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Cisco Systems, Inc. (NASDAQ:CSCO)

Cisco Services Business Webinar

May 31, 2012 8:00 am ET

Executives

Matt Hardwick

Nick Earle - Senior Vice President of Customer Advocacy European Markets and Global Enterprise

Analysts

Grady M. Burkett - Morningstar Inc., Research Division

Matt Hardwick

Hearing about the slight technical delay we have there for a couple of seconds, but hopefully, you should be hearing us now.

Okay. Hello, everyone, and welcome to this webinar focused on Cisco Services. My name is Matt Hardwick, International IR Manager for Cisco, and I'm joined today by Nick Earle, Senior Vice President for Worldwide Services Sales; and Grady Burkett, equity analyst for Morningstar. Thank you, and welcome to you both.

This webinar is one in a series hosted by Cisco Investor Relations to help aid and educate our investor audience and larger stakeholder audience on some of the many areas of Cisco's business. As is our practice, the webinar will be recorded and available for download from the Cisco IR website at the conclusion of this call.

May I remind you, the audience, that in -- may I remind the audience that in accordance with Reg FD that there will be no update on the cautious performance or any update to guidance given during this webcast, and the following presentation and subsequent Q&A may include forward-looking statements. These statements and projections are only predictions, and actual events or results may differ materially. Please see Cisco's filings with the SEC, including its most recent filings on Form 10-K and 10-Q, for a discussion of important risk factors.

For today's session, we will begin with some prepared comments by Nick and then move to a Q&A session moderated by Grady and on to an open Q&A session. [Operator Instructions]

Now with the housekeeping rules out of the way, I'll turn the call over to Grady. Grady, over to you, please.

Grady M. Burkett - Morningstar Inc., Research Division

Thank you, Matt, and thank you, everyone, for joining today's discussion. As Matt mentioned, my name is Grady Burkett, and I'm an equity analyst covering the data networking industry at Morningstar. I'm glad everyone could join us today to learn more about Cisco's Services organization.

As those who follow Cisco closely know, the firm's Services business has delivered consistently strong revenue growth and gross profitability over the past several years. Recently, Services' revenue growth has sort of decoupled from product revenue growth, and Cisco Services now account for 21% of the firm's total revenue. So this business is approaching $10 billion in annual sales.

Here at Morningstar, we feel that Services are an important component of Cisco's competitive advantage. And so I'm really excited to be learning more about this business today, and I think it's going to be increasingly on investors' radars as time goes on.

With that, I'm very pleased to introduce Nick Earle, Senior Vice President of Cisco's Worldwide Services Sales group. Nick has held various leadership positions with Cisco since joining the firm in 2004, and he has nearly 30 years of experience within the IT industry. Nick's career includes 18 years with Hewlett Packard, where he ran global marketing for HP's enterprise computing business. I'm sure many of you met Nick at Cisco's most recent Financial Analyst Conference, and I'm very pleased that he's chosen to provide his current perspective today.

Nick, I'll turn it over to you.

Nick Earle

Thank you, Grady, and good morning or good afternoon or evening, wherever you are. So I'll -- just 15 minutes. I've got about 5 or 6 slides just to give you an overview, and then, as we said previously, we're going to open it up for Q&A.

And just to set the context, and I'm sharing the slides on WebEx, as Grady said, it's been an interesting journey. In fact, over the last 10 years, what we've done is we've very successfully grown the top line of our Services business from FY '01, you can see there $2.7 billion, to FY '11, last financial year, $8.7 billion. And we've done that through changing our value proposition from break-fix to, increasingly, software, which I'll major on in this call.

However, perhaps more interesting for this audience is the fact that we have significantly increased the gross margin in that time, and the gross margin in this period has gone from 63% to 67%. And it raises one of the big questions is that, given that 10 years ago we were a purely a maintenance business break-fix, and in that time, we've added a people consulting business of just a bit north of a couple of billion dollars. Traditionally, consulting businesses have lower margin, a dilutive effect.

And so one of the key points I want to answer from an investor perspective is how has Cisco Services grown, not only grown the business faster than the product business consistently over the year, 10 years and continues to do so, but also at the same time, consistently increase the bottom line whilst creating a people business? And the short answer to that question is that Cisco Services is primarily, and it’s our key differentiator, a software-based business with leveraging intellectual capital, our intellectual capital that we have about our products as well as the people business.

