F2Q08 Earnings Call
February 6, 2008 4:30 pm ET
Blair Christie - Vice President, Corporate Communications and Investor Relations
John T. Chambers - Chairman and Chief Executive Officer
Dennis D. Powell - Executive Vice President, Chief Financial Officer
Rick Justice - Executive Vice President of Worldwide Operations and Business Development
Frank Calderoni - Senior Vice President of Customer Solutions Finance
Ned Hooper - Senior Vice President of Corporate Development and Consumer and Small Business
Pankaj Patel - Senior Vice President General Manager, Service Provider Technology Group
Jim McDonald - Chief Executive Officer, Scientific-Atlanta
Mark Sue – RBC Capital Markets
Tal Liani - Merrill Lynch
Inder Singh - Lehman Brothers
Brant Thompson - Goldman Sachs
Ehud Gelblum - JP Morgan
Nikos Theodosopoulos - UBS
Ari Bensinger - Standard & Poor’s
Paul Silverstein - Credit Suisse
Tim Long - Banc of America
Phil Cusick - Bear Stearns
Scott Coleman - Morgan Stanley
Welcome to Cisco Systems second quarter fiscal year 2008 financial results conference call. At the request of Cisco Systems, today’s conference is being recorded. If you have any objections, you may disconnect.
Now I would like to introduce Ms. Blair Christie, Senior Vice President of Corporate Communications for Cisco Systems. Ma’am, you may begin.
Thank you, Kim and good afternoon, everyone. Welcome to our 72nd quarterly conference call. I am Blair Christie and I’m joined by John Chambers, our Chairman and CEO; Dennis Powell, Chief Financial Officer; Rick Justice, Executive Vice President of Worldwide Operations and Business Development; Frank Calderoni, Senior Vice President of Customer Solutions Finance and our next Chief Financial Officer effective February 15th; as well as Ned Hooper, Senior Vice President of Corporate Development and Consumer and Small Business; Pankaj Patel, Senior Vice President and General Manager of our Service Provider Technology Group; and Jim McDonald, Chief Executive Officer of Scientific-Atlanta.
The Q2 fiscal year 2008 press release is on full national market wire and the European financial and technology wire and on the Cisco website at www.Cisco.com. I would like to remind you that we have a corresponding webcast with slides. In those slides you will find the financial information we cover during this conference call as well as additional financial metrics and analysis that you might find helpful.
We have posted full GAAP to non-GAAP reconciliation information along with our financial statements on our website in the investor relations section. Additionally, downloadable Q2 financial statements will be available following the call including revenues segment by product and geography. Just click on the financial section of the website to access the webcast slides and these documents.
A replay of this call will be available via telephone at 866-357-4205 or 203-369-0122 for international callers and is also available from February 6 through April 18 on Cisco’s investor relations website.
Throughout the conference call we will be referring both GAAP and non-GAAP financial results. The financial results in the press release are unaudited.
The matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent annual report on Form 10-K and 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.
Unauthorized recording of this conference call is not permitted and I’d like to turn it over to John for his commentary on the quarter.
John T. Chambers
Thank you, Blair. During the opening comments of the conference call, I will focus on what I view to be the key takeaways for Q2; an update on why we are comfortable with our long-term growth projections of 12% to 17%; and our revenue guidance for the next quarter with the appropriate caveats.
The opening comments will also include discussions on what we believe is driving our current growth as well as what we think will be the key factors that we expect should allow us to continue to maintain a solid long-term growth rate over the next three to five years.
Dennis will follow with additional details on Q2. the third section of the call will focus on a more detailed discussion of business momentum and strategy on a geographic, product, and customer segment basis. Frank will then provide additional financial parameters around our guidance for Q3. I will then wrap it up with some comments in terms of Cisco’s momentum going into Q3 and finally, our Q&A session.
Now onto the discussion of Q2. This quarter was another solid quarter with good balanced results from a product, geographic and customer segment perspective. To put these results in perspective, I will summarize the quarterly highlights first from a key financial perspective; second, from a product and services perspective; third, from a geographic point of view and fourth, by customer segment.
Key financial highlights for Q2 include the following: total record revenue of approximately $9.8 billion, a 16.5% year-over-year increase, which was slightly above our guidance of approximately 16% provided in the Q1 conference call. We are pleased with both the growth on the top line and bottom line.
Order growth was good with product book-to-bill of approximately 1. We will provide additional details about how the order growth occurred throughout the quarter later in the discussion.
