Cisco Systems (CSCO) Charles H. Robbins on Q2 2016 Results - Earnings Call Transcript

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Cisco Systems, Inc. (NASDAQ:CSCO)

Q2 2016 Earnings Call

February 10, 2016 4:30 pm ET

Executives

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Charles H. Robbins - Chief Executive Officer & Director

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Analysts

Pierre C. Ferragu - Sanford C. Bernstein & Co. LLC

Vijay K. Bhagavath - Deutsche Bank Securities, Inc.

Simona K. Jankowski - Goldman Sachs & Co.

James Dickey Suva - Citigroup Global Markets, Inc. (Broker)

Mark Moskowitz - Barclays Capital, Inc.

Brent Bracelin - Pacific Crest Securities

James E. Faucette - Morgan Stanley & Co. LLC

Jess I. Lubert - Wells Fargo Securities LLC

Jeffrey Kvaal - Nomura Securities International, Inc.

Ittai Kidron - Oppenheimer & Co., Inc. (Broker)

Simon M. Leopold - Raymond James & Associates, Inc.

Timothy Patrick Long - BMO Capital Markets (United States)

Operator

Welcome to Cisco Systems' second quarter and fiscal year 2016 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 would like to introduce Marilyn Mora, Head of Investor Relations. Ma'am, you may begin.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Thanks, Kim. Welcome, everyone, to Cisco's second quarter fiscal 2016 quarterly conference call. This is Marilyn Mora, Head of Investor Relations. And I am joined by Chuck Robbins, our CEO, and Kelly Kramer, our CFO.

By now, you should have seen our earnings press release. A corresponding webcast with slides, including supplemental information, will be available on our website in the Investor Relations section following the call. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements, and other financial information can also be found on the Financial Information section of our Investor Relations website.

Throughout this call, we will be referencing both GAAP and non-GAAP financial results, and we'll discuss product results in terms of revenue and geographic and customer results in terms of product orders unless stated otherwise. All comparisons throughout this call will be on a year-over-year basis unless stated otherwise.

The matters we will be discussing today include forward-looking statements, including the guidance we will be providing for the third quarter. They are subject to the risks and uncertainties that we will discuss in detail in our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. With respect to guidance, please also see the slides and press release that accompany this call for further details.

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

Please note that during Q2, on November 20 we completed the sale of the Customer Premises Equipment [CPE] portion of our SP Video Connected Devices [VCD] business to Technicolor. As such, all of the revenue, non-GAAP, and product orders information we will be discussing is normalized to exclude the SP Video CPE business from both the Q2, fiscal 2016, and historical results. We are providing Q2, fiscal 2016, and historical financial information for the SP Video CPE business in the slides that accompany this call and on our website to help to understand these impacts. As a reminder, the guidance we provided during our Q1 earnings call and today's call has been normalized in the same way.

With that, I'd like to go ahead and turn it over to Chuck.

Charles H. Robbins - Chief Executive Officer & Director

Thanks, Marilyn. We delivered a strong Q2 in a challenging macro environment. Recently, we've experienced one of the most volatile times in the global markets. This volatility led to a slowdown in spending impacting our business, especially during the last few weeks of January as we closed our quarter.

Despite this slowdown, we executed very well, with total revenue growth of 2% and non-GAAP EPS growth of 8%, strong margins, and operating cash flow up 36%. Our ability to deliver strong profitability in a challenging environment reflects the operating leverage we've created in our business over the last several years.

Our portfolio is more strategic than ever to companies and countries that are digitizing everything. As billions of things become connected, creating massive amounts of data, Cisco is playing an increasingly critical role, enabling our customers to drive their priorities with industry-leading security. Cisco is unique in our ability to connect everything for our customers, from the sensor to the data center, with security and analytics. As a result, our conversations are no longer just in IT. They have become prevalent in the C-suite and the boardroom.

When I took this role two quarters ago, I discussed my focus on accelerating our innovation engine and portfolio transformation to execute on the opportunity ahead of us. I believe we are executing well, and I would like to highlight our momentum in four key areas.

First, we are defining the next generation of networking, beginning with the data center with our ACI platform providing the automation and programmability for our customers' most critical business applications, with the scale, speed, and security they require. In just two years, we have built ACI to a $2 billion run rate business that grew once again last quarter over 100%. We are aggressively focused on winning in the 10-gig, 40-gig, and 100-gig transition, and firmly establishing our leadership in the next-generation data center.

Second, security remains the most critical priority for our customers. And as everything connects, it makes the network even more relevant. As the largest security provider, we have been focused on driving the growth of this business, while at the same time migrating our model from a primarily hardware business to a software and services business. In Q2, not only did our security business grow 11%, but our security deferred revenue grew 26%.

Third, we saw double-digit growth in our cloud-based SaaS businesses, specifically WebEx, Meraki Cloud Networking, and security. You are seeing us move more of our portfolio to be delivered in both on-premise and cloud-based models, and we are aggressively driving this transition.