And it helps to answer the question as to why we've not -- you've seen us -- not seen us acquire a 100,000-person consulting company, because our strategy is not to do that. It's to differentiate through software, and I'll deep dive on that. And it's very relevant in terms of the world that we're moving into because the cloud world that is emerging and Cisco's strategy point of view is that it will not be just a pure public cloud nor a private cloud, but a hybrid cloud with SPs and SPs, money service providers, providing public cloud-type offerings, large enterprises building their own private clouds and user endpoints increasingly going to smart devices, BYOD. It's actually a world that is very much enabled by Services.

So the first part of our business, one of the strongest demands that we get is to help companies build this world. So the large top-right of the slide a service provider saying, "Can you help me build and also operate?" We do help service providers operate their networks in many cases, because we've got the intellectual capital for them to be able to operate this in a proactive and preemptive way, particularly the management layer of what many of you will know as ITIL, I-T-I-L, ITIL services, like configuration management, software management, compliance management, asset management, trouble ticket management. That's the real key issue in this very realtime world. So we help them build and operate.

End users, we help them design their environment, such the workshops you see down the bottom. We help them convert their infrastructure to be cloud enabled. We help them adopt and implement and roll out. And in many -- and in some cases, we're actually hosting cloud services direct from Cisco. So we are also running voice, contact center, video for several major corporations, which -- all of which creates an annuity business for us.

In fact, the annuity -- one thing that clearly differentiates the Service business from just pure product business is annuity. You'll have seen from our public disclosures that our -- Cisco's total deferred revenue last quarter was $12.65 billion, of which $8.78 billion, or roughly 70%, was Services. So Services is a very big annuity, profitable business, and many of the Services that we sell in this world are in, of course, annuity services, subscription annuity services.

But there's something else that's happening, and to me this is next slide is the key one, and that is that in a world where you have hybrid cloud, then the -- it requires a new model for service management. And just the analogy I'll use, and I did talk about this at Financial Analyst Conference, if you just think about your car, you can't service your car yourself. A mechanic can service your car. Your car is no longer reactive. It's proactive and preemptive. Your car contains at least 300 million lines of code, often 12 IP ports, and your car tells you when it's got a problem. And in many cases, the manufacturer fixes it because before it goes wrong.

The same thing in the world of hybrid cloud is going to happen to service management. This is the section which Gartner, for instance, called RIM, remote infrastructure management. Forrester, down at the bottom, talking about ITIL moving to software-based from people.

So the world of end user IT departments, large IT departments and service providers is increasingly moving to software because of the need to be reactive, to take reactive support, it's broken, so I'll fix it quickly; into proactive, do this before it breaks; or preemptive, I have fixed it as the manufacturer via software, and, therefore, I'll give you a guarantee it will never break.

When you do reactive, proactive, preemptive, one of the key ITIL process that you manage is asset management, which means the customer lets you choose the hardware. That is really key, because it shows that the -- there is a direct linkage between services relevance and Cisco architecture pull-through, that if you say I'll guarantee the network for you, I'll guarantee its performance, then -- and let me choose the hardware, let me choose the upgrades, then this is a really key point.

This is not outsourcing, where you own the assets and you 2P the people. You transfer the people over. That is a market that is fragmenting, and all the data shows that. It's breaking up. It doesn't drive innovation for the end user, and it also drives lousy margins for the people who are in that business. So the outsourcing market, which has various estimates of between $60 billion and $80 billion TAM with regard to networking, is fragmenting into a series of service management offerings. So it's not just technology as a service. It's ITIL processes as a service, where you're leveraging your intellectual capital.

And on that point, that is really, that's the nerve of our Services strategy. It helps to answer this question, how do we grow the Services business faster than the product business and the margins faster at the same time? And the reason is that, increasingly, everything that we're doing is around our strategy called Smart Services. What Smart Services is, is the ability for -- to discover what's in the network as a probe, discover what's in the network to analyze it, its software, to correlate the information you get based on your internal, intellectual capital that says I know how to fix things. I know that if you do this, you will get the following outcome. And then you turn that into a new service that you tell to the user, which says, why don't you let me manage that? So essentially, you go on this reactive, proactive, preemptive journey with your customers.

