged. And in those challenging areas from a revenue perspective using high-end routing switches as an example, they were down in double digits, bookings were down in the -minus 5% and minus 6% respectively. The emerging countries were better this quarter than last quarter but way too early to call a trend and I don't want anyone to take away, we are basing our estimate on this next quarter with no improvement in terms of the current economic scenarios or what we are seeing with inconsistencies in emerging countries in terms of the direction.

The product orders were down 4% in the direction and as we alluded to earlier, there were several areas that we felt very, very good about in terms of security and the data center progress that we made. The reoccurring revenue, that's about 1% delta that we would have had if we had recognized this in traditional ways. It just increased from the last quarter to this quarter. So I feel very good about where we are now. I think the transitions are working. We are playing about. We gave guidance for this next quarter. Last quarter was 8% to 10%. We said this quarter 6% to 8% and you are going to see us just move this market right along through the transitions and returned to positive growth one quarter at a time.

So I feel a lot better where we are now versus where we were a quarter ago. I don't know if you want to add anything to that, Frank.

Melissa Selcher

Thanks, Tal. Next question.

Operator

Thank you. Your next question comes from Brian White with Cantor Fitzgerald.

Brian White - Cantor Fitzgerald

Yes. Hi, John.

John Chambers

Hi, Brian.

Brian White - Cantor Fitzgerald

I am curious. We look, sales down 8% this quarter, 6% to 8% in the third quarter. To get growth moving again here, do you feel like Cisco needs a new product category? I mean you obviously are a leader in networking. You have done very well in servers in a short period of time. But to get the revenue growth to more reasonable levels, do you think Cisco needs a new product category?

John Chambers

Let me think about that for the second to put my thoughts. Okay. I think, we have got four or five major product categories using your words in play at the present time. We have the explosion and remember, when we entered the data center saying we are going to bring together the network with server technology with storage which has really been a huge part of our growth and positioned us very well in the data center from the CIOs perspective as well and that's playing out extremely well.

We talked about application-centric infrastructure. Remember just for four months ago, when everybody really got what we are doing with this and how you are going to have intelligence throughout your entire network and what we are doing with both, applications and the network in the infrastructure and the ability to do north bound and south bound API. I mean, that is a huge product category for us in terms of direction.

Then as you pull together the Internet of Everything, and we have been on this for six years. Heavy lifting a year ago, if I had to buy somebody a drink for me to talk very long about the topic. Now, they are offering to buy us dinner and they bring the board of directors here. It's that light switch went off in a very, very positive way with the CES the World Economic Forum and when Google bought Maps, it was a light switch that all of a sudden every consumer, player, manufacturer realized.

Now, the size of those markets is $19 trillion. That's a profits potential. That doesn't count all the infrastructure underneath of it $1.5 trillion in retail alone $2.9 trillion in terms of manufacturing, so you could imagine the conversations that we are having with the leaders in that and we don't go in there selling them routers and switches. We sell outcomes and there is probably no better example than outcomes fail than what we did in Israel.

The challenge for the top government leaders in Israel 18 months ago focus on job creation, focus on inclusion of minorities, focused on healthcare, education, innovation, the ability to move some of the cities to their south, security and do this in terms of support with all three major political parties from the top down and we did that together and 18 months and we have won every single major bid in total on that.

You really began to think about the key takeaway here is the network is at the center of every transition you are seeing. Every one of it and it's going to be an intelligent network and we positioned ourselves very well to both, - again the new competitors coming at us piece meal and the old peers to who piece meal. If you are just a piece meal hardware player with a single product, you are going to really have a tough time as you go forward.

I believe architectures win and I think the categories we outlined, if we execute well, we fuel this growth for the next decade. As we think we have plenty in terms of the opportunities in front of us and I want to careful we prioritize in the right way.

Melissa Selcher

That's the last question.

John Chambers

Mel, you are the boss. Go ahead.

Melissa Selcher

All right, so I think that that's going to conclude our call. Cisco's next quarterly call, which will reflect our FY'14 third quarter results, will be on Wednesday, May 14, 2014 at 1:30 PM Pacific, 4:30 PM Eastern. Again I would like to remind you that in light of Reg FD, Cisco plans to retain its longstanding policy to not comment on its financial guidance during the quarter unless it's done through an explicit public disclosure. Please call the investor relations department with any follow-up questions from this call.

Thank you for your participation and continued support. This concludes our call.

Operator

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