And fourth, we are using M&A to augment our internal innovation in key growth areas. In the last 12 months, we have added critical capabilities and talent in the growth areas of cloud, security, SaaS, IoT, and analytics. Our recently announced acquisition of Jasper combined with our other capabilities is a strong example of how we will play unique and strategic role in unlocking the value of IoT. We will enable our customers to monetize the data from the billions of sensors and connections with the security, speed, and reliability they have come to expect from Cisco. Our momentum reflects the uniqueness of our business model and our ability to weather volatility while accelerating innovation in key markets to drive our long-term growth.

Now I'll turn it over to Kelly to walk through more detail on our financials.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Thanks, Chuck. I am pleased with our continued execution on our financial strategy of delivering profitable growth, managing our portfolio and strategic investments, and delivering shareholder value.

Starting with delivering profitable growth, total revenue was $11.8 billion, up 2%, with product revenue growth of 2%, led by growth in security, routing, and collaboration. In switching, as Chuck mentioned, we are driving the next-generation data center architectures and are very pleased with our ACI momentum. The 4% decline in switching was largely driven by macro weakness in our campus business, something that we've observed in the past during volatile times as customers pause spending decisions. We saw our routing business grow 5%, driven by double-digit growth in our CRS platforms, with particular strength in mobility and web-scale service provider.

Collaboration grew 3%, driven by 17% growth in WebEx, partially offset by some slowdown in our Unified Communications business. Deferred revenues showed continued strength, growing 15%. Our data center decline of 3% was also driven by a slowdown in spend. In addition, we had tough comparisons from Q2 2015 when revenue grew 40%. UCS continues to be a strong franchise for us and is a foundational piece of our next-generation data center stack.

Wireless was flat as a result of declines in our access point controller business, offset by strong growth in our cloud-based Meraki platform. SP Video grew 37%, largely driven by strength in China. Security grew 11%, with deferred revenue growth of 26%. We had strong growth in our advanced threat security and Web security solutions, which grew over 180% and 40% respectively. We added over 2,000 customers on our AMP advanced malware solution, bringing the total customer base to over 10,000.

Services revenue grew 3%, and we continued to show very good progress against our goal of driving more recurring revenue. Deferred revenue had solid growth of 8% in total, with product up 11% and service up 7%. The portion of our product deferred revenue which is related to our recurring software and subscription businesses grew 34%. In total, product orders grew 2%. Our book-to-bill was approximately one.

Looking at our geographies, which is the primary way we run our business, Americas was flat, EMEA declined 1%, and APJC grew 17%. Total emerging markets grew 7%, with the BRICs plus Mexico [BRICM] showing strength at up 17%, with China up 64% and India up 23%. Total emerging minus the BRICM countries was down 3%.

In terms of customer segments, enterprise declined 2% and commercial grew 4%, both of which were impacted by macro uncertainty. Public sector was flat and service provider grew 5%.

We drove strong profitability, with discipline and rigor on gross margins and operating expense. Non-GAAP gross margin was 64.2%, with non-GAAP product gross margin of 63.3% and non-GAAP service gross margin of 66.7%. Non-GAAP operating expenses were 33% of revenue, and non-GAAP operating margin expanded to 31.2%. We will remain disciplined with our operating expenses and portfolio management.

From a profitability perspective, we delivered non-GAAP EPS of $0.57, up 8%, with $0.015 attributable to a lower non-GAAP tax rate resulting from the permanent reinstatement of the federal R&D tax credit.

From a GAAP perspective, EPS was $0.62.

In addition to the typical reconciling items between GAAP and non-GAAP EPS, there were three material items to call out which we excluded from our non-GAAP results: the gain on the sale of the SP Video CPE business; the impact of the settlement of federal tax audit; and prior-year fiscal year impact of the reinstatement of the federal R&D tax credit. The total impact of these and other immaterial items was a benefit to GAAP EPS of $0.13.

Q2 non-GAAP net income was $2.9 billion, up 8%. GAAP net income was $3.1 billion.

So moving on to shareholder value, in Q2 we delivered operating cash flow of $3.9 billion, up 36%. Total cash, cash equivalents, and investments at the end of Q2 were $60.4 billion, with $3.9 billion available in the U.S.

In the first half of fiscal year 2016, we returned $4.6 billion or 75% of our free cash flow to our shareholders, comprised of $2.5 billion of share repurchases and $2.1 billion of dividends. Today we announced a 24% or a $0.05 increase to the quarterly dividend to $0.26 per share. This represents a yield of approximately 4.6% based on today's closing price. We also announced a $15 billion increase to the authorization of the share repurchase program, raising the remaining share repurchase authorization to approximately $16.9 billion. This significant dividend increase and additional share repurchase authorization reinforces our commitment to returning capital to our shareholders and our confidence in the strength and stability of our ongoing cash flows.

