Cisco Systems' CEO Discusses Q3 2011 Results - Earnings Call Transcript

 |  About: Cisco Systems, Inc. (CSCO)
by: SA Transcripts


Welcome to Cisco Systems Third Quarter and Fiscal Year 2011 Financial Results Conference Call. At the request of Cisco Systems, today's conference is being recorded. If you have any objections, you may disconnect. Now I would like to introduce Ms. Laura Graves, Senior Director of Global Investor Relations for Cisco Systems. Ma'am, you may begin.

Laura Graves

Thank you very much, operator, and good afternoon, everyone. Welcome to our 85th quarterly conference call. I am joined today by John Chambers, our Chairman and CEO; Frank Calderoni, Executive Vice President and Chief Financial Officer; and Gary Moore, Executive Vice President and Chief Operating Officer.

Our Q3 fiscal year 2011 press release is on the U.S. High Tech Market Wire and on the Cisco website at I would like to remind you that we have a corresponding webcast with slides. In those slides, you will find financial information that we cover during this conference call as well as additional financial metrics and analysis that you might find helpful.

Additionally, downloadable Q3 financial statements will be made available following the call, which will include revenue by geographies and as well as product categories. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet and cash flow statements can be found on our website in the Investor Relations section. Click on the Financial Reporting section of the website to access these documents.

A replay of this call will be available via telephone from May 11 through May 18 at (866) 357-4205 or (203) 369-0122 for international callers. A webcast replay is available from May 11 through July 22 on Cisco's Investor Relations website at

Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results. The financial results in this press release are unaudited. The matters we will be discussing today include forward-looking statements and, as such, are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent 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 conference call is not permitted. With that out of the way, now I'd like to turn the call over to John for his commentary on the quarter.

John Chambers

Laura, thank you very much. I would like to start off our call today by crystallizing for you where Cisco stands at this point in time. The network is driving the future of the core Internet, and it's clearly become one of the most valuable assets in IT. Cisco is extremely well positioned to lead this change.

In short, Cisco is a very strong company in a healthy market with a few problematic areas. And that, we are taking comprehensive action to address. The first of these is simplifying actions that we're going to do and focus on our organization and operating model. As we announced last week, we are streamlining our organization and overhauling our business model dramatically. We are making it easy for our customers and partners to do business with us and speeding up internal decision-making.

Second, aligning our call structure given transitions in the marketplace. We will take out $1 billion in costs from our FY '12 expense run rate. We also expect changes in how we do business will assure a lower cost base going forward.

Third, divesting or exiting underperforming operations. As we have already started to do this, we are examining our operations through the filter of the 5 company priorities as well as our own comprehensive metrics.

Fourth, delivering value to shareholders. We are working on both the financial and operational fronts to realize value that rewards our shareholders for their investment and their support. We have initiated a quarterly cash dividend. We are continuing our stock repurchase program, and we are focused on making changes that improve our operations in order to realize consistent profitable growth and assure the most appropriate use of our domestic available cash.

We are moving quickly, and we'll continue to implement our action plan to fix what is broken and solidify our foundation for the future. Gary will continue to lead that effort. We will be in a position to outline the next phase of our transformation when we report Q4 earnings. As a result, while Q3 met expectations, Q4 will continue to show weakness while we do the hard work behind the scenes to be able to execute these changes, and we will provide for Q4 guidance that reflects that light. We know what we have to do. We have a clear game plan. We are a company with a track record of constant market-shaping innovations.

We've had to make big changes before, and each time we have made these changes, we've emerged even stronger. We are embarking on a course that will address our challenges while building on our foundational strengths.

Now for more on the format of today's call. First, we will share perspectives on our current environment, how we are moving forward aggressively with an action plan to address challenges we are seeing while staying focused on our long-term vision and strategy in areas that we are working well across Cisco.

Second, we will share with you the areas of our business that are under pressure, including what we view to be market-driven versus what we think are within our own control.

Third, a discussion of what is going well across Cisco; and fourth, the specific plan and actions we have taken and will take going forward to strengthen Cisco. Gary Moore will cover much of this during your portion of the section. We will then cover Q3 business and financial highlights followed by our guidance for Q4. I will cover the business highlights, and Frank will cover the financial highlights in Q4 guidance. And finally, we'll outline our expectations going forward and move into Q&A.

Starting with the current environment. As we make these changes, we will stay very focused on 5 company priorities: leadership in our core, i.e. routing, switching and services, which includes comprehensive security and mobility solutions; second, collaboration; third, data center virtualization and cloud; fourth, video; and fifth, architectures for business transformation.

These 5 company priorities are the key drivers of the future of the network and core Internet. Our customers know Cisco is uniquely able to deliver in these areas to support their business success. These strategic priorities are the constants that will guide us. They offer the most significant and certain opportunities to increase value for our shareholders. At this time, we have acknowledged our challenges and the need for speed. With progress already under way, we are intensifying our focus and accelerating our pace to the level I know we are capable of and we have clearly demonstrated in the past. This is exactly what we are addressing now.

Moving on to areas of concern. As we have discussed before, we've had several areas of our business come under pressure: consumer, traditional set-top boxes, switching, and our public sector customer segment. We have taken action in our Consumer business and are executing well with our next generation of video delivery and IP set-top boxes. So I will focus on the 2 remaining primary areas that impact our business today: switching and the public sector.

First, switching. The switching market is in the midst of a significant transition. Across the industry, prices at each speed had been driving down price per port along with significant transitions from 1G to 10G, where we are at the forefront of this innovation. This is good for our customers as it will enable faster and more efficient infrastructure long term and will enable even faster adaptation of cloud-based solutions.

As we have said previously, in the short term, this has placed pressure on our revenue opportunities across the market as customers have begun to adopt these new technologies. Specific to Cisco, our gross margins have come under pressure due to the transition of our own products at the high end of our switching portfolio as customers adopt the Nexus 7000. The gross margins are the remaining catalyst, and Nexus switching product lines have continued to improve over the course of the fiscal year through our traditional switching gross margin levels.

In order to address this shift, we have introduced a new series of innovative products in our switching portfolio over the last couple of quarters, our largest-ever product portfolio refresh in such a short time period. Introduced and seen traction in our architectural approach, addressing the convergence of service providers and enterprise customers. We are the only skilled player in these 2 customer segments and are uniquely positioned to address this opportunity. We are transforming both our cost and organization structure that will make us more efficient. Gary will be discussing this shortly with you.

From a product capability and innovation perspective, we are positioned well. As a scale market leader with the broadest switching portfolio of products to serve our clients, we are highly leveraged to benefit as this market stabilizes. With all the appropriate caveats, we feel we are also well positioned to get our fair share of any market growth.

Now onto public sector. We are seeing a broad focus on cost reductions in public spending in almost every developed market around the world. We shared our initial concern about public sector spending in the U.S. state and local government several quarters ago. We are in almost every sector of government, every category of public sector, and with the vast majority of our business being new every quarter, we tend to experience challenges and opportunities quicker than others.

You may be starting to see these public sector challenges; granted, in earlier stages; from some of our industry peers. While we maintain our strong market share position in this customer segment, we are rapidly focusing our resources on share of spend within these government environments, with emphasis first on data center evolution, especially as it relates to cloud and second collaborations. And these are the areas where our customers are telling us they want the innovation and are where we have to go in terms of they have budget to spend.

Public sector historically has been approximately 20% of our business. Routing and switching represent our largest market share in this segment, and we must address very aggressively the dramatic spending changes that will occur. We have seen significant declines in the growth rate of our public sector business since the beginning of our fiscal year, going from over 30% year-over-year 4 quarters ago to decline in the quarter -- current order growth rate of 8% in Q3. No excuses. We must adjust quickly, we are, and we will.

Now there are many areas that are going well, and that's what we're going to focus on at this point in time, including solid sales growth across our key markets, market share improvements in some of our key product areas and, in a number of cases, actions to continue to drive improvements in gross margins. Cisco is the leading network provider for our customers, and the network has clearly become one of the most valuable assets in IT. Let me just focus on some key areas in terms of the opportunity and current momentum.