Non-GAAP net income was $2.4 billion, an increase year-over-year of approximately 14%. GAAP net income was $2.1 billion, representing a 7% increase year over year. Non-GAAP earnings per share were $0.38 and GAAP earnings per share were $0.33, which were increases of 15% and 6% respectively year over year.
Cash generated from operations was $2.4 billion. We repurchased $4 billion of common stock and we exited the quarter with $22.7 billion in cash, cash equivalents and investments as compared to Q1 fiscal year ‘08 of $24.7 billion.
However, if there are two key takeaways from our Q2 results, the first would again be the continued unique balance in terms of our business models which are implemented from a technology architecture and a business architecture perspective. This balance is illustrated across 20 major product families, four key customer segments, and four major geographies.
The second takeaway is built around market transitions which is a core competency of Cisco; and then to develop our vision for how these market transitions play out for the industry and position Cisco in terms of our sustainable differentiation in industry leadership. This second takeaway, which is just beginning in my opinion, will drive our growth and differentiate us from our peers over the next five years plus will be phase 2 of the Internet. We expect the second phase will be driven by collaboration enabled by network Web 2.0 technologies. In the last several quarters, we believe we have achieved a clear number one position from both a thought leadership and equally important implementation and we intend to expand upon this position of leadership.
This collaboration enabled by the network Web 2.0 technologies will in our opinion transform business models with a speed we have not seen in over a decade. It is our intent to not only lead in terms of thought leadership when applying these technologies but to be the best example of how this can drive productivity and a number of cross-functional opportunities a company can focus on at any point in time. We will discuss this also in greater detail later in the call.
Whether it is the service provider’s potential increase in the network loads driven by Web 2.0 technologies; where the commercial enterprise customers who see the next wave of productivity occurring through these network technologies, we are seeing increased acceptance of both Cisco’s business and technology architecture strategy and this dramatically differentiates us versus our industry peers.
In the last several months I’ve had the opportunity to travel throughout Asia Pacific, North America and emerging markets. Whether it is with the government leaders in developed and emerging markets, or service provider or enterprise decision makers, our thought leadership, technology architecture, and our ability to help them achieve their business and governmental goals is increasingly understood at all levels. We saw this in November during our business day in India and China and most recently in the World Economic Forum where we met with almost a dozen heads of state or key government leaders.
We also saw the unique opportunities systems can play during a recent trip throughout the Middle East Gulf states where order growth opportunities remain very strong. One example of this architecture and thought leadership would be in Saudi Arabia where two weeks ago I spent three days meeting with various business and government leaders. Whether it was on the topic of their new economic cities, Cisco’s role as their infrastructure partner, or Cisco’s role when assisting in their global competitiveness, our vision, strategy and execution is playing out as we envisioned. As we become a trusted advisor and implementation engine for both the business and government leaders, we can normally expect to get the growth that accompanies this leadership position. Saudi Arabia is an example of this in this last quarter where we achieved 70% order growth rate year over year.
Revenue growth from our key products, including services, was strong across almost all categories. In terms of our three broad product categories, routing revenue grew year over year by 18% led by our high end routing products which grew in the high 20s year over year. Switching revenue grew year over year by 11% and the total of our Advanced Technologies revenue grew year over year by approximately 25%.
Again in considering our ability to move into new markets to achieve both growth and profitability, our total Advance Technologies revenue was more then 20% greater than the revenue from our routing products. This again speaks to Cisco’s balanced product portfolio and to our constant evolution of moving into new markets and product adjacencies.
Although we will discuss growth in a number of products in more detail later in the call, I want to provide a quick snapshot from a revenue perspective of five of our product highlights in Q2. High-end routing was very strong and the cis1 continued to be our best example of a flagship leadership product with revenue growth of approximately 60% year over year.
In the data center we had a very strong revenue growth of approximately 27% for our MDS 9000 product family.
Our Catalyst 6000 high end switching line had a very solid quarter of revenue growth of approximately 20%. While on this subject I would like to call your attention to the very successful launch of our Nexus 7000 series data center platform which is the first in a new line of switching products optimized for high density 10 gigabit Ethernet in the data center and the expansion of our Catalyst switch family on January 28. Analysts are calling the Nexus 7000 one of the best products ever to emerge from Cisco. Purpose built for the very high end -- the data center -- in terms of software architecture with a focus on high availability, capacity, performance and security.
Unified Communications including products from our WebEx acquisition had revenue growth of approximately 60% year over year.
We continue to achieve good product balance both in terms of breadth and depth of our product portfolio. We now had ten product families with orders and revenue run rates above $1 billion, and many of them continue to gain share in their respective product categories.