Overall, Q2 was a solid quarter in a volatile macro environment. We saw good top line growth, strong profitability, and operating leverage. We continue to shift our business model to more software and subscription recurring revenue.

Let me now reiterate the guidance we provided in the press release for the third quarter of fiscal year 2016. This guidance includes the type of forward-looking information that Marilyn referred to earlier. Q3 does include an extra week, which occurs every five to six years for us. We have factored this extra week into our guidance for both revenue and expenses. Although it is difficult to forecast the impact of the extra week, we have assumed roughly a 2% year-over-year impact on total revenue growth along with approximately $40 million of incremental cost of sales and $110 million of operating expenses.

The guidance for Q3 is as follows. We expect revenue growth to be in the range of 1% to 4% year over year, normalized to exclude the SP Video CPE business from Q3 fiscal year 2015. We anticipate the non-GAAP gross margin rate to be in the range of 62.5% to 63.5%. The non-GAAP operating margin rate is expected to be in the range of 28.5% to 29.5%, and the non-GAAP tax provision rate is expected to be 22%. Non-GAAP earnings per share is expected to range from $0.54 to $0.56. We anticipate our GAAP EPS to be lower than the non-GAAP EPS by $0.08 to $0.12. Further details to this range are included in the slides and press release that accompany this call.

I'll now turn it back over to Chuck to summarize the call.

Charles H. Robbins - Chief Executive Officer & Director

Thanks, Kelly. Let me quickly summarize. While macro growth has clearly slowed, the speed with which technology is changing every industry and every country has not slowed, and we are moving full speed ahead. This speed coupled with our innovation, strategic partnerships, and our M&A capabilities will allow us to meet the expectations of our customers and lead into the future.

On this front, I feel very confident, and that conviction about our future business is what led us to increase our dividend by 24%. My confidence in our future is confirmed every day by CEOs, boards, and country leaders as we preview our strategy and roadmaps. They see the next-generation data center and cloud architectures we're building on UCS and ACI. They see our extensive security portfolio that protects them before, during, and after an attack. They see the IoT and analytics platforms that will enable them to act on and monetize data and connections, and they want us to be their strategic partner as they drive their digital agendas. They trust us. They value our innovation, and they believe our portfolio is critical to their ability to execute on their vision.

Our customers and countries around the world know this move to digital is real, and it's happening now. As we help them through this transition, you will see us operate on two fronts. In the near term, you will continue to see us to be a well-run company that executes even in challenging markets. Longer term, we will continue to make the right investments that will accelerate our growth as our customers embrace and adopt this next wave of technology.

Marilyn, I'll turn it back to you for questions.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Great. Thanks, Chuck. Kim, let's go ahead and open the line for questions. And while Kim is doing that, I'd like to remind the audience that, all analysts, we ask you to please ask one question.

Question-and-Answer Session

Operator

Thank you. And our first question comes from Pierre Ferragu with Sanford Bernstein. Your line is open.

Pierre C. Ferragu - Sanford C. Bernstein & Co. LLC

Hi, thank you for taking my question. Chuck, really what I'd like to understand is your perspective on the macro environment. So first of all, so you of course see Bloomberg TV and read the Financial Times, as we all do. But what do you see – what can you see through Cisco as you get feedback from your channels, from your salesforce, or country managers? What do they really tell you about and what color can you bring us that we don't necessarily see from where we are?

And also on the same front, on the macro environment, your guide for next quarter, what kind of macro scenario have you baked in? Would you qualify that as prudent, very prudent? And if you can take us through the thought process of how you came up with that guidance, that would be very helpful.

Charles H. Robbins - Chief Executive Officer & Director

Okay, Pierre. Hey, thanks for the question, good to hear from you. So on the macro front, I think the thing that I can tell you is that as we began last quarter, we certainly have a set of expectations as we have run our business for a long time and really know what to expect. And our expectations were obviously based on the discussions we had with all of you at the end of our first quarter.

And I would tell you that through the first 10 weeks of the quarter, that was very much in line with what we expected. We were executing very much in line with how we would have expected the quarter to go. And our week 10, just so you have the data point, was the end of the calendar year. So while a number of companies have reported earlier this year, not many have actually had their quarter end in January, so we ended at the end of the third week of January, which we all know those first three weeks were reflective of the uncertainty that occurred in a lot of the financial markets.

And so what I will tell you is that after week 10 through those three weeks, we saw customers as they were trying to just digest what was going on, they just paused a bit. And you see customers say I want to just wait and see what's going on. Let me take a look at this, we want to understand this a little better. And I think to Kelly's point when she talked about the switching business, the campus refresh opportunities that have been actually pretty consistent for us over the last few quarters, we saw customers say hey, our infrastructure is working, so we're going to just hold on that for some period of time and let's see where things go. So that's probably the extent that I can add to what we all know from what we're seeing every day.