First, let's start with collaboration, which is already at a $4 billion pace from both revenue and order perspectives. Our year-over-year revenue growth in collaboration has been consistently strong over the last 5 quarters, exceeding 25% growth in every quarter and in Q3 at 39%. These include the benefits of our TANDBERG acquisition. With collaboration, our TelePresence flagship products continue on a very strong growth path. Our TelePresence solutions reached an annual revenue run rate of $1.15 billion, with product revenue growth in Q3 at approximately 25% year-over-year as normalized for TANDBERG.

Second, data center virtualization and cloud, which is approaching a $1.5 billion annualized revenue run rate, growing at 31% year-over-year and an order run rate of $1.8 billion, growing at 61% year-over-year in Q3. Our UCS server experienced strong momentum and pipeline growth across almost all of our geographies and customer segments. We grew our UCS customer base by 1,570 customers to approximately 5,400 customers during Q3, with product orders now at an annualized run rate of $900 million. We are rapidly gaining market share in the data center as networking, storage and compute comes together.

Third, emerging markets continues to be an opportunity for Cisco. While results will always vary with geopolitical factors such as those that we're seeing today, our largest emerging countries are doing extremely well. For example, in the BRIC countries, Brazil grew at 18%, Russia grew at 14%, India grew at 44%, and China grew at 16% from an order perspective in Q3 year-over-year.

Fourth, Asia Pacific continues to have very consistent and strong results with Q3 product order growth at approximately 14% year-over-year.

Fifth, global enterprise and commercial continues on a very strong pace, especially in the U.S. In Q3, total global enterprise grew at 12% year-over-year, and commercial grew at 14% year-over-year in terms of orders. The U.S. grew even faster in both categories than the global total.

Sixth, we continue to gain both mind share and architectural leadership in many of our global service provider customers. In key areas that are very important to them, such as cloud, convergence in the network, storage and compute, new business models, video, mobility and security, we are positioned extremely well. Service provider video remains a key priority for Cisco and for the Service Provider business. The development and delivery of our video state platform and solutions will not change.

Our service provider video strategy has been and will remain network-centric, and we'll continue to include in-home-connected devices, such as next-generation set-top boxes.

Seventh, services, which represent approximately 20% of our total revenue, grew 14% year-over-year. Gary, nice job.

Now on to our plan going forward and actions that we have and will take. We are taking very specific steps to address our challenges, and we are moving quickly. We are identifying key areas of work over the next several quarters, simplified, focused, more efficient organization and operating models, aligning cost structure given the transitions occurring, managing our portfolio where we either eliminate or cut back on lower-producing areas.

What we have done to date: aggressively addressed our organization and operating model, first, by appointing a COO; second, by reorganizing major functions of sales, engineering, and services; third, moving away from a broad council and board structure, implementing clear decision-making responsibilities by strengthening the connection between strategy and execution across functional groups; and finally, continuing to streamline operations across the company.

We've addressed non-core elements of our portfolio in the consumer business, closing fifth slip [ph] and restructuring home networking, cutting lower-performing programs. I asked Gary Moore to become Cisco's Chief Operating Officer with a specific mission to drive strategic prioritization and accountability within Cisco, with a laser focus on simplifying operations. I would like to turn the call over to Gary to discuss how we are addressing our action plans.

Gary Moore

Thank you, John. So let me walk through some of our plans to address the key areas of work that John outlined. As we look at our portfolio, the first step is aligning our resources with Cisco's 5 top priorities. That is aligning our people and our investments so that we can move with speed and agility in the highest-impact areas.

We will also simplify the way we run our business, prioritizing investments to run, grow and optimize our business. For example, a comprehensive portfolio review has begun, starting with the consumer business, where you've already seen us take significant action. We are looking at our portfolio from the perspective of both current and long-term market potential and return perspectives, and you will see us make choices and trade-offs in the months and quarters ahead. We will keep you posted on these decisions.

In terms of simplifying our organization and operational model, we have already taken aggressive steps by reorganizing the major functions of sales, engineering and services as well as moving away from a broad council and board structure. Under this new organization structure, we will be accelerating the pace of innovation and our technology refresh cycles as well as driving clear accountability for top- and bottom-line performance.

Our more than $5 billion R&D budget will be focused on accelerating our leadership in our core products and next-generation technology platforms while employing world-class product development processes. To achieve this, we are focused on speeding up the time to innovation by reducing the complexity of decision-making and allowing for greater agility on the part of our engineering leadership. We have appointed 2 seasoned leaders who now have clear functional leadership and accountability for our world-class engineering team.

To align our cost structure, we will focus on a number of areas. First, we will achieve gross margins improvements through product simplification, aggressive value engineering, maximizing commodity pricing opportunities and enhance supply chain strategies. From an expense reduction perspective, we are also looking across the business with an emphasis on actions where we can lower costs and improve operating margins. As John mentioned, we will take approximately $1 billion out of our annual expense run rate using Q4 as our base, the majority of which will be executed upon by the end of Q1, fiscal year '12.

Expense reductions will come from the consolidation and streamlining of our processes, portfolio rationalization and the simplification of our operating model and an enhanced focus on workforce deployment levels. As we look at our workforce, our first step was to reorganize our major functions. We are now taking the next 2 steps in parallel. We are continuing the process of assessing our portfolio and what's needed to fuel the growth of our prioritized opportunities.

We are strategically reviewing and determining where we need to reduce, align, and redeploy our existing workforce to support our priority areas. To be clear, we do anticipate a workforce reduction. On a global basis, affecting both our full-time and contractor workforce, we are taking the time needed to do what's right for our business and for our people.

Outcomes from these 2 parallel moves alongside a review of initial steps taken, like the early retirement program that we recently announced, will provide us with a solid view of the next actions we need in order to plan for a headcount reduction that we can execute with precision. The decision to include headcount reductions of our full-time and contractor workforce as a way of reducing expense is difficult. It is not something we take lightly, and we will communicate exactly what these decisions mean to our employees by the end of summer. Decisions will be made in compliance with all laws governing labor practices in any affected location around the world.

As our people would expect from Cisco, we will treat our employees and contractors with respect, support, and fairness. Our values here are very clear. Again, we are taking these broader steps and expense reductions to address our challenges quickly as we reinforce our strength.

On the other side of these changes, you will see that we are one where we have one, reset our expense base to align our financial model with our growth and driven operating leverage in the business; 2, established clear accountability that is aligned to our top priorities; 3, simplified our cross-functional model so that our people can put greater focus on our customers; 4, improved the ease of doing business for our customers and our partners; 5, more tightly aligned our global operations; and finally, number 6, clarified and empowered decision-making for improved competitiveness and agility. At this time, I would like to turn it back to John.

John Chambers

Gary, nice job and good for the first time period. We will update you as appropriate during our Q4 call, and you can expect a broader dialogue around our business model and capital structure at our financial analyst conference for shareholders in September.

Now I'd like to move on to discussion of Q3 business momentum and the key highlights in Q3. As Laura said at the beginning of the call, there will be accompanying set of slides company covering much of the additional data we have covered in prior calls. So I'll cover this one for a little bit higher level, and we're going to provide that so you can see the details that many of the people have asked about in the past.

So from a high-level, geographic perspective, which is the primary way we run our business, this analysis will be done in terms of orders. And as a reminder, by comparison, our Q3 this year included one less week than Q3 of last fiscal year 2010.

First, the U.S. was approximately flat, with the strength in enterprise and commercial offset by the public sector and the reductions in our Consumer business. Second, European markets were mixed, again, doing better in the northern region than the southern region, with strength in enterprise offset by weakness in the public sector. Third, as we discussed in detail earlier, our emerging countries are performing extremely well, especially the BRIC countries. Fourth, Asia Pacific continues to be our most consistent performer, with enterprise, search provider, and commercial all growing in the mid- to upper-teens. Nice job [indiscernible] and team.