And you can see that down the bottom of the slide, we have made many announcements in that. First of all, our -- 65% of the boxes, broadly, on the global Internet are -- have a Cisco badge on. We have the franchise for the maintenance of the majority of the Internet. That's a very nice business. And that -- and our brand that we use for that is SMARTnet, but SMARTnet is a reactive, box-based support business. We've just announced that SMARTnet has now been upgraded to Smart Net Total Care, which is Smart Services embedded within our existing support structure, which is several hundred thousand existing support contracts.

We also made some key acquisitions around what we call Cisco Intelligent Automation space, or CIAC is the acronym we use, and this is, for instance, in the data center space, where we do automatic provisioning and automation, orchestration, acquisitions such as Tidal, newScale and LineSider, which really gives the business benefits for UCS around provisioning and orchestrating applications using software rather than people. Helps explain why UCS is gaining so much market share, because people haven't got enough time to provision the applications in this world. If you think about it, when you just press that little icon on your iPhone, you don't -- there's no time for someone to orchestrate the resources, the CPU, the storage, the operating system. That stuff is moving from people to software. And so automatic orchestration is a very big deal, and it's one of the reasons why UCS is growing so well.

And then the final icon, down the bottom-right side, is network configuration and compliance management. And just to give you some indication, we take 6 million phone calls a year in our Services businesses, and 60% of them are configuration questions, configuration questions. And so by automating that, and you'll see on the next slide, we already have automated 80% of our -- all of our Services business. So of those 6 million, 80% are managed by -- handled by software, not people. If you then turn that into a service, you can offer configuration and compliance as a service to the industry. And that is a -- and another example of an ITIL process, 2, actually, in that case, that will become a service.

And from a differentiation point of view, this is clearly something that only we can do, because, as I said, for 25 years, with the franchise on the majority of the world's Internet, we've been automating this. We're now with 200 billion of installed base net out there. We actually can do -- handle -- our Services business does 80% through software, not people. Again, that's why we didn't buy a 100,000-person consulting company. There are many manufacturers, some of them of the Asian variety, who will put a lot of people in to solve issues at low costs. But we're fundamentally betting that software beats people.

And intellectually, the biggest -- with 2 assets that we've got, which are -- which we believe are very sustainable is, one, the install base. The highest percentage of install base you have, the highest knowledge you have of how to do this. That's your intellectual capital. Second asset that we've got is the fact that we've already automated 80% of our global Services business. So if you combine those 2 assets together, you're in a very strong position for this new world of IT service management, which is a very fast-growing area and is absolutely dependent on intellectual capital and relevance. And so that's why we believe that we're in a great position to do this.

And the final thing I'll say before I open it up is that if conceptually you see that -- we believe that in the world of private -- of hybrid clouds, there's a new control point. It's very consistent with our software-defined networking strategy that we also did an update on yesterday, the programmable Internet. But in this world where the management layer becomes a really key control point, then what we've got to do is leverage the other asset that we've got, the third big asset, which is our channel. And just some stats on the screen there. I don't intend to go into them. But we clearly have -- are famous for our channel strategy and our very loyal channel base.

By the way, channel partners make 70% of their profit through their services business and 30% through hardware resale. So when a vendor calls on the channel partners and says, sell our box, the channel partner wants to know what the service model is for the box. So our strategy is to maximize our partner's services profitability by franchising the Smart Services software through the channel.

Okay, so if you -- what we did, and some of you may be aware of this, at our global Partner Summit in San Diego, just about a month ago, we announced a global program called Cisco Services Partner Program, which has 2 components: a Cisco Services resale. You can resell our Services, and you can see -- you make the rebates up to 24%; or you can create your own services by doing API integration into Smart Services. In other words, if you want to be a big cloud provider, we will franchise this software to you with APIs, where you will embed it in your own offerings. So we become sticky in the partner's service offerings.

By the way, somebody's not on mute and is typing quite loudly. If they could just go on mute, I would appreciate it.

So the idea is rather than just to say, well, the Cisco Services and there's this huge partner ecosystem and partner's new services, the new model is, it's like Intel Inside. Whichever device that you bought in the PC industry, there was the common chipset. This is Cisco Services software inside our channel model, which, as a reminder, drives 70% of their profit, because people get turned into software. The more of this software they adopt, the more profit the channel partners make because they need less people, which means the more loyal they are to Cisco, which drives Cisco architecture preference.