What I would tell you, and I'll ask Kelly to comment on our guidance, is I would say that we took that sort of feeling of those first three weeks into consideration as we built our guidance, and that's what we based it on is what the last three weeks of last quarter led us to relative to this level of uncertainty. Kelly, any comments?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

I think to your question, Pierre, I think Chuck summarized it well. When we do our guidance, we look at everything we know at the time, which is our funnel, the momentum we see and everything else. So I'd say to put it in the words you used, I'd say that our guidance is prudent. I think you see that we expanded our range to three points of range versus our normal two points just because I think it is more volatile than normal. And so I'd go with prudent based on what we see right now.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

All right. Thanks, Pierre. Operator, we'll go ahead and take our next question.

Operator

Thank you. Our next question comes from Vijay Bhagavath with Deutsche Bank.

Vijay K. Bhagavath - Deutsche Bank Securities, Inc.

Hi, Kelly. Hi, Chuck.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Hi, Vijay.

Vijay K. Bhagavath - Deutsche Bank Securities, Inc.

My question is around Cisco is a tale of two cities here. We're seeing enterprise products trending light versus consensus, while your service provider products, routing, video, et cetera, are beating expectations. I'd like to get your view on this enterprise versus service provider dichotomy, if any.

And then you have a bigger picture strategy around software and you're cutting services, fully believing that strategy and model. So my question is really around, do you see IT spending skewing quickly towards OpEx versus the traditional CapEx model of spending? And how would Cisco be levered to this higher than usual OpEx IT spending moving forward? Thanks.

Charles H. Robbins - Chief Executive Officer & Director

Okay. Thanks, Vijay. I would say the initial question you asked relative to the difference between the enterprise and service provider space, I think what we saw was that our customers were spending in areas that are incredibly mission-critical for them even in these times where there's uncertainty. So you see them continuing to spend in security. You see them continuing to spend in the next-generation data center evolution, which was indicative of the 100% growth we saw in that portion of our portfolio. And I think we saw customers where they had the option to wait, they chose to wait a bit. So I don't view it as any – I don't see any fundamental issues relative to the enterprise portfolio or things like that. I think that it was largely just a prioritization effort that we saw within our customer base on the enterprise side.

On the service provider side, I think if you go back a couple of quarters, what I said was that our teams have been working hard to really get to alignment with our customers around the future of the industry, the future of their architectures, how they were going to evolve to position them for the opportunities ahead, and I think that we did that. And then I would say that our teams have really executed well over the last couple of quarters as they align with our service providers on those priorities across the portfolio. And so we're pleased with where we are. I don't think that if you really unpack those numbers over two or three quarters that you're going to see you'd be able to delineate a whole lot between what went on with the exception of the enterprise customers just prioritizing where they spent their money.

As it relates to the OpEx versus CapEx move, I'll ask Kelly, and maybe she can comment on the software part of the question. But I didn't see any fundamental change this quarter in how our customers look at that versus what they've been doing for the last three, four, five, six quarters. So it's something that we deal with as it relates to, as an example, our collaboration portfolio. We made announcements last quarter that all of that portfolio, the entire portfolio is now available, or we announced that it will be available to our customers from both an on-premise and a cloud-based perspective, and in many cases it will be a hybrid model. So to the extent that our customers would like to procure our solutions in that way, then we'll make that available to them. Kelly?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

I think you summarized it well. On the software shift, Vijay, we are making great progress. Whether it's – internally we talk about how we're driving that in our software and SaaS businesses within collaboration and security. But also in other parts of our portfolio, we are really developing new offers, that there are ways to monetize our services and software along that way. So we'll continue to disclose more, especially as we look as our business and it becomes a bigger part of that. So I'd say it's progressing well. And we're adding to our models with acquisitions like OpenDNS and Jasper, which are both SaaS models. We'll continue to build that out as it becomes a bigger part of our portfolio.

On the IT to OpEx, just to add to what Chuck said, I'd say one thing that we have tremendous flexibility on is leveraging our great balance sheet to help provide solutions for whatever it is. So whether it's our Cisco capital offers or the ability of us to build managed service-as-a-service, those kind of offers, we're very active working with our customers that want different ways to consume our products and services differently; that we're coming up with all kinds of new solutions for different ways of consumption. And we have that flexibility because of our strong balance sheet. So I'd say we're making a lot of progress on both of those accounts.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

All right, thanks, Vijay. Operator, our next question, please.

Operator

Okay, your next question comes from Simona Jankowski with Goldman Sachs.

Simona K. Jankowski - Goldman Sachs & Co.