From a customer perspective, in terms of year-over-year growth, global product orders, Cisco total grew in terms of products 4% year-over-year, enterprise grew 12%, public sector decreased 8%, search provider grew 3%, commercial grew 14%. From a product revenue perspective, on a year-over-year basis, routing grew 7%, with high-end routing growing 12% and midrange routing decreasing by minus 2% while low-end routing decreased by minus 4%. High-end routing accounts for approximately 70% of our total routing business.

New product revenue grew 15% year-over-year, with collaboration at 39%, the data center at 31% from a revenue perspective, security at 2%, wireless at 32% and video-connected home decreasing by 5%.

In terms of a couple of new products that may be of interest to you, our Nexus 2000 and 5000 grew 105% and 29%, respectively, year-over-year. The ASR 1000 grew at 46%. The ASR 5000 grew at 353% and the ASR 9000 at approximately 140%. Now let me turn it over to Frank for a discussion on Q3 financials and Q4 guidance. Frank, to you.

Frank Calderoni

Thank you, John, and good afternoon, everyone. As John just mentioned, our comparison to Q3 of FY '11 does include one less week than the 14-week base that we had in Q3 FY '10. During the quarter, we increased total revenues to $10.9 billion, up 5% from the prior year. Our total product revenue was $8.7 billion, of which $3.3 billion was in switching. This represents a 5% quarter-over-quarter increase in revenue. While our switching product transitions continued to gain traction, as evidenced by the performance of our Nexus product line and the new fixed switching products in the data center on campus, we did see a 9% decrease in switching revenue year-over-year.

Routing revenue was up 11% quarter-over-quarter and 7% year-over-year to $1.9 billion. The growth reflects continued acceptance of the new CRS in our core, overall strength in our EDGE ASR product families and the stability in access routing, with increased adoption of our ISR G2. The new products category totaling $3.3 billion increased 15% year-over-year and 2% quarter-over-quarter. Total service revenue was $2.2 billion, and that was up approximately 14% from the prior year. We did experience year-over-year growth of 12% in technical support services and approximately 19% in advanced services.

Looking at our results by theater, revenue increased across all geographic segments on a year-over-year basis, ranging from 11% in emerging markets to 3% in our Asia Pacific market. U.S. and Canada and our European markets both came in with 4% year-over-year revenue growth, and beginning in the first quarter of fiscal 2012, we will report based on the 3 new geographic segments that were announced in our press release on May 5.

Total product book-to-bill was approximately one. Our Q3 FY '11 non-GAAP total gross margin was 63.9%, up 1.5 percentage points quarter-over-quarter and down 1.3 points year-over-year. Non-GAAP product gross margin for the third quarter was 63.1%. That was up 2 points from last quarter. The increase was primarily due to cost savings and the impact of certain nonrecurring items. We also saw some benefit from the higher volume and mix, driven by the lower consumer business in the quarter. These effects were partially offset by pricing and discounts.

On a year-over-year basis, our non-GAAP product gross margin was 63.1%, down 2.2 points, primarily driven by pricing and discounts and product mix, which was partially offset by cost savings and volume. We saw a consistency quarter-over-quarter in our non-GAAP service margin of 67%, up from 64%, 64.8%, in Q3 FY '10. For a total gross margin by geographic segment, please refer to the accompanying slides.

Turning to the expense slide. Our third quarter non-GAAP operating expenses were approximately $4 billion, which represented 36.7% of revenue. Our non-GAAP expenses increased $44 million from prior quarter, or 1%. This past quarter, our expenses, which were lower than anticipated, are a result of expense savings due to a significant reduction in hiring, lower variable compensation and sales commissions and discretionary expense spending.

Non-GAAP operating margin for the quarter was 27.2%. Our non-GAAP net income for the third quarter was $2.3 billion, a decrease of approximately 5% year-over-year. As a percentage of revenue, non-GAAP net income was 21.6%. GAAP net income for the third quarter was $1.8 billion as compared to $2.2 billion in the third quarter of fiscal year 2010.

Non-GAAP tax rate was 21% for Q3 FY '11. Our non-GAAP earnings per share on a fully diluted basis were $0.42. That was flat year-over-year, and our GAAP earnings per share for the quarter were $0.33 versus $0.37 in the same quarter of fiscal year 2010.

During Q3 FY '11, we did recognize restructuring charges to our GAAP financial results, with a pretax impact of approximately $150 million, and this was in connection with our Consumer business. This included the announced exit of our Flip Video business and included charges related to inventory, supply chain, severance and other items.

Now moving on to our balance sheet. We did close the quarter with a total of cash, cash equivalents and investments of $43.4 billion. That was up $3.1 billion from last quarter, which included net additional borrowings of $1.5 billion as well as continued strong operating cash flow of $3 billion. Of this balance, $4.6 billion was held within the U.S. at the end of the quarter.

Accounts receivable balance at the end of Q3 was $4.4 billion, with a DSO of 37 days as compared to 40 in the second quarter. We ended the quarter with total inventory of $1.4 billion, with non-GAAP inventory turns of 10.3, which was up 3/10 compared to the last quarter. We had inventory purchase commitments of $4.3 billion, which was up approximately 10%, or $382 million, quarter-over-quarter, and this increase in purchased commitments was driven primarily by securing supply components in Japan, which contributed approximately $300 million of that increase.

John Chambers

Frank, on a quick note on that. Our Japan team did an amazing job within 2 areas after the earthquake occurred. Not only were we watching out for our people, the supply chain crisis management team kicked into gear, and we went through all the tiers of our delivery cycle. And I just want to congratulate them. I thought it was just amazing what Angel and team did there.

Frank Calderoni

Excellent job, I agree, John.

John Chambers

And also on the team, I just want to say, [indiscernible] he did an amazing job with our employees. So I just want to make sure they hear that as well.

Frank Calderoni

With an increase of 14%...

John Chambers

I didn't mean to get you out of stride.

Frank Calderoni

I think that was an important comment. With an increase of 14% year-over-year, we ended the third quarter with deferred revenue of $11.7 billion, $3.7 billion of which was deferred product revenue and $8 billion of deferred services revenue, with increases of approximately 6% and 17% year-over-year, respectively. This quarter included share repurchases totaling $1 billion of 54 million shares and our first quarterly dividend payment of $329 million.

At the end of Q3, our headcount was totaling 73,408. This was an increase of 473 from last quarter, approximately 40% of which were from acquisitions, and the remainder were critical hires in sales and services in support of our partners and customers.

Let me now provide a few comments on our outlook and our guidance for fourth quarter. Before I get to the numbers, let me remind you again that our comments include forward-looking statements, and actual results could materially differ. And as a reminder, this will always be affected by major economic change, capital spending patterns, new and existing competitors, potential issues affecting our suppliers, our ability to execute or not on our strategy and risk factors discussed in our SEC filings.

The guidance is based on our current pipeline and our view of the business trends based upon the information that we have available today, and this could be above or below our guidance if any changes do occur. As John mentioned, we will take approximately $1 billion out of our annual expense run rate using Q4 FY '11 as a base and the majority of which will be executed upon by the end of Q1 FY '12.

In connection with these actions, we expect there to be future restructuring charges to our GAAP financial results. Given where we are in the process, the extent of the additional restructuring charges relating to these activities are not currently known.

In the third quarter, we did recognize charges relating to our first steps in support of our plan by restructuring our consumer business. We expect to take further restructuring charges in Q4 as related to our consumer business of approximately $40 million, bringing the total aggregate pretax charge for Q3 and Q4 to approximately $190 million.

In Q3, we also identified an opportunity to allow for a segment of our populations in the U.S. and Canada to take advantage of a voluntary early retirement program, similar to the program that we introduced in 2009. We do expect pretax charges to our GAAP financial results relating to the program in Q4 in the range of $500 million to $1.1 billion. The extent of the charge will be dependent upon the number of employees who voluntarily elect to participate in this program.