And so what you're seeing on this final slide, well, before the summary, is a slide actually from one of our largest global partners that basically said on the right -- and the name's been protected, but on the right there, a very large global partner is making a very aggressive move into cloud. On the right-hand side is all of the things they see as their value add, so multi-vendor, for example. That's how we avoid being in multi-vendor, because the partners do it. And on the left-hand side is our Smart Services stack. And by using the API integration, we actually build joint stacks with our partners. So they pull through Smart Services. They make more profit, which, in turn, means that they promote Cisco architecture. And that's that piece at the top you see, Cisco architecture preferred strategy.

So it's also -- Smart Services also has a huge implication on channel relevance. So the 3 assets in summary that we're leveraging is the installed base, 200 billion, about 65%, 70% of the Internet globally; second asset is 25 years of supporting it, where we're now doing more than 80% through automation; and the third asset is the world's largest ecosystem of partners.

I've gone through that pretty quick. But I just wanted you to understand kind of what's under the cover and how do you grow the top and the bottom line of a Services business whilst at the same time, clearly, you're adding people, and the answer is because of the software automation strategy. So it has been consistent top and bottom line. You saw our Q3 numbers. Our CAGR over -- for revenue over that 10-year period is 12.3. In Q3, it was 13. You saw our margins in Q3, which were north of 67. The hybrid cloud architecture is also going to grow the service management marketplace, and the key there is who's got the intellectual capital. And obviously, the vendor is in the greatest position to do that.

Smart Services turns -- I like -- I call this -- the analysts haven't named it that. I call it service as a service. When you think of x as a service, people say, oh yes, voice as a service is this term, video as a services is this term, infrastructure is this term. This is service as a service, which is actually a much bigger term than any of the technology pieces. And then we're leveraging that through the global ecosystem, which is why you will not see us -- we have no current plans to make a 100,000-person, for example, acquisition, because we believe we can continue this strategy by leveraging software through the ecosystem as opposed to compete with our partners.

So I'll leave it there. And, Grady, I think we're at the point where we can open it up for questions.

Question-and-Answer Session

Grady M. Burkett - Morningstar Inc., Research Division

Okay. Nick, as we wait for questions to come in online. I'm going to lead off with a few. First, you alluded to the fact that Cisco has the largest installed base out in its customer environments, and so we've been surprised to see the growth over the past several years of Services. And can you talk a little bit more about how Cisco is penetrating this installed base more with Services, how you're driving that growth, and how you expect that to play out over time?

Nick Earle

Yes. In the box support world, which every vendor is in, not all customers put all boxes on the contract. In fact, I talked about this at FAC, Financial Analyst Conference. Of the 200 billion installed base, which, by the way, is net value of installed base based on about 7 years. People keep products for about 7 years before refreshes, but with probes in the network, we can correlate that number. And what we actually found is that very interestingly, only 60% of that is under any form of a support contract. So a simplistic view would say, wow, that's great. If we can just find it, then customers will give us more money. Well, they don't, because they say, I'm actually quite happy to only support 60% because you guys have got a great support business. Cisco wins a lot of accolades for support. But when you then say, well, if we -- if you actually put all of it under contract as opposed -- again $100, if you put $100 on the contract as opposed to $60, I can then use Smart Services to give you an SLA, where I'll guarantee the interim performance of the entire network, you're moving the value proposition to -- from reactive to proactive or preemptive. And the value of that in this hybrid cloud world is actually worth the -- any premium to put the additional boxes under contract. Now I have to do the caveat here. It's not a linear relationship. In other words, if you find 20% more boxes, we don't say, okay, I'll pay 20% more. But it's certainly an incremental relationship. So there's an incremental relationship to supporting the entire network because again, back to the analogy, your car company supports the entire car, not just part of the car. So what we're doing is there's a flywheel effect by actually Smart Services, on the one hand, creates a form of annuity revenue around ITIL processes such as configuration, but what it really does is pull through more of your core offering, which is maintenance on the install base. So just as voice sold more routers and switches, Smart Services sells more maintenance. And that flywheel effect is actually the prime driver of the growth dynamic that you referred to.

Grady M. Burkett - Morningstar Inc., Research Division

And as you move your customers from reactive SMARTnet to Smart Services and into broader service level agreements, can you describe that process, the length of that process, the success you've seen out in the marketplace?