To add additional information regarding the balance of our revenue across our product line and potential future momentum, 13 of our top 20 product families had year-over-year revenue growth run rates for Q2 of 15% or better. Although the competition remains robust, we believe we are maintaining leadership versus many of our major competitors in many product families and we also believe we are getting a larger share of our customers’ total spend on communications and IT.
As we have discussed in prior conference calls, our services are not standalone product areas but rather they are the delivery vehicle through which we earn our customer’s trust and satisfaction by enabling their technology and business goals. Our services revenue represents approximately 16% of our total revenue. In Q2 our revenues for services grew year over year approximately 18%. This is obviously a strong revenue growth rate for a $6 billion run rate business with non-GAAP gross margins of approximately 63.5%.
Also, our services-led approach to sales continues to gain traction with our customers. There is usually a direct correlation between the amount of services our customers buy from Cisco and the growth rates of our core products. In other words, the more services customers purchase usually the higher the customer satisfaction and the higher the growth rates in our product orders.
An example of this would be our strategy in emerging markets. The geographic and customer segments discussion will be primarily in terms of orders as this is how we run our business. From a geographic perspective, order momentum was solid and balance was reasonably good across our four large theaters during Q2 with the year-over-year order growth rate ranging from 8% to mid-20s. Emerging markets, which tend to have large orders and be lumpy in terms of when the orders occur, grew 24% in terms of product order growth rate. Asia Pacific continues to be very solid and grew approximately 23% followed by the U.S. with growth of approximately 12%. Europe grew year-over-year approximately 8% in Q2.
Additional detail by theater that may be of interest is that our combined orders for commercial and enterprise -- that does not include public sector -- grew in the low-20s. The service provider business after a very strong growth in the mid-20s in Q1 was actually down approximately 6% year over year in Q2. Public sector in Europe was flat year over year in Q2.
From a customer segment perspective, we again saw a solid balance across our commercial markets, service provider and enterprise segments. The global commercial market segment remained our most steady segment with order growth of approximately 20% year over year in Q2. With the exception of Europe, the core global service provider business remained strong. Orders from a service provider perspective Scientific-Atlanta grew approximately 20% year over year. The U.S. service provider business continued with growth in the high 20s, again excluding Scientific-Atlanta, and this is in terms of orders and marks the 12th quarter in a row that they had order growth rate above 20% year over year.
As a reminder Scientific-Atlanta saw significant growth last year due in part to the 707 security requirement. Those are very tough comps Jim year-over-year, although revenue growth for the quarter was 20% if I remember right.
John T. Chambers
Video continues to drive service provider network demand and is potentially the killer application for loading and bringing value to the network. We continue to be very pleased with the accelerating momentum from video applications. Consumer video and broadband build-outs are driving much of the service provider investments.
From an enterprise and commercial perspective, we expect that the global video implementations such as IPTV, TelePresence, Unified Communications, physical security and other video applications will drive increasing future network loads and therefore also require upgrades to existing networks.
Using Cisco as an aggressive example, as we began to implement Unified Communications, TelePresence, and other video applications across our entire company, we expect the future growth of our network loads could be closer to 400% annually over the next several years.
In the last 12 months we have conducted over 68,000 meetings via TelePresence and have had only 174 units installed. I think all of us understand the opportunity this represents for Cisco and our service providers’ partners if networks evolve the way we hope.
Think of the possibilities if companies begin to implement 1,000 plus TelePresence units and eventually move into employees’ homes for both business and entertainment purposes with this type of technology. One of the best indications of the industry anticipated loads on networks is our order growth rate in high end routers. While we had a strong order growth rate in high end routers during the first three quarters of fiscal year 2007, which averaged approximately 20% year over year, we are now experiencing growth rates in 4Q07, again in 1Q08 and now in 2Q08 of approximately 30% year over year or better. 2Q year-over-year order growth rates were approximately, as I said, 30% in our Q2 and this was led by the crs1 with year-over-year order growth rates over 100%.
Global enterprise business, which includes public sector, was solid. Our enterprise customer segment on a global basis grew approximately 11% year over year in terms of orders. There is one major area that I would like to update you on every conference call because of its importance to both Cisco’s future growth and the industry as a whole.
This is built around our view of how the industry will evolve both from the intelligent network’s role as well as the next generation of productivity, business and governmental models built around network technology capabilities.
We believe that as the network becomes the platform and we approach this from both a business and a technology architectural perspective, that the next frontier for growth will be around collaboration enabled by the network tools often defined as Web 2.0.