Hi, thank you very much. I just wanted to clarify first, Kelly, in terms of the two percentage point bump that you've embedded in the guidance for the extra week, that compares to four to five points that you guys saw last time you had this kind of pattern back in 2010. So I just wanted to understand if there's anything different this time, or if that's just an extra measure of conservatism.

and just more for the substantive question, Chuck, I heard your comments on the pause on the campus switching side of the business. I just wanted to also ask. What is happening on the data center side of your switching business? Is that returning to growth in the first half of this calendar year as you had expected it to? Any update there would be helpful. Thanks.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

All right. So, Simona, on the 2%, yes, great question. Let me give a little context there. So the last time we had this was in Q3 of fiscal year 2010, and it was about a 4% to 5% increase. I'd say what I baked into my 2%, so it's roughly about $250 million – $275 million. What I baked in the guidance is the incremental revenue I know that we will get from things like our services subscription businesses, our SaaS businesses, as well as some products around the distribution that we are seeing. So that's what I baked in the guidance. I am not assuming there's going to be a lot more because of the current macro environment. The sales guys are out there, the teams driving to a monthly number and a quarterly number.

And given the spending constraints that we're seeing right now, I'm not being over-bullish in my guidance on that. So that's how I'd build that up. Just to remind you, back in Q3 of 2010, our growth that quarter was 27%, so it was a much different macro environment.

Charles H. Robbins - Chief Executive Officer & Director

So, Simona, just the second part of your question, I think the word that we would use relative to how Kelly modeled in that would be the same that we talked about with Vijay, which would be prudent.

On the switching front, from a revenue perspective, it was negative this quarter. We're trying not to give you lots of random pieces of information every quarter so that we can build some consistency in how you guys look at how we're performing. But I will tell you that on the new order side on the data center switching business this quarter, we did see slightly positive growth on orders. And I would say in the context of that last three weeks that we felt in enterprise that we're cautiously optimistic.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Okay. Next question, please, operator?

Operator

Thank you. The next question comes from Jim Suva with Citi.

James Dickey Suva - Citigroup Global Markets, Inc. (Broker)

Great, thank you and congratulations to you and your team at Cisco. My question is now that it's been a few months with the new partnership and Ericsson, can you let us know if you have actually had any concrete wins or anything (27:22) showing up in the NGN segment of reporting, or is it too early to see or any anecdotes about that new partnership? Thank you and congratulations.

Charles H. Robbins - Chief Executive Officer & Director

Hey, Jim. First of all, thanks for your favorable comments. I appreciate that. On the Ericsson front, we've seen – I will tell you that we've never seen – outside of Apple, we've never seen a partnership that has gotten so much energy and excitement inside the company. And as you know, on the Apple front, we are actually doing the development. I think Tim [Cook] alluded to it on his conference call that both companies are doing the development that we need to do to actually deliver that joint innovation to our customers.

But the Ericsson partnership has immediate opportunity with it, and we have begun to close transactions together. I would not translate that to a significant impact to any of the numbers that we put out there today because we're literally in the handful stage right now, but we do see that accelerating. We have a lot of focus on it with our teams. Hans [Vestberg], their CEO, and I are going to be together quite a bit in Mobile World Congress in a couple weeks, and we're also going to have a lot of the next-generation joint solutions that we are putting together for our customers that will be on display in both of our booths there. And Hans and I actually are on a panel together at Mobile World. So that partnership is going probably as well as we thought it would be at this point, and I think you'll really see the acceleration over the next 12 months.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Thanks, Jim, for the question. Operator, next question, please?

Operator

Thank you. Our next question comes from Mark Moskowitz with Barclays.

Mark Moskowitz - Barclays Capital, Inc.

Yes, thank you. Good afternoon. Just want to see if you can give us a little more context about how we should think about the routing glide path going forward the next few quarters given the nice growth you generated this past quarter. How much of it is related to the CRS-X cycle continuing? Does it have to do with more vertical penetration or service provider penetration? Just any color you can give us because what I'm trying to understand, can you still be in the 3% to 4% or 5% bogey for that business for the next couple quarters from a growth perspective?

Charles H. Robbins - Chief Executive Officer & Director

I'll speak to some of the areas of strength, and I'll let Kelly talk about the numbers and how we think about it going forward. But we did see strength in our core routing and we saw strength in enterprise access routing this past quarter. And we have some new products in our portfolio that are very early. And one of them was the co-development effort that I had talked about over the last couple of calls that we would expect to see some positive momentum out of over the next few quarters. And we've got some virtualized routing capabilities that our teams are working on. So I think the portfolio looks good. The pipeline looks good from an innovation perspective. And then, Kelly, any comments on how we think about the numbers going forward?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

I think you summarized it well, Chuck. Really, I think we feel fantastic about the portfolio and we feel good about what it looks like. But I don't really give guidance by business unit just because there's a lot of volatility. But I would say we feel really good about how the portfolio is sitting and the new products that we've launched on that platform.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Okay. Operator, next question, please?

Operator

Thank you. Our next question comes from Brent Bracelin with the Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you, one clarification and one question, if I could. Chuck, just could you clarify? Was the pause you saw with customers the last couple weeks, was that global or was that concentrated in the Americas?