During the quarter, it is our goal to grow orders faster than revenue as we have experienced in prior fourth quarters. So for Q4, we expect revenue growth to be in the range of flat to up 2% on a year-over-year basis. Our non-GAAP operating margin is expected to be in the range of 24% to 25%, and our non-GAAP tax provision rate will be approximately 22% in the fourth quarter.

Our Q4 FY '11 non-GAAP earnings per share is expected to be in the range of $0.37 to $0.39 per share, and we anticipate our GAAP earnings will be $0.14 to $0.23 per share lower than our non-GAAP EPS. This range includes our typical differences as well as an impact of $0.06 to $0.13 per share as a result of our anticipated restructuring associated with our consumer business and the early retirement charges. Please see the accompanying slides of this webcast for further detail.

For the quarter, we anticipate non-GAAP total gross margin to be approximately in the range of 62%. Our gross margin outlook will vary as a result of factors, including product mix, cost savings and pricing, and, of course, we will adjust our guidance accordingly.

Other than those quantified 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. As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

In closing, we are moving quickly, and we'll continue to implement our action plan that we have more lasting implications. The guidance I just reviewed for the fourth quarter reflects that we will continue to show some weakness while we work through these changes. So with that, let me turn the call back over to John.

John Chambers

Thank you, Frank. Moving forward, we'd like to give you some perspective on the fiscal year '12. While we don't think our Q4 guidance is indicative of our growth rate next year, we also recognize that the growth rate that we sometimes talked about in the past, of 12% to 17% long-term growth outlook, is not reflective of the environment either.

Our portfolio positions us for growth next year, and we will communicate both our targeted operating model and our long-term growth expectations as part of our September Financial Analyst Conference with our shareholders. We do not underestimate the transition in front of us or the importance to rapidly simplify our organization to deal with the competitive challenges facing us in switching and the shift in public sector spending. We are completely committed as a leadership team to make the required fundamental changes to our operating model as well as to make the tough decisions necessary to position Cisco to be leading in tomorrow's market.

I've always believed that our strategy and direction starts and stops with our customers and the partners that serve them. Having spent a lot of time with customers and partners, I am confident that we are well positioned in their minds in terms of our leadership. We are taking the network where our customers need it to be. No one has the breadth and scale of Cisco and Networking. No one has Cisco's breadth of innovation, the scale and reach of our customer delivery model or our talent and experience of our employees. Cisco's value to our customers is differentiated, and it is very simple. We are globally delivering to them a network-centric platforms that make them more competitive and allow them to achieve their business goals.

Our customers are dealing with the same level of complexity as they grow, and we are sharing our plans with them as we simplify our own operating model. Innovation has never been an issue for Cisco, but simplification and making it easy for our customers to work with Cisco and for our employees to do their work at Cisco is something that we must change quickly, boldly and decisively. And Gary, I'm really asking you to play the key leadership role here. You're off to a great start.

Our employees are ready for this change, and they know what an energized Cisco is capable of achieving. Throughout our history, Cisco has adopted and evolved to meet both challenges and opportunities. This time is no different, although our path to get to the end goal may be different. We have done it before, and we would do it again now.

Make no mistake about it. All of our efforts we are putting in place are focused on driving shareholder value. I want to thank our shareholders, employees, customers and partners as we transition to the reinvigorated Cisco, the aggressive, focused, and simplified Cisco, as you've come to expect over the years. So with that, Laura, let me turn it over to you.

Laura Graves

Thank you, John, Gary, and Frank. We will now open the floor to Q&A. We still request that sell-side analysts please ask only one question. We're ready to go. Operator, go ahead with your first question, please.

Question-and-Answer Session


Our first question comes from Jeff Kvaal with Barclays.

Jeffrey Kvaal - Barclays Capital

John and Gary, I was wondering if you would spend a little bit of time talking about switching in particular and down 9%, just maybe picking on one of the worst numbers. But if you could help us understand what has shifted in the switching landscape and then how long you think you'll need to correct that and get back where you'd like to be in switching?

John Chambers

Got you. Jeff, it's no problem asking tough questions. Those are one of our 2 problematic areas that we've got to address. Let me start with the most basic elements. I'm very pleased with the new products we've introduced over the last year. We are extremely competitive at the low end with the Catalyst 3000, 2000, at the mid-level with the Nexus 2000 and 5000. And if you look where we are, we need a little bit of work on our high end at the 7000, to be very candid. If you watch what we just announced in terms of organizational alignments from an engineering perspective, under Gary's leadership and now Padma and Pankaj leading the engineering team, for the first time in many, many years, we have all of our resources together. So you'll be able to share those switching resources across the engineering and one priority to be able to work together as we do this. You will see us be able to also look at how we bring products to market faster. Instead of thinking about our product cycle of 5-years-plus, we're going to be thinking 3 years. Instead of thinking of gross margin improvement in the, if you will, what we've traditionally seen, Frank, to take 2, 3, 4 years to play out, we're now thinking how we do it in 1 to 2 in terms of the direction. If you, Jeff, want some additional data, we didn't share it, but our orders for the switching category, the fixed orders were up 8%. The modular were down 10%. So we have seen a little bit of balancing here, and too early to call that a trend. We want to watch it into Q4 and Q1. As we've traditionally done, when we get hit with new competitors, we get back on our heels a little bit and we adjust. We've got the product breadth here that feels very good. Our problem is you can now do with a 2000 what you used to do with a 3000 or more, which is a nice way of saying we're coming down Moore's Law but faster than Moore's Law, which means our sales force has to sell 2x to 3x as much. Our customers will tell you in the enterprise environments and many of our government accounts, we're not losing share. But they would tell you in that environment, they wouldn't focus on how much of our revenues go up or down. So clearly, we have some shared challenges in a few areas, but overall, our port position is very, very solid. Bottom line, I like the progress we're making. You didn't ask about gross margins to go with that. Our gross margin challenges, candidly, it's a very high end. It's the transition with 6000 to the 7000. Gross margins on the prior-generation 2000 and 3000 and actually our new-generation are within a couple of points, which is pretty good at this stage. And I want to congratulate our Nexus team in the 2000 to 5000 in the middle, you've seen improvements to gross margins by almost 10 points this year. So a lot of what Gary talked about was good, but we're going to take it to a different level as we move forward and streamline this. And this is what Kathy is going to be leading towards with Randy in terms of some of the direction. So Jeff, a long-winded answer to your question. I apologize, but it's the one on people's mind, along with public sector.


Our next question comes from Tal Liani with Bank of America Merrill Lynch.

Tal Liani - BofA Merrill Lynch

First, thanks very much for the very clear disclosure about your plans, makes life easier. John, just -- I would like to ask about the next quarter guidance, but before that, just clarification. You did not address in your comment your long-term growth target that used to be 12% to 17% and whether you have any plan to change it. My question is not about that. My question is really just about the components of the next quarter. The revenue growth is pretty healthy sequentially, but then the margins, you expect it to go back to the difficult last quarter, while gross margin this quarter was pretty good. So the margin you guide down to 62%. So I'm just wondering about the dynamics. Why do we see revenues growing sequentially nicely but then gross margins going back down again next quarter?