Nick Earle

Yes. Let me pick a segment, which is absolutely doing that, and that's the SPs, the service providers. And the reason -- they're the lead pin in the bowling pin analogy. They're the lead pin. The reason is because they're the guys who are moving all of their models to the cloud. By the way, I'm doing this broadcast from Miami, and the latter market is absolutely -- A, it's booming from GDP point of view. Everybody knows that. But the SPs here -- it's very SP-centric market, and all of SPs are moving to cloud very, very rapidly, as they are in other parts of Asia, for example. So in that world, the -- they're all competing with each other based on, clearly, price and value. So the first step is that we upgrade our core offering, which is by a no-cost upgrade. When we renew the contract, we renew it as Smart Net Total Care as opposed to SMARTnet. So that gets you the probe, the discovery probe, and it gets you some basic ITIL processes like software update management, security management. Then what we have is a set of additional services they can buy, where they make the choice between whether to do it by hand, which really is by person, or to do it by software. Software beats people. And the car analogy, core software beats people. So broadly what we find is that the renewal value of a contract will go consistently up year-on-year. It's funny, as I was tracking that this morning for some of our major SPs. If you look back 3 or 4 years at the amount that we would collect from a Services point of view and the amount that we're collecting now, there's a very definite -- it's not a 1:1 correlation between the amount of additional product that's going into the SP and the additional services. They're spending more in services as they're adding more of these Smart Services on top of the core SMARTnet. Just from a TAM point of view, just to understand why that's got legs. There's lots of data out there that says customers, let's take service providers, spend 6x more on operating, managing, maintaining and running networks than they do on buying networks. So if Cisco sells, say, $35 billion worth of hardware in any 1 year, the customers, end user and channel partners or SPs, MSPs, will spend $200 billion managing that. So Services is, as a TAM, 6x bigger than product. The -- most of that is currently being satisfied today by people, IT departments in service providers, IT departments in end users, IT departments in channel. In the future, increasingly, and this is an industry thing, not just a Cisco thing, people will become software. And as people have to drive their cost down on BOYD, they have to collapse the cost of running their IT department, which means mass virtualization, UCS, for example, but also they have to collapse the cost of their people, because it's the OpEx cost, not just the CapEx cost. So you have a people dynamic and an SLA dynamic kicking in at the same time. So typically, what's happened is you will -- if you -- the service management market will continue to grow for all vendors. We talk about our intellectual capital, but everyone's talking about this. Starting to call it RIM, remote infrastructure management. Because what's basically going to happen is that people maintaining networks is going to increasingly move to a people-plus-software world. So the answer to your question, Grady, is that we constantly add more Smart Services into our relationship, which constantly allows them to collapse the cost of operating, managing, running, maintaining the network service management and, at the same time, brings us more of an annuity business year in, year out. And in return, we get to cover more of the network, which reinforces our core offering. So that's sort of the dynamics as to what's really happening in the Services business.

Grady M. Burkett - Morningstar Inc., Research Division

Okay. And I guess just to follow up. As the SPs spend more on services to support hybrid cloud in this transition, I suppose an argument could be made that the enterprises could potentially spend less. Can you talk about how that shift occurs over time and what you're seeing?

Nick Earle

Yes. What we're actually finding is that the enterprises spend less on people. They actually spend more on services. So -- and because it's a hybrid cloud world for a hardware, it's also a hybrid cloud world for service management. So the end user uses Smart Services software to be -- to run their own environment, which they're trying to get to look and behave like an SP. The MSP, I mean, it doesn't have to be a telecom company, could be a major channel partner that's becoming a managed service provider, they spend more. So you think, well, okay, it's got to come from somewhere. People have got less money. Where it's coming from is people being converted into software, and so both sides grow. It's not just one. But the dynamic, the lead pin is that somebody somewhere has got to be competing with somebody else to do this first. And right now, it's the SPs. For instance, let's say, deploy video in 4G, I mean, absolutely. Video has got very low tolerance for dropped packets. There's nothing worse than bad video. So if you want to manage the network to deploy video, you've got to do that with software. You just haven't got time for people to try and tune a network. So as technology becomes more and more network-centric and becomes more realtime, and you get the Internet of Things, the BYOD, all of these big changes are actually driving a different service management model in the marketplace, which, in turn, is playing into our strategy.