And then my question is really around APJC, the recovery you're seeing there, the recovery you're seeing in China. What's driving that? Is that sustainable? Is that easy compares? Walk us through what you're seeing in APJC that drove the rebound this quarter. I guess, A, is it sustainable?

Charles H. Robbins - Chief Executive Officer & Director

Hey, thanks, Brent. On the pause that we saw, this is typical. When there's uncertainty in the market, we see enterprise customers, and they just basically say hey, look, let's just – let's wait. Let's see what's going to happen. They may say let's wait a week. They may say let's wait a couple weeks. And when you're in the last three weeks of your quarter, those kinds of decisions have an impact. So I just want to clarify.

And your specific question, we saw it pretty holistically I'd say around the globe. And then the other thing that we haven't really talked about is obviously outside the United States, we saw currency. We talked about it on the last call in Europe and Asia. That clearly continued and maybe even got a little worse in some places.

On the APJC recovery, the team there has done a great job. We've talked a lot about what we've seen happening in India. We've seen tremendous success there. We have – that's one of the key countries that we have a country digitization effort that John [Chambers] has been leading for us, and our business there continues to grow very well.

In China, which is the crux of your question, I would tell you that as we've navigated our way through the last three years, and I think, Brent, you and I have talked about the amount of time that I spent over there during that window, the team did a great job. And what they really did is they diversified our business strategy across customer segments, so not only being aligned to state-owned enterprises, but moving out and creating a commercial market strategy, moving out into second and third tier cities, so geographic diversification. And they really focused on their teams being able to sell our entire portfolio. So the good news is what I'll tell you is that the growth that we saw in China was very well balanced across our portfolio. We saw routing up. Kelly, keep me honest, but routing in double digits, switching in double digits.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Wireless.

Charles H. Robbins - Chief Executive Officer & Director

Wireless in double digits, as well as SP Video in double digits. So it was a very balanced performance for the second quarter in a row. So there's clearly a lot of uncertainty out there, so we're going to take things a quarter at a time, but we're pleased with where they are.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Kim, we'll go ahead and take the next question, please.

Operator

Thank you. Our next question comes from James Faucette of Morgan Stanley.

James E. Faucette - Morgan Stanley & Co. LLC

Thank you very much, just a couple of quick questions. First on acquisitions, you guys have been fairly active in the last few quarters. Should we expect this type of pace to persist both in terms of tuck-in acquisitions and maybe more detailed acquisitions?

And then the second question I had was security, it seemed like there was some acceleration in that business this quarter. Is that just the result of the SaaS model starting to accrue to the P&L, or was there underlying improvement in the billings and activity in that business? Thank you very much.

Charles H. Robbins - Chief Executive Officer & Director

Thanks, James. So let me comment on the M&A activity that you've seen. We have built a strategic framework that is guiding us for what we believe we need to have in our portfolio and the architectures that we need to be able to build relative to cloud, security, analytics, SaaS, IoT. We have built that framework with our team in the first two or three months that I was in the role. We then stepped back and looked at where do we have R&D activities that are going to build some of these opportunities, and where are there opportunities like what we saw with Jasper where we can move and actually fill a substantive portion of our portfolio. And so that's what's driving us.

It's very much connected to our broader strategy and connected to what I believe that our customers care about in the future. And I would say that you should expect us to continue the pace. And obviously valuations in today's market, that's one piece of good news, is that they're more attractive. As it relates to – I'm blanking on the second part of your question.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Security.

Charles H. Robbins - Chief Executive Officer & Director

Sorry, security, thank you. On the security front, I would say that it is primarily, and Kelly can just again keep me honest on the deferred piece of this if it's flowing through. But what we talked about was the integration of the Sourcefire assets as well as the Cisco assets as well as other acquisitions we made along the way, plus the other innovation that our teams internally have done. And that has – we put all that together about two quarters ago, and we told you that we thought that this would continue to improve, and our teams have driven that. And when you look at that advanced malware portfolio, and we added yet another 2,000 customers this quarter, so we're up to 10,000, which is they've really done a great job of executing on that strategy.

And then during the quarter, we also launched our next-generation firewall product that we need to get out in the marketplace for obvious reasons, and so we're hoping for similar success. But I think primarily it's because of continued improvement in the portfolio and the work our team has done. I wouldn't suggest that there's a significant revenue impact coming back in from the deferred yet, although we are seeing...

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

That's what we expected, what we said a couple quarters ago. So that ramp that we talked about a few quarters ago is happening in addition to the growth that you're highlighting in just the core businesses.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Kim, let's go ahead and take our next question.

Operator

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

Jess I. Lubert - Wells Fargo Securities LLC

Hi, guys. I also have two quick ones. First for Chuck, I was hoping you could provide some additional details regarding the weakness in the data center business, what changed there, how you expect that to progress moving forward.