John Chambers

So a couple of questions, and let me maybe try to summarize. During Q4, it's traditionally our strongest quarter. Our sales force is strongly incented there, and actually we have incentives in place for those that may not be in position to achieve their goals. So it's a quarter that we traditionally grow well, but usually it comes toward the back end of that quarter. Second, during this quarter, we had a very good booking UCS quarter, as you all saw, 61% growth. It was clearly -- we did not get a lot of those shipped, so that's why you saw 31% in revenue. Q4's going to be a very solid quarter for us in the data center. You're starting to see cloud activity take off. You're seeing us take on the big guys in that environment. I'm very comfortable with where we are in terms of the data center strategy. But you are clearly going to see in that quarter, we're influenced in some of our areas that don't have as high a gross margins. We will provide in our September analyst conference an update in terms of where we see the long-term guidance being. We clearly are taking 12% to 17% off the table on that. We ran at that pace for a number of quarters, but no excuses. Here's where we are, here's what we see our growth rate going forward, and we're going to do that one quarter at a time. So as we go, we're going to show you that we deliver on Q4. During that time, we're going to do behind the scenes the very heavy lifting that our shareholders fully expect us to do to bring expenses back in line with revenue. We expect to grow revenue faster and, Gary, if we do our job well, a lot faster than we do expenses as we look out 3, 4, 5 quarters out. And then we'll show you the progress, if we do our job right, with all of the appropriate caveats, each quarter next year. And as you make these changes in Q4, Tal, it takes a while to really drive those through the organization. By the time you do the easy stuff, such as the consumer, such as the early retirement, then you change organization structures. You put your first layer in, then you put additional layers in below that. And as people get responsibility for their area, then they are able to input in terms of where we prioritize resources, and then you're able to take the expenses out in a constructive way. That is hard, and it is heavy lifting, and communications is challenging on it. We're going to do that over the next 120 days very crisply. And when you do that, kind of, it slows down on your momentum in the quarter you do it, and I'm not making any excuses on that. We're going to focus on driving our orders very, very aggressively. And if you were watching momentum coming out of Q4, I'd watch book-to-bill coming out of Q4, and I'd watch our booking growth.

Laura Graves

And Frank, did you want to comment? There was a question with the delta between the Q3 and then the Q4 gross margin guidance.

Frank Calderoni

John covered it, as it primarily related to mix, if you look at it from a Q4, also looking at the strong UCS ramp that we see, which has had an impact on margins. And the other thing, I just, Tal, I just wanted to add, which I did mention in the prepared comments, is if you look at Q2 to Q3, we did have a few nonrecurring items, which did provide a benefit in Q3 that do not continue in Q4. So balancing that along with the mix that John just talked about, that's taken into consideration with the approximate 62% that we provided from a guidance standpoint.


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

Mark Sue - RBC Capital Markets, LLC

John, the decision criteria in the past to move into a new market was dependent on whether or not Cisco could be #1 or #2. Conversely, as we divest and refocus the business, do these same rules apply? Or should we look at the business model as that from a margin contribution or ROI calculations? And does the understanding of the challenges change the behavior of -- can we accelerate the behavioral change, which points to a quick reorg and restructuring, since the concern from investors is that large companies, once they start down this path, they perpetually restructure?

John Chambers

Okay, so that's 5 questions. In the order of sequence, the overall rule is we enter markets with the goal of being #1 or #2 within that. These are markets, however, that are very tightly interfaced. And so when you think about it from the data center, the convergence of compute, storage and a networking across any combination of networks to any device by data, voice, video, across enterprise and search environment with mobility built into that and video built into that and security built into it, those are areas that you must have an architectural approach. If you don't have an architectural approach, candidly, to your second part of your question, you don't have good margins, you're not going to make a difference in your customer environment, and you get relegated to somebody providing infrastructure that also may be purchased from a cloud in terms of the future direction. To your other point, I think you're going to see us, and this is one of the things Ned's going to leave for us, really look hard, along with Frank, on our margin components and saying, "Where do we really need to made a difference here? Which markets do we really want to focus in on or not?" But if they are not strategic to us, and if they don't architecturally tie together, and we're not able to move into the #1 or #2 position, by definition, not only should we be trimming back, what we're asking, and Gary's going to lead for us, we will really cut back. And so we've got to make the tough decisions there. And we are seeing willingness -- I've seen willing behavior. Now, Mark, each time we've done this in the past, we've done it crisply, and we've emerged out of it stronger. We've already shared that with shareholders. We do it once and very aggressive, and then we take our actions off of it. Our employees know we're going to make this change. This is not going to be a surprise to them today. In fact, they're anxious. They want we want us to get it out and tell them what it is. We want to do this surgically as opposed to with an blunt instrument. We want to do it in a way that brings full value to our shareholders. We want to do it with maintaining our #1 leadership as we move forward. And as you can tell from my comments, I'm not only energized, our whole group is moving with tremendous speed. I mean, Gary, we were all here for the last couple of weeks, 9:30 at night; although the pizza wasn't too good. The other things, we're very focused and we're ready. And we got knocked down, we get right back up, and we give you our plan of action. Nice way of saying, Mark, I doubt it. I think you're going to see us make these changes crisply. We'll make a few mistakes as we do it, and we'll fix those. But you'll look back a year from now, 2 years from now, and you'll find a much stronger Cisco that moved through that $40 billion bump that many large companies get and focus about how we move on to much longer. The nice thing about what we're seeing is these are healthy markets. There's no problem with market availability. And this is why you see our peers coming at us, because the network's enabling most of this. It's video, it's cloud. It is collaboration. It's an architectural play, not pinpoint products. And if you think about our competitors, how many of our pinpoint products competitors really end up keeping up with where the market goes in terms of direction? So this consolidation and this architectural plan to market is going to happen. We'll do it once crisply if we do our job right. Now, Mark, you never say never. And that's exactly what we said in 2001. But in 2001, we went through this extremely well. This is going to be a different path, but very much in control of our destiny and very much united with our board in terms of what we do for full shareholder return, very much united with our senior leadership on what we need to do and very much united with our employees who are a family even during the tough times, even though we know some of us will be affected by that in terms of where we go.


Our next question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc.

John, I just wanted to ask you about one of your 5 priorities now; namely, video. Obviously, we all would agree that, that is a really big part of the future, and you guys have been very early in identifying that. And I think part of the thesis for you has been that there's a significant infrastructure investment that comes along with something like TelePresence. But what I want to talk to you about is there are a number of offerings now that are popping up, say, from like a video or even like a Skype, which is now part of Microsoft, that seem to be significantly lower cost, and, obviously, they don't offer anywhere near the quality, but maybe for a large part of the market, they'll be good enough and won't necessarily come along with that infrastructure attached to them. So how do you view that? And how much do you think that, even if you're right on video as a big trend, it may not play out as positively for you in terms of the infrastructure attached?

John Chambers

Okay, a series of questions. First, we bet on video 5 years ago. We said video would be the next voice. You begin to invest in software 3 or 4 years after you bet before people began to see it. Secondly, video will not be standalone streaming through dumb pipes. It's about the ability to put underneath of it a fabric, in our words, and I apologize for getting technical, Medianet, that enables you to build upon it to be able to translate what is the voice within there to be able to push that to communities of interest, to be able to search upon it, because video is a mess if you can't search on it. Merely transport of information is of nominal value to company. That saves you travel, it allows you to do meetings, but the ability to really bring that together architecturally with areas such as TelePresence combining with what we're doing with our quad, which is the equivalent of YouTube- and Facebook-type capabilities within the enterprise with proper security, et cetera, is sustainably different. However, to your point, which is a fair challenge, you are seeing a number of peers now focused on video; i.e., we have a 5-year lead, but this is a big growth market and you are going to see a lot of good competitors in that. Now a lot of what Skype does is also to consumers. And candidly, what you do in this environment, you load networks big time. Back to a question earlier, a lot of our emerging technologies might sell, let's say, $1, but they load networks $3 to $4 to $5 with what they do within that. And so as you think about the implementation here, I love anything that loads networks. Now our service providers are going to say to us, "Cisco, John, Gary, Frank, how do you monetize this stuff going over the network?" So if you can't do this intelligently, if you haven't got intelligent pieces throughout the network, if you're not able to control your destiny in the cloud as these service providers deliver this capability in the new format, if you're not able to prioritize the traffic and be able to differentiate it and charge for it, if you're not able to allow this to any open device, any open device, to any content with proper security and manageability, then that's a different scenario. Nice way of saying, it's a healthy market, we're going to get a lot of good competitors. Every video loves networks, so whether it's competitors or ourselves, I'm comfortable with that. And I think it's going to be a great market load for us. It's different than switching. Switching, it's hard to load those ports fast, to really -- given the price performance coming down; i.e., the challenge in revenue. Routing, a different scenario. Routing revenues were up 7%. We're positioned very well with service providers over this next year. And we're very well positioned with the service providers on how we partner with them as they move in the cloud and move into the transport. So I think we're well positioned here, but if you haven't got good, big competitors and good startups, you're in the wrong market. The good news is we got a lot of competition in almost all of our markets, which is a nice way of saying, we're in healthy markets.