Grady M. Burkett - Morningstar Inc., Research Division

And just to shift gears quickly. I know there's a lot of uncertainty out in the market now, and we were really surprised as we look at this business in the resiliency of this business during the last recession. Gross margins actually improved as the recession moved through. Services revenue growth was strong. It actually stayed strong through 2010 as your products business recovered. So can you talk a little bit more about what drives -- the characteristics of the business that drives that resiliency?

Nick Earle

I mean, yes. I mean, broadly in 2 levels, the Service -- I mean, clearly, a services business is an annuity business which has momentum. It's actually relatively independent to new product sale. I've encouraged people when they look at us to have a bifurcated model to analyze us. Because on the one hand, you can see how much hardware Cisco sells, and that's a great story, and other people do the briefings on that. But on the other hand, the Services business has momentum. And of course, when you take the maintenance -- you take a maintenance contract for $12 million, you recognize $1 million a month. So the 90% plus of the Services business is independent of how much product you sell that quarter because of the annuity effect. So you have a timing effect. When -- as product goes up and down, which it does, Services tends to be more, for any company, but certainly for us, certainly, Services tends to be more stable because it's annuity business. The way you have -- at any one time, most of the business is already in backlog. So it's more like in excess [ph] of services-type business, where you're looking at adding contracts for future revenue, as opposed to a transactional business, which is where you recognize it all within the quarter when you ship, actually when you invoice. So that's why one dynamic is that it's a services business versus an annuity versus a very predictable annuity versus a transactional business. It doesn't tend to grow as fast, but it also doesn't tend to drop as much as -- that's just generic services hardware. But secondly, I think the primary driver is that as economic conditions turn downwards, there's more pressure on budgets in end users, which means the idea of converting people into software is even more attractive. Add BYOD, iPads, smartphones, Internet of Things, and suddenly people say, I need a new model for this. And I think that actually is the -- is the primary driver of what's happening, and that's going to happen for a long -- that's going to play out over multiple years going forward.

Grady M. Burkett - Morningstar Inc., Research Division

Matt, we can open it up, or I can continue.

Matt Hardwick

I do -- I have a couple of questions, but if you've got one more before we open it up, then feel free.

Grady M. Burkett - Morningstar Inc., Research Division

Okay. As we -- Nick, as we look forward and think about how this business is going to align with management targets, growth targets that were set out in 2012, and obviously, they started -- or in 2011 and they set a 3-year target for the overall business of 5% to 7% revenue growth. How comfortable do you feel with the Services organization's contribution to that target today relative to last year? And could you touch on that?

Nick Earle

So, Grady, of course, you know that I can't comment on any future-looking, whatever. But in terms of the spirit of the question, I just come back to the fact that -- like I said, I'm here in Miami, and it's a booming GDP economy, Brazil, for example, et cetera, et cetera. But I spend most my time -- I'm based in London. I spend most of my time on an airplane, actually. But I'm based in London. And even if I went to Spain, which is a terrible economy, we're seeing strong demand for this. And so the -- it's -- although, clearly, our business from a Services point of view, is affected by GDP, I mean, clearly, it is, I think that the fact that -- I come back to the 3 assets. It's -- if you were looking at our business from the outside, which is what most -- almost all of this audience is doing, the question is, what is our sustainable competitive differentiation that we've got in light of all the things that's happening in the world economy and technology and et cetera, et cetera? And you can look at competitors, and they say, well, they can do this, and they can do that. And that's true. We've all -- I've been, as you said, been in the business for 30 years. I've seen tons of things go in. But the -- as business models becomes network-centric, whoever knows the most about the network is in a pretty good space. Secondly, if you can then have a track record of already being able to do 80% of this -- [indiscernible] this problem is software, you can create multibillion-dollar software businesses where people go to websites. That is a very nice model as other companies have done it. We're actually the most advanced hardware company to be able to do that, and there are a lot of hardware companies in the networking space who have no Smart Services strategy. They have a cheap people strategy. And so to leverage that software knowledge is that intellectual capital is one of the most valuable things we've got. If you then add it on to a track record of always selling 80% of everything you sell through a partner ecosystem and you understand that 70% of the partner's make -- partners make 70% of their profit from services, then if you can make that profit go up through software and you then take a look at the business and say, well, hold on a second, despite economy's going up or down or technology shifting left or right, we've got 65%, 70% of the Internet, which you have the support contract on. Secondly, you've got software capabilities that will solve the cloud problem with regard to management. And thirdly, you've got over 300,000 people out there who make their living selling your stuff, then you feel pretty comfortable about a long-term strategy to grow the Services business. That's the best way I can answer it.