And then for Kelly with respect to capital allocation, it seems like you have a little bit less than $4 billion in U.S. cash, yet you materially raised the dividend and the buyback. So I was hoping to understand if we should be expecting a debt raise, and to what degree this means any acquisitions we may see are likely to be on the smaller side. Thanks.

Charles H. Robbins - Chief Executive Officer & Director

Hey, Jess. So I'm surprised we got this far in the questions before someone asked about data center, so I was beginning to worry. We track that business very closely obviously. And largely what we believe is that it is connected to the broader macro issue. That data center business has a strong buying season that actually runs into the end of December. And while it is a fantastic franchise for us that has contributed and will contribute to not only our success in the data center in the past, but also our success in the next-gen data center as we build next-generation data center stacks going forward, but we also believe that in the December quarter that we actually still gained share with that performance.

We had a tough comp from a year ago, 40%. But I'll tell you the other thing we looked at is that even with the lower performance, it still remained the same percentage of our business this quarter that it was last quarter, that it was a quarter a year ago, which says that just in my mind, it says it suffered at the same rate that the rest of the business did from the macro. Kelly, the second part of the question?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

So on capital allocation, so overall, our strategy around capital allocation hasn't changed. We want to give a minimum of 50% back to our shareholders. We've been listening to our shareholders, and the bottom line is we feel very, very good about our business model and our ongoing cash flows. You saw our operating cash up 36% this quarter that we thought we'd increase the amount of our dividend sustainably going forward. So it's a blend. We also increased our authorization just as we would normally would increase our authorization, the $15 billion.

In terms of flexibility, yes, we will be accessing debt in the near future. Again, that's one of the benefits of our balance sheet, and our access to capital is very, very good. So we will continue to do that until anything changes with our overseas cash. But it does not change our flexibility in any way in terms of acquisitions. When we think through these capital allocation decisions, we're playing out what we're thinking about acquisition-wise, how we're building that out, as well as our future cash flow. So I think no change to our acquisition strategy. It does not hamper us in any way. We have easy access to capital. And again, we wanted to share some of that cash back with our shareholders.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Okay, let's move on to the next question, please.

Operator

Thank you. Our next question comes from Jeff Kvaal with Nomura Securities International, Inc.

Jeffrey Kvaal - Nomura Securities International, Inc.

Yes, thanks very much. I have a few margin questions, Kelly, for you, perhaps.

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Okay.

Jeffrey Kvaal - Nomura Securities International, Inc.

Can you talk a little bit about the drivers inside of the gross margin structure? It was a little bit ahead of plan this quarter. It seems to be going back to normal next quarter. And what are the moving parts there? The second part of that is on the operating margins. I know 30% is the target. When should we be thinking about that, and how much progress are you making in that regard?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Sure. So on gross margins, we continue to be very focused on margins, and we look at it as all the different levers in there. So as you know, we continually have some price erosion, and we use price as a lever to drive selling. Our price erosion has remained very, very disciplined. You'll see that it's been in the normal ranges that we have been in the last quarter and actually slightly better than a year ago, so that continues. We're getting real traction, continued traction from our engineers and supply chain on the productivity side. So for the price erosion we have, we're more than offsetting it with productivity, and we're continuing to drive those projects to continue to do that so we can have that flexibility to make sure we're taking advantage of all opportunities for growth out there. So that's continuing.

On the operating margin side, again, we're going to be smart about managing the overall equation. We want to make sure we're taking advantage and investing in the right areas to be able to take advantage of future growth and balancing that equation. There is a bit of goodness coming through at the OM line because of FX favorability that you guys are aware of that falls to the bottom line. But in general, I'd say that we're being very disciplined in terms of how we make these trade-offs and balance the bottom line with the investments we're trying to make to accelerate growth.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Thanks, Kelly. Let's go ahead and take our next question, please?

Operator

Thank you. Our next question comes from Ittai Kidron with Oppenheimer.

Ittai Kidron - Oppenheimer & Co., Inc. (Broker)

Thanks and congrats, guys, on strong execution. I wanted think a little bit ahead, Kelly, just given this extra week that you had in the guidance. Historically, as you move into your fourth quarter, you typically post a solid sequential increase quarter over quarter. As we lose this week, should we assume a little bit more of a flattish performance then into July versus April?

And then regarding the software and SaaS, clearly you're making very good progress over there. Is there a way to quantify, from your standpoint, how much of growth are you giving up right now as you transition businesses, more and more of your products, into those type of purchasing model, how much of a growth headwind this transition is impacting you near term?

Kelly A. Kramer - Executive Vice President and Chief Financial Officer

Sure. So on the extra week, this is, I think, how you can think about it. So I tried to be pretty transparent of what we're assuming in there. So literally, the $250 million or so, the $275 million that we're assuming literally is just the businesses where it's just going to – because we have weekly billing is going to amortize off our balance sheet. That is basically a guarantee, and just marginally a little bit more for some of the distribution and flow business. So I would say as you are modeling for Q4, I think you should assume the normal ranges. Take that out, that $250 million to $275 million, and assume the normal ranges of growth in Q4.