The next question comes from Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co. Inc.

John, I wanted to follow up on the switching strategy. You've talked about accelerating product cycles and trying to reduce cost and trying to plug some product gaps with the new introductions that you've just mentioned and probably some more to come. But what you haven't talked about is your strategy within switching. And just listening to your commentary, it doesn't seem like that has changed in the complex [ph] stuff. Port share, you're still the priority in that business. And if that continues to be the case, why should we assume that the margin profile of that business will change any time soon? Is there a room or ability to reconsider the balance you draw between port share and margin? Are you more willing to lose share in order to maintain margin? How do we think about your strategy in this business changing?

John Chambers

Very fair questions, and, candidly, very tough ones. First of all, let's talk about switching, and then I'm going to expand to the areas that you covered. In terms of switching, if you're standalone switches and you're just in the background, you're going to have a tough time over the next 5 years. We saw that coming a decade ago. We went to an Indian [ph] architecture, and within our switching, you put in a card, it's the #1 router, you put in another card, it's the #1 IP telephony player, you put in other capabilities, you really go into security. You put in another card, you become the #1 router player, and that's within the physical framework. As you virtually tie together those switches to the data center and the switches to the device type, you have an architecture that no one else in the industry reaches across the enterprise and service providers, no one else reaches across the video all the way to the cloud. No one else has the partnerships like we do and the capability in the cloud to do storage and the networking and the compute capability and distribute that across the whole network. So our switching strategy in that way has not changed. It is an architectural play. It's an integrated play, physically and virtually. To the second part, port share is one of the key factors on it. And we said we were holding our in own port share in a market with a whole bunch of competitors coming at us. And interestingly enough, several of those competitors are coming at us making great inroads. We learned how to compete. And whether it's on price, and we're going to go after them, or whether it's on issues such as low latency, we're starting to win our first financial accounts back. Thank you very much, team, with our new announcements on the 3000. And we're going to adjust within that with a faster speed. Now that speed, because for the first time, you already know, I've never had my engineering teams all together with one group on switching. That makes it much easier for ASICs to develop, much easier to realign priorities of resources and directions on it. So I would think about it as port share, much as we did at the Wells Fargo conference, in one category. In another category, market share in terms of revenue; and another category, margin comparison; and in another category, what your revenue growth wants to be. And actually, those are 4 variables in the equation that you can tweak and modify within it. Now what you've seen us already start down using Nexus 2000 and 5000 example, we are clearly improving our gross margins there, and just a great job by Mario, Prem and Luca, now run by David Yen. It is an amazing job what they've done in terms of margin improvements over the last year. Our Catalyst 2000 and 3000, we said earlier, had pretty solid margins. They got a couple of points below what our traditional Catalysts are, but that's not bad for this stage in the development. We have a long ways to go on our margins on the 7000. That's where the price per port, and that's where when you used to buy 6000, you might buy a 4000 now or where you might buy one 7000 for 2 6000s. The 6000 clearly has very high gross margins. The 7000 Nexus is below that by almost in the high teens in terms of gross margins. So to answer your question, we think that of this 4 variables, we're positioned well in terms of where we are from a competitive product perspective, but we've got to move faster, like in design cycles and otherwise. But port share, probably one of the key factors on the direction, and it'll be interesting to see how we do over the next 3 to 4 quarters in terms of total market share on switching. But I do look at it, what's my value return for our shareholders? And let me repeat that theme throughout here, it's about full value return for our shareholders. And that is a balancing to that, because you can maximize profits in the short run of growth and cost yourself an awful lot later on in terms of shareholder value. So while we're very much aware of short-term implications on profitability, we also want to make and we'll always make the right long-term decisions as well. We won't compromise it. I'm sorry, if I talked a little bit long on that one.


The next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank

My question is around OpEx. Just wanted to make sure I captured everything here. So looking at the guidance that you gave for the fourth quarter, it looks like OpEx is going to be about $4.1 billion, give or take a little bit. And the annual savings of $1 billion off that, so that's about $250 million. So should I think about OpEx next year being about $15.5 billion if I take about $250 million off the next quarter and run-rate that throughout the year? So that would be the first part of the question. And then the second part, related to that, when you mentioned that there would be a $1 billion charge or so from the severance, is all the OpEx savings that you talked about going to be related just to the severance? Or is there upside to the OpEx comments you gave?

John Chambers

So let me take -- I'll take the easiest part. And Nikos, I always tend to make it very simple. Let's assume our run rate's about $4.2 billion, multiply it by 4, that's $16.8 billion is what run rate we would be on if we did not change it going into next year. We clearly have an expense run rate that was based upon a much higher projection, which we thought was going to happen strongly, in terms of revenue growth. When it doesn't, you've got to bring expenses not only back in line, but given the pressure on margins, you have to bring expense growth slower, and potentially much slower, than you do on the top line growth and really focus on return for our shareholders on it. So I would say $4.2 billion, multiply by 4, $16.8 billion, take $1 billion off of that, that would be the run rate we'd be at in Q3 and Q4. You have to stair-step into it. It takes a while to do that, and so this will be a multiple quarter process. Now, Frank, how close did I get on that answer? And then you can answer the second part of that question.

Frank Calderoni

That was perfect. And I think, Nikos, the second part of your question as it relates to restructuring, as I mentioned, the restructuring associated with that $1 billion would be in our GAAP results and not in our non-GAAP results as we pro-forma that out. We have not identified that as we work through the plan over the next couple of months. That will be the purpose of -- part of the purpose of the plan, as we get more refined on that, and we'll identify it as soon as we do know that. Of the restructuring charges that I mentioned for this quarter and last quarter, those are restructuring charges that are part of the consumer announcement that we made several weeks ago. And that has an impact total of about $180 million between the 2 quarters. Again, that is something that's going to be in the GAAP results and not in the non-GAAP results. And then the other thing which would be part of that $1 billion or the restructure associated with would be the early retirement. But right now, the program is open, and so we don't know how that will turn out. We still have several weeks left for employees to make their decisions on that. The range that I gave, which is probably in the range of $0.5 billion to $1 billion of charges associated with that, would also be pro forma-ed out, but we don't know what that it is. I just gave a range based on the participation, low to high levels, and we'll, again, have a clearer view on that at the end of Q4 and provide that on the call.

Nikos Theodosopoulos - UBS Investment Bank

Okay. Just to clarify, maybe I didn't ask it properly. What percentage of the $1 billion OpEx...

Frank Calderoni

Try again, I'm sorry, Nikos.

Nikos Theodosopoulos - UBS Investment Bank

What percentage of the OpEx $1-billion savings next year do you think will be delivered by just the early retirement plan?