Matt Hardwick

Okay, Grady. Look, I do have a couple of questions that have come in over WebEx while we've been talking. And I think, Nick, one in particular from a buy-side investor, which was, can you provide a bit more color or detail on which segment is particularly progressing more quickly? I presume they're commercial or enterprise, government. It's public sector. They've also asked for an example of a recent competitive win, which I'm not sure if we can provide without naming names. But if you've got that, it certainly would be great. But certainly, some additional color around the sector would be great.

Nick Earle

Yes. So although what I've described is horizontal in nature, it applies to every customer. People converting into software to do IT service management is a horizontal opportunity. The fact is that the bowling pin piece of this, there's always one segment at work. So the -- I've already said this, so the SPs absolutely want to move to this. And so if you, John Chambers in the analyst call says, the last 2 or 3 -- said something which is he sees that, increasingly, service providers are standardizing on Cisco end-to-end. And now there are many reasons for that, and lot of the reasons for that have to do with our technical capabilities from a hardware perspective. But if you can actually make the management of the infrastructure better from a one-stop-shop point of view, then you actually -- the services has a direct correlation on hardware infrastructure choice. So if you're looking for examples of Smart Services -- and remember, our entire global support contract database is now taking Smart Services. So it's not like we've got this line of business and we've got a Smart Services business. We're putting Smart Services capabilities into our existing portfolio. So you don't -- so everyone gets a Smart Services. But the people who are using it in anger are primarily service providers. Pick any of them, because you can see, any of the big ones are using this because that's what they get from us. And secondly, what I would say is we're starting to see large enterprises use it to break the outsourcing contract. So I'll use a example of a very large bank in America, which has a very large outsourcing contract with HP of north of $1 billion a year, and they realize that, that outsourcing contract, they own the assets and they own a lot of people, classic outsourcing. But what the bank is actually paying for is they're paying for people to manage the network as part of the contract. So by actually getting the HP to use Smart Services, they're actually reducing their cost of the outsourcing contract without having to take the assets back. And if you think about that, if people outsource for a reason to lower their costs, they've got their assets off their books. But in this world of hybrid clouds, they can't afford to bring the assets back. So there's a lot of outsourcing contracts out there. $60 billion-$70 billion of networking outsource contracts are in the market. And what people are saying is, I don't want your mess for less because I've got to drop my cost. And I want more innovation, but I can't afford to take it back. So there is an emerging opportunity for end users to ask that their outsourcers embed Smart Services in their contracts to drop the cost and give them a proactive, reactive, et cetera, et cetera, SLA. So I would say, right now, the answer to the question is the people who are using it in anger are our channel partners. That was that slide I showed where the 2 things merged. The channel partners say, this is a great opportunity for me to sell new services and make more profit. But now we're seeing end users say, not only could I use it to reduce my IT department, but actually I could use it to manage my outsourcing contracts better. And again, there's a lot of research out there, Gartner, Forrester, IDC, have written a lot recent reports about how the world's outsourcing market is going to change. And some people call it thin-layer outsourcing, some people call it ITIL outsourcing. But classical your-mess-for-less outsourcing is a market that's going to fragment and splinter and become ITIL process-based, which is what I mean by service as service. And so I think that that's something that people should keep their eyes on, because there is an enormous outsourcing market out there that is going to have to move to automation.

Matt Hardwick

Nick, now I do have -- I have one more question, which -- from the WebEx, which was, kind of how deep does Smart Services go, in particular, within the product portfolio? It's obviously across routing and switching. So how deep into the...