On software and SaaS, I know you and others ask me this question a lot. It's tough to quantify. Certainly it's a point or two easy to say off the top. Some of the businesses we're growing are businesses that we've had that are great, like collab and security. We are adding more to this profile with some of these different offers, like these big enterprise ELAs we have. It's just hard to quantify it for any one quarter of when it's going to fall in. But there's certainly something on the top line, but we'll see that come back through as we continue to build that out and amortize it.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Okay, Kim. Let's go ahead and take our next question, please.

Operator

Thank you. Our next question comes from Simon Leopold with Raymond James.

Simon M. Leopold - Raymond James & Associates, Inc.

Great, thank you very much. A quick clarification. Strength in Service Provider Video, I think you highlighted China. If you could, just talk to what you think the duration is.

And then in terms of market verticals, I was interested if you could talk a little bit more about your exposure to what we've often called Web 2.0 or Web-scale operators. Certainly there's the idea that they buy white box, but we know you sell to them. So I'd like to get a sense of your exposure and the trends from that group of customers, if we might.

Charles H. Robbins - Chief Executive Officer & Director

Hey, Simon. Thanks. This is Chuck. So on the SP Video front, I think that the team has done a great job of evolving that portfolio and really building some great solutions. They're engaged with lots of customers. Our strategy when we divested of the Video CPE business was to really focus on a cloud-based delivery model, and that is occurring. And we're having obviously good success with that platform in China. And that tends to be an ongoing – a longer-term solution that the customers deploy, so we'll see. Again, we're taking things quarter by quarter, but we feel good about where they are there.

On the second part of your question relative to the Web-scale guys, we've talked the last couple of quarters about how we had been having success with them. And I talked about us really changing our strategy about 18 months ago and moving more into a collaborative co-development mode with them thinking about what their very unique needs are. And I'll tell you that our business with them last quarter grew 17%, so we continue to see relatively good strength with those customers.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Thanks, Chuck. We'll go ahead and take our next question.

Operator

Thank you. Our next question comes from Tim Long with BMO Capital Markets.

Timothy Patrick Long - BMO Capital Markets (United States)

Thank you. Hey, Chuck, maybe just to go back to the data center, if we could, I get the macro and the tough compares there. Just looking more broadly at that market, I think the share gains are starting to normalize a little bit, at least in the server market. So when you think about the continued growth on the hardware side of the data center, do you think we need to broaden the server offering, maybe get more involved in storage or ADC or some other products that are important to the data center that Cisco might not fully be participating in? Thank you.

Charles H. Robbins - Chief Executive Officer & Director

Hey, Tim. It's good to hear from you, and that is a very good question. And what I would tell you is that we are currently – we have a lot of work going on around the future next-generation data center and what the future stacks look like in that data center, which will be a combination of infrastructure hardware with a heavy dose of software and orchestration. And you can assume that we're looking at our role up and down that stack going forward.

I would tell you that there was a recent article I think late last week, last week in InfoWorld where Biri Singh actually outlined how we're thinking about this market. So you're spot-on, and we are spending a lot of time thinking through what role we play there and what the opportunity is, but we believe it's going to be significant. So I appreciate the question. Tim, thanks.

Charles H. Robbins - Chief Executive Officer & Director

That was apparently the last question we have, so I'm going to close with just some short comments. I am incredibly pleased with how we executed this quarter. And as I said, in a very uncertain macro environment, our teams did a great job.

And as we look forward, I think about how we're operating the company on these two fronts. The first front is that we will continue to execute and run this company in a well-managed way, even in challenging environments. But at the same time, we're going to move full speed ahead. And the second front is we are going to make the long-term investments and build our strategy and the architectures and the solutions that our customers need. And I believe that our growth will accelerate as our customers embrace and move towards this next wave of technology that's going to fundamentally change every company and every country around the world.

I believe we can do both, and I think that will allow us to take advantage of the incredible opportunity ahead of us, and I have a great deal of confidence in our ability to execute against that.

So thank you for spending time with us today, and we look forward to talking to you soon.

Marilyn Mora - Director-Global Investor Relations, Cisco Systems, Inc.

Thanks, Chuck. Cisco's next quarterly call, which will reflect our fiscal 2016 third quarter results, will be on Wednesday, May 18, 2016, at 1:30 PM Pacific Time, 4:30 PM Eastern Time. And again, I'd like to remind audience that in light of Regulation FD, Cisco's policy is not to comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

We now plan to close to call. If you have any further questions, please feel free to contact the Cisco Investor Relations department, and we thank you very much for joining the call today. Kim, go ahead.

Operator

Thank you for participating on today's conference call. If you'd like to listen to the call in its entirety, you may call 1-888-562-6191. For participants down from outside the U.S., please dial 1-402-280-9986. This concludes today's conference. You may disconnect at this time.

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