John Chambers

Nikos, we have our own internal modeling on that. The minute you start to break this into pieces, we, in essence, will be talking about the total headcount. We owe it to our employees to do it step by step. We made the easy decisions first, which were, candidly, the consumer. And I think you all -- we made a run at it. Candidly, we missed, and back to one of your colleague's questions earlier, I think it might have been Tal who asked the question, we said we can't be #1 or #2. We don't have sustainable differentiation here. The market moved in a different way. We exited. The second easiest thing to do is early retirement. That treats people with class. It allows us, candidly, to organize around that and allow people who are within a certain time of retiring to do that in a way that also benefits and brings down our expenses. We would then look at what the delta is in many areas. Part of it will be contractors, part of it will be our own employees, part of it will be other sector services, and we will balance within that how we take that out. That will roll out and be announced to our employees first. That is the way it deserves. We've got management meetings next week with our top leaders. We've got the week after that with our top 3,000 people. We have employee meetings, regular communications. So we're going to keep that internal. And this is where, for the shareholders, we're going to take that out. There'll be no doubt we're going to do it. But we're going to do it surgically, and we're going to it based on the input of each group, and we're not going to create more questions than we have answers by throwing a number out. Then people begin to slice and dice what does this mean for each group. We've got to allow the teams to execute. Gary, what you're doing great on, on the 5 stages that you're driving through the company on that, and then how you drive it through. This is heavy lifting. To do it right surgically, we'll make some mistakes, but we aren't going to make a broad mistake, we're just doing a haircut. You've got to organize the structure first, then you've got to offer that structure, drive it down through each layer and very directly address that. So that's how -- it's a nice way of saying that, that will be shared with our employees first, and it will be shared later in this 120-day cycle, not within the short time period. But we will get those expenses out. The 3 of us are very much committed to doing that, very much.


Our next question comes from Paul Silverstein with Credit Suisse.

Paul Silverstein - Crédit Suisse AG

John, I'm sorry to do this, but I need to return to the margin question. My question, it's regarding the long-term structure. I'm trying to understand, first off, whether the pricing pressure and the product gross margin decline you've seen is just in HP and switching. Or is it also a function of Huawei and ALU and Juniper and others? Then related to that, you used to give us your emerging market, well, all of your regional gross margin. I didn't hear it during the call. My question is do you see further decline, in particular, your emerging market in Asia Pac gross margins, which have been down over 500 basis points over the past year? And the final question related to this is, again, I heard your comments, but I'm trying to understand how you negotiate the dilemma of maintaining share via lower price at the cost of lower margin or maintaining your margins in losing share. I'm not sure I understand in terms of the long-term model how you negotiate that?

John Chambers

Okay. The answer, going in reverse order. Very difficult. The question on lower price translating automatically lower margin, I don't buy. And if you -- the numbers -- and I went through it very fast, and I apologize, and I know you will sometimes ask me a clarifying question. Our gross margins on our prior-generation 3000 and 2000 and our current generation of 3000, 2000 are within a couple of points. So we've done a very good job there in terms of gross margins and, by the way, done a pretty good job on port share, given the competition and how they're coming after us. But it does need to be multiple variables. We are going to be aggressive in winning key architectures. And to your point in emerging markets, if you don't get the market early, you often don't get it 3 years later. So we are not going to back off of direction on that. Now in terms of competitors, I wish it were just one competitor. We're going to get hit by HP and Huawei on price, consider that a given. We're going to get hit by some traditional players who do their own ASICs, their own software and hardware like Cisco. That is also a given. You will have other players who would do this in a vertical style, perhaps an IBM, top-to-bottom type of approach, and you see other peers thinking about it. Hopefully, some of those we'll partner with. We'll see over time whether we do or do not such as what Oracle's doing or what IBM is doing in the arena. You have other players who are going to come at us with silicon, merchant silicon. They're going to put software on top of it, and they're going to come ride right down that silicon curve. By the way, we can do the same thing with our own ASICs if we execute well, Gary, and I think Padma and Pankaj would agree. The problem is the price per port drops so rapidly, it's hard to load on switching, on it. And then you're going to have other players that are going to do this purely as a software play. So you're going to have a lot of people come at us from different directions. Bottom line, we're going to maintain our leadership in switching. We're going to maintain the vast majority of the market. We know our barriers to entry are low. By the way, they've been low for 20 years.

Paul Silverstein - Crédit Suisse AG

Frank, can you share with us what the regional gross margin was?

John Chambers

That's a nice way to say I didn't answer that part of your question.

Laura Graves

It's is on the slides that are on the website.

Frank Calderoni

So if you look at -- you mentioned emerging markets, Paul. The margins went up several points. The current margins right now for Q3 was 64.3%. Those are combined margins, product services as well as financing. And that was up several points, as I said, quarter-on-quarter.

Paul Silverstein - Crédit Suisse AG

And Asia Pac?

Frank Calderoni

Asia Pac went from 61.2% to 62.5%, so they improved quarter-on-quarter. All the other theaters as well. U.S. and Canada went from 62.2% to 63.7%, and Europe went from 65% to 65.2%. And then, of course, the overall total, 62.4% to 63.9%.

Paul Silverstein - Crédit Suisse AG

John, one related, if I might. Is your Public Sector business, from a margin perspective, any different than your enterprise in general?

John Chambers

It's better, and we have much larger market share. So in routing and switching, in public sector and the develop around the world, we are the #1 player by a much higher out percentage point, well in excess of 70% in switching, and I mean well in excess 80% in routing. The reason is we help them solve their business problems. We do it secure. We do it architecturally, et cetera. So we get hit disproportionately, both on margins and revenue growth, when they slow. To answer the indirect part of your question on public sector, we do not think we have a major competitive differentiation here. There's always -- I mean, competitors changing the game there. We are very effective on maintaining the majority of our market share. That doesn't mean in one area of state and local government, on E-Rates, it might not be an issue and others, it may. So we need to think about it in terms of that tone, Paul, for the balance. Sorry, a little bit long on that.


Our next question comes from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley

Firstly, John, just couple of quick clarifications and then my question. The gross margin was strong this quarter, and I know you described the gross margin down next quarter on mix, partially due to the UCS and partially due to some onetime issues. Frank, if you can just give us a sense as to why gross margin was strong this quarter, how much of it was from these onetime issues, that would be helpful just to understand that. And another clarification, Flip, as it is now, is it -- it's not discontinued operations? Was it in the numbers for this quarter? And is it in next quarter? How should we look as to what that revenue did? John, you mentioned in a previous question, you mentioned your answer something about the gross margin in the Nexus 7000. Did I hear you say high gross margins?

John Chambers

Low gross margins in that.

Ehud Gelblum - Morgan Stanley

I'm sorry. Was it high teens? Was it really high teens for the gross margin for the 7000? Or was that relative to something else?

John Chambers

All right. So let me answer the questions, and then we'll take them in sequence. Occasionally, I speak a little bit fast, please forgive me for that. And I'll also want to hear very directly the areas we need to improve on. Switching is clearly one that if you look at -- seeing that decline, that's one that we need to improve on also. Now to answer the question, the gross margins at the low end 2000, 3000 are very close, a couple of points below what our original 2000 was. The Nexus 2000 and 5000, which are new, had come up very well over the last year, and that's just classic Cisco execution. On the high end, our 6000 had very good margins. Our Nexus 7000 is below that in the high teens. So I'm just being very open with you for you to be able to do the math on why you see the pressure on margins. We have one product area that has very high margins with the product that's replacing as well as the classic 2:1 leverage point in terms of double or triple the price performance, which means you've got to sell 2x to 3x the number to get the same capability. On Flip, Flip was in the results for part of the quarter, but it's out for next quarter. And so in your modeling, that's about 1% of our total business that is gone. So when you think about growth, take 1% out for the next quarter in terms of the growth, because we will not have revenue on that. The first part in the gross margin mix, Frank?

Frank Calderoni

So let me just add at a very high level, if you look at it from Q2 to Q3, I would say the 3 major categories that I would identify from a margin standpoint -- as you know, the margin improvement, overall, was 1.5 points. About half of that was related to these nonrecurring items. Another portion was related to the consumer, primarily around Flip, in the delta quarter-on-quarter. One has to do with the lower volume as it relates to the performance in exiting the business, and the second has to do with removal of some of the inventory impacts that we had seen in the previous quarter. And then the third piece is a combination of services margin improvement quarter-on-quarter as well as some slight improvement in the other base business, which is a combination of some mix as well as overall margin improvement. So going into Q4, you don't have the nonrecurring and the consumer from a quarter-on-quarter. It pretty -- gets to be a bit more consistent.