Nick Earle

Good question. First of all, it goes across all of our products, because we have the intellectual capital in all of our products. But let me actually go deep on the question of deep. It actually goes into IOS. So there are several million lines of code in IOS, our operating system, which actually are the smart hooks for Smart Services. When I talk about API integration, the -- you're integrating into IOS through the API hooks. We have a whole portfolio of published APIs where you can write a software realtime interaction with IOS. But then -- but we also design ASICs. So actually Smart Services, we're creating products that are smart out of the box. We can create Cisco hardware that is optimized for Cisco Smart Services. So this is not just a case of somebody saying, well, I can copy this. I've got lots of money and people. I'm going to launch Smart Services, which is anybody can. The real question is, who's got the intellectual capital, who's got the intellectual capital, the knowledge, like Google have the knowledge of the search, that -- which they monetize, who's got the knowledge. What we have got is the -- we are now changing the ASIC design, the IOS design so that products are smart out of the box. And just an example of that, by the way, people looking for proof of that, one of the offerings is Smart Call Home, where the box calls us when it overheats or it starts to get a bit wobbly or starts to -- it's pattern matching. It's heuristic algorithms based on pattern matching. And so Smart Call Home is a standard feature on a large part of our box. In the same way as your car will tell you if the air pressure is low in a tire. It's a standard feature in a car. We're putting standard features literally out of the box in this case. So it goes deep from a technical point of view. And again, the SDN, software-defined networking update that we did yesterday with Morgan Stanley, is exactly along the lines of this as well, because you can put new functionality in the operating system layer, which enables the management capability.

Matt Hardwick

Great. Okay. Look, well, I don't have any more questions my end, so -- and we are getting almost back to the top of the hour. So what I'll do I think if we wrap it up there. And that is...

Nick Earle

Unless Grady has another question.

Matt Hardwick

Grady?

Grady M. Burkett - Morningstar Inc., Research Division

I guess, if I may, just one last question on how this is affecting your competitive position, particularly from the channel space. I know we've seen some entrants in North America. How do you feel your channel is reacting? And how are they perceiving your services now relative to the competitors?

Nick Earle

Yes. So we had our global partner program, San -- conference, San Diego. We had about 2,500 physically there and about another 2,000 or 3,000 virtually there, and we announced our new global Services program. I showed a slide of that CSPP, Cisco Services Partner Program. We took 47 existing programs, collapsed them down to 1. And that 1 program gives them Smart Services in the way that I described. So there's a lot of public information there about -- if you look at the press and the analyst reports and the Twitter feeds, 60% of all of the feedback from Cisco's Partner conference was based on Services. And a lot of very, very positive comments about this, because what the service partners were saying is, we've changed it from a those [ph] and then I have my service offering. Cisco has theirs. And when I engage in the field, am I competing with your sales force, to a world where that slide where the 2 stacks came together. If a partner sells it and takes the paper and takes the prime or does the invoicing, hey that's fine, because they're going to pull through the Smart Services, which gives us an opportunity to actually get the software. The key for this is how fast can we deploy this? That -- my challenge is how fast that we clearly, intuitively -- of course, we've got the intellectual capital. I mean, of course, we've got -- we make the products. The challenge is how fast can you deploy this into tens of millions of customers. So you need a scaling engine. So the channel piece is really important. If you can get the channel partners wanting to resell this and give you annuity revenue back in return, you've got a scaling engine. So that -- the new partner program is designed to do exactly that, and so we actually showed the partners how their profitability will go up if they use this software to enable their process. So again, I want to stress this. This is not a binary -- people should not just say, oh, wow, spreadsheet, change the variable. This is -- I encourage people to look at a long-term trend. If you take smartphones, Bring Your Own Device, consumerization, Internet of Things, cloud, and then you think what's going to happen and think about the service management layer, then you'll see over a multiyear year period that there's a trend here. There's a sort of flywheel effect. And so that -- this is a long-term consistent strategy as opposed to a, hey, we've got these new things, so next quarter, we'll sell x amount of it. It's a strategy for the Services business, which helps explain your opening comment that over the last -- I mean, Grady, you've noticed, over the last few years, there's clearly something happening to our Services business, which is perhaps people haven't thought about, because they've been looking at the hardware business. And so that's -- I think that's actually -- that's what I've attempted to explain in this, and hopefully, I've explained it well. Thank you.

Grady M. Burkett - Morningstar Inc., Research Division

Thank you, Nick. Great.

Matt Hardwick

All right. Look -- yes, thank you, Nick and Grady for you both for taking out the time out of your schedule to host this informative and interesting webinar.

As a reminder, to those people listening, a replay of this webinar will be available for download from the Cisco Investor Relations website at investor.cisco.com shortly after the conclusion of this session. I would like to remind investors that the next quarterly results announcement for Q4 FY '12 is set for Wednesday, the 15th of August.

And with that, I'd like to draw this session to a close. Thank you all.

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