Every quarter over the last year, Cisco has expanded our position in terms of thought leadership and how we use these capabilities internally. We believe that we are the example in business of what’s possible when an organization adopts a collaborative approach enabled by network Web 2.0 technologies. We consistently hear this from both our enterprise and service provider customers as well as from key industry analysts.
I cannot overemphasize the importance of leading in this market transition from products to process through internal adoption and utilization and what we believe this leadership position means for Cisco’s future. Our ability to understand market transitions where the technologies or business model base has been one of the key contributing factors to our success.
We have seen dramatic growth from our investments as market transitions have occurred whether it is the Advanced Technologies five years ago, emerging countries two years ago or globalization in India over the last year. At the beginning of this fiscal year we shared with you our aggressive implementation of new technologies and new business models based on collaboration. Instead of doing one or two priorities a year as we did very successfully in our traditional command and control approach, we can now focus on 20 priorities with a collaborative structure and replicable process driven by our consoles and boards.
These smaller teams are moving faster than we could in the command and control structure and are enabling our ability to move into new market adjacencies with the speed and effectiveness that we would not have been able to do before.
When you think about our long-term growth opportunities, there is no other important market transition than this revolutionary business model change and we have been very pleased with the progress and results in the first half of the year.
This is one of the key reasons that in spite of what happens with macroeconomic and other issues in the short term we remain comfortable with our long-term growth projections.
The key takeaway is the potential business model changes that are occurring at Cisco which enables our ability to move into new market adjacencies and innovate with the speed and effectiveness that we would not have been able to do before positions us to compete uniquely during these market transitions.
Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors and our ability to execute or not on our strategy and other factors as we’ve discussed in our financial reports. For purposes of our long-range guidance as well as our quarterly guidance we are also assuming that our vision of how the industry and the market will evolve will be accurate and we will effectively execute on that vision.
Therefore, we continue to believe with the appropriate caveats our long-term guidance should be in the 12% to 17% range year over year. While at the risk of stating the obvious and as we’ve said repeatedly in prior conference calls and we will continue to say in our future conference calls, there may be times when our revenue growth is above the 12% to 17% range and there will definitely be times when our growth is below this range.
While we continue to be extremely comfortable with our vision and differentiated strategy of the value that intelligent networks will bring across all of our customer segments and geographies, we also see the economic challenges that the U.S. is experiencing. Our customers in many of the emerging countries -- especially in India and China and Middle East -- remain optimistic about their business momentum. However, we are seeing our U.S. and European customers become increasingly cautious. This was my key takeaway from the World Economic Forum two weeks ago.
While we were pleased with our revenue growth slightly above 16% in Q2, our product order growth in Q2 was in the low 10s. The second quarter was unusual by month in terms of these order growth rates. December was strong with year-over-year growth in terms of orders in the high teens. But January’s growth was less than we expected with order growth rates of approximately 10%.
We are all seeing the challenges that global stock markets and the U.S. stock markets had including a very challenging January as well as a steady stream of challenging economic and confidence data over the last month. These and other events, along with our own order growth in January, combined with the economic business and consumer confidence changes make forecasting next quarter’s business momentum extremely challenging.
In traditional Cisco fashion, our approach to financials will be transparent and conservative in our projections to the best our abilities. Again let me repeat with our usual caveats discusses earlier that we continue to believe in our long-term growth guidance of 12% to 17%. While it is always possible that January’s order growth rates were an aberration, given the uncertainties of the global financial markets and the cautiousness we are seeing from some of our customers and our peers, we believe that the proper approach to guidance with our usual caveats at this point in time is to assume that January’s order growth rate may continue over the next several months.
One of Cisco’s core competencies is our ability to focus on market transitions, understand their long-term implications and opportunities, as well as to position Cisco to gain strategic advantage during these transitions. There are three key basic rules we follow during periods of potential economic challenge. The first is to review whether or not your strategy is working well going into the time period, but as you contribute to the potential challenges. Secondly, how long do you think it will last and how challenging do you think it will be? Third is to position the organization for the upturn.
We have done this repeatedly through the years in 1993, 1997, 2001, 2003 and in each of those scenarios we gained both market share and profit share and as a result we were better positioned coming out of the transition versus our peers. In terms of the current economic transition that may be going on, we believe that our strategy and the critical role the network plays in enabling all forms of communication in IT is right on target.
Secondly, with all of the appropriate caveats, our best estimate is that this is a relatively short-term challenge going forward. Cisco will use these bumps as a chance to gain market share and to be aggressive about moving into new market adjacencies. Whether we return to our longer-term growth target of 12% to 17% in one or two quarter or a little longer is yet to be determined. Therefore our revenue guidance for Q3 fiscal year 2008 including our usual caveats as discussed earlier and in our financial reports is for revenue growth of approximately 10% year over year. For those areas that we can control or influence, I am very optimistic of our ability to achieve the desired business results both in the short term and in the long term.
For areas out of our control or influence, including the broader macroeconomic environment, we will share with you what we are seeing to the best of our ability just as we have done in the past during our quarterly conference calls.
In summary, we believe that we are very well positioned in the industry from a vision, differentiated strategy and execution perspective. As I stated earlier, we believe we are entering the next phase of the Internet as growth and productivity will center on collaboration enabled by network Web 2.0 technologies. We will do our best to provide the product architectures and the expertise to help in the implementation of these collaborative capabilities from a technology and a business perspective. We will also shared with our customers how we have done this internally. In short, we are going to attempt to execute a strategy over the next decade that is similar to what we did in the early 90s. As we said before, empower growth through the next decade except with the obvious difference being a company that is now approaching $40 billion in sales and over 64,000 employees focused on this opportunity.
At this time I would like to turn it over to Dennis for a further discussion of Q2 financial highlights.
Dennis D. Powell
Thanks, John. We were very pleased with Cisco’s solid results this quarter. Total revenue for the second quarter was $9.8 billion, an increase of 16.5% year over year which is above our guidance. Routing revenue continued to be strong at $2 billion up 18% year over year, due primarily to continued growth in our high end router portfolio at 27% year over year with particular strength in the crs1, 7600, and the GSR family.
Switching revenue was $3.3 billion, an increase of 11% year over year with balanced growth in both modular and fixed portfolio. Advanced Technologies revenue totaled $2.4 billion, representing an increase of 25% year over year with strong performance in unified communications, storage and video systems.
Other product revenues totaled $523 million, an increase of 9% year over year. Total service revenue was $1.6 billion, up approximately 18% year over year as a result of solid growth across all geographies. We are particularly pleased with growth in advanced services of 37%.
Total revenue growth by geography grew in a range from 8% year over year in the European markets and Japan to a high of 53% in the emerging markets. Emerging markets revenue growth was higher than the order growth that John had reported on earlier due to increased shipments and recognition of previously deferred revenue.
Q2 total non-GAAP gross margins was 65.5%, approximately flat from last quarter and up 0.7 point year over year. For product only non-GAAP gross margin for the second quarter was 65.9%, up from 65.7% last quarter and from 64.8% in 2Q FY07. The favorability was driven primarily by continued cost savings partially offset by pricing and discounts.
Our non-GAAP service margins for the second quarter were 63.5%, down from 65.2% last quarter and 64.4% in 2Q FY07. Service margins will typically experienced some variability over time due to various factors such as the change in mix between technical support services and advanced services as well as the timing of support contract initiations and renewals.
Total gross margin by geography ranged from 62% for emerging markets to 70% in Japan. As expected, non-GAAP operating expenses as a percentage of revenue were approximately 36% in 2Q FY08, up from 34.6% in 2Q FY07. The 2Q year-over-year foreign exchange impact on operating expenses was $93 million which adds approximately 1% to this ratio.
Our 2Q FY08 non-GAAP tax provision was 24%. Non-GAAP net income for the second quarter of fiscal 2008 was $2.4 billion compared to $2.1 billion in the second quarter of fiscal year 2007 representing a 14% increase year over year. Non-GAAP earnings per share on a fully diluted basis for the second quarter were $0.38, up from $0.33 in the second quarter of fiscal year 2007, a 15% increase year over year.
GAAP net income for the second quarter was $2.1 billion as compared to $1.9 billion in the second quarter of fiscal year 2007 and GAAP earnings per share on a fully diluted basis for the second quarter were $0.33, up from $0.31 in the same quarter of fiscal year 2007.
Moving on to the balance sheet, the total of cash, cash equivalents and investments at the end of Q2 was $22.7 billion down $2 billion from Q1. During Q2, we generated $2.4 billion in cash flow from operations as well as $626 million in proceeds from stock option exercises and employees stock purchases. We repurchased $4 billion of common stock or 139 million shares of our stock at an average price of $28.67.
Moving on to accounts receivable, we ended the quarter at $4.2 billion up from $3.4 billion at the end of Q1. At the end of