Our next question comes from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank AG

John, so just to be clear, so you're saying that the 7000 gross margin's in the high teens?

John Chambers

No. Let me reword that. What he's saying is that -- and he's right. I did a poor job explaining that. Please forgive me. Gross margins of the 6000 are at a very high level, you all know where they are. Gross margins for the 7000 are below that, let's say about 18 points, to be very specific. And so as you think about the math, that's the delta between the 2, and I did a very poor job of saying that. And Brian, thank you for correcting me in a way that the audience clearly understands. So your question?

Brian Modoff - Deutsche Bank AG

The question is around going back to switching again. Can you talk about port shipments? How did they do on a year-on-year basis? Revenue's down 9%. How did port shipments do? And can you break it down between data center and campus, please?

John Chambers

I'm not sure we have it in that way, Brian. We might need to do it as a follow-up. Let me may perhaps give you an idea in terms of the revenues. I think the revenues were down 5% on the, if I'm remembering right, let me verify it here before I state it. Down 5% in terms of the fixed and, as I said earlier, the orders were up about 8% year-over-year. In terms of the actual port shipment breakout, I don't have it. We ran that analysis when I was looking at share market. A nice way of saying I don't have that data to answer your question.

Laura Graves

Brian, we'll follow up with you after the call. We are expecting just the preliminary market share data that's just coming in now. Full market share will come in over the next couple of weeks.

John Chambers

Since I didn't answer the question, do you have one more?

Brian Modoff - Deutsche Bank AG

Yes, councils. So you went from 5 to 3. So you are streamlining them, but do you think -- are you contemplating perhaps eliminating them altogether? Do you think more of a direct-line management structure might be a better structure for the firm to get more direct accountability to the various divisions?

John Chambers

Let me have Gary go through it in just a second, but let me be very explicit. We went from 9 councils to 3 councils, that we went from 42 boards to 15, that we've moved the decision-making clearly into engineering and into sales for the decisions. We used the councils by customer segments, which are enterprise, service provider and emerging, and that's to connect our strategy to connect it with our operations. Clear decision-making is back in the functional groups, and Gary has just done an amazing job here. So Gary, take us down one more level.

Gary Moore

So I mean, at the high level, John hit it quick. So to come at it a different way, the key message here is we moved to functional leadership driving the 3 councils we have left. So Padmasree Warrior, who is one of the co-heads of all of engineering along with Pankaj, the 2 of them own the number along with -- and Rob's organization that he announced. Nick Adamo, aligned to Pankaj, drive our customer-facing business with service providers globally. They make the decision, and they own the number. So it's not a group thing anymore. That group, that council is there so that we can stay close to those customers, collaborate across the different functions that support them but, more importantly, get that feedback into engineering from a product point of view as well as when we talk to you about our Service Provider business. We have to be aligned and competitive in the Service Provider business. Same thing in Enterprise. And so Padmasree Warrior and Paul Mountford will co-lead that council, and they both have decision-making responsibility for both sales and engineering. The third council that we left in place is also customer-facing from the point of view. It is our emerging countries council, and that council is, again, helping to drive the transformation we're doing. We're setting up legal entities. We're doing a lot of work at Cisco to get things done to be able to operate in countries where we haven't had the infrastructure. I felt it was important to let that work continue on, and there's a lot of good people that are driving that. So again, we're holding the country leadership accountable to drive that, but we're giving them a forum to reach into. So elimination of 6 councils and 31 boards that we did is not the headline here. The headline here is the way we've changed the way we're operating, to drive simplicity and agility into the organization. As John said, we're going to drive our earnings faster than our revenue. This is the way we have to do it.

John Chambers

So simple takeaway in summary, we simplified the organization and operating model. That's what we just did, and we did it both with engineering, sales and also our services. We are using the councils and boards purely as how you connect the strategy to the execution, which, by the way, you need architecturally. We also recognize that the strength during one stage of your development; i.e., developing the visual products to compete with each other during the 90s, becomes your weakness later. Councils and boards, we didn't evolve quick enough where we needed to go on that. It allows us to align cost structure, it allows us to make better decisions in terms of who has ownership on divesting of underperforming assets the way we're set up, and bottom line, it brings more value to our shareholders. That's what we're really focused on short and long term.


Our last question comes from Brian White with Ticonderoga.

Brian White - Ticonderoga Securities LLC

Just -- you talked a lot about UCS. It obviously has pretty strong momentum here. And I'm wondering if you could talk a little bit about VCE with the Vblock Solution. There's a lot of buzz at Interop around that. Maybe if we can get some metrics around VCE and Vblock?

John Chambers

Got you. I think once again, Cisco, along with our partner EMC and VMware, called a market transition well ahead of what actually has occurred. And you had to, because our movement in the cloud, when Padma came here 2.5 years ago, we didn't have a good cloud strategy, and Padma did an amazing job there. So the combination, and this is why it has to be architectural plays not only within the data center or various products, but also within our customers changing buying behavior as they begin to see the ability to buy by the drink within that. The relationship with VCE is extremely important. We are making very good progress on that, and our pipeline is looking more and more -- I'm not sure what I have, I probably don't have authorization to share that. We have to coordinate with EMC and VMware, but our pipeline looks very good. If I were to just talk federal government alone, we had to move from just traditional routing and switching, et cetera, we move quickly to collaboration and we need it moved into cloud, and yet we're still seeing the declines, but the pipeline is almost doubling every quarter in terms of large cloud opportunities. And this type of relationship has tremendous power for our group. But again, it's an architectural play, not pinpoint products. If you're a pinpoint product player, you're going to get commoditized over time or just put into the infrastructure. So good momentum on it. Michael Capellas is doing a very good job of leading that group and creating both the understanding from some customers and the integration, and I think I speak for Joe Tucci and myself and Paul Maritz in saying we're very pleased with where we are on it. Good momentum. I think this is a market -- the question is our peers are now starting to come at us the same way with our own development, so we've got to be able to pull it back together. And so -- Laura is very nicely saying I'm coming up on the time constraint.

Laura Graves

Do you have any closing remarks?

John Chambers

Yes, I do. My normal approach would be to talk about all the positives, and there are a lot of areas here. I'm going to focus on the 2 areas that are problematic for us. And it's important to understand in switching and in public sector, that gives us challenges on our growth number that we have to be able to move faster and in terms of our organization structure but also bring expenses not only in line with top line growth, but grow top line growth faster and potentially dramatically faster than you grow expenses. We're going to approach this very simply. First, by simplifying our focus on organization and operating model; secondly, by aligning the cost structure, given these transitions that are occurring; third, by divesting or exiting underperforming operations; and fourth, a fanatical approach to delivering value for our shareholders. Our board, our leadership team, our employees are united in this type of approach. We're going to move very decisively in controlling our own destiny. And by the way, how many times have we not in the past? And while the path this time will clearly be different, every time we've gone through this, we emerge as a stronger player. Nice way of saying, if I were a competitor, this is a tough company to bet against, whether you're talking switching, routing, data center, UCS, mobility, video, collaboration overall in terms of the approach. They're areas that we must do different, and the buck stops here. It's my responsibility, I get it. We're going to move rapidly in terms of the direction. And so takeaway from this call, we want to thank you, especially the shareholders, for your supporting us. We need to really focus on getting you the return in both short term and long term, and that's our commitment to the leadership team. So with that, Laura, let me turn it back to you.

Laura Graves

Thank you, John. We remind our audience that Cisco's next quarterly conference call, which will reflect our fourth quarter and annual fiscal 2011 results, will be on Wednesday, August 10, 2011 at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern time. As a reminder, downloadable Q3 FY '11 financial statements are available following this call, including revenue segments by product and geography. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet, cash flow statements can all be found there on the Investor Relations website. Click on Financial Reporting. We'd like to remind you that in light of Regulation FD, Cisco plans to retain its long-standing policy to not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. Please contact any member of the Investor Relations team with any follow-up questions from this call. We thank you for your participation and your continued support. This does conclude our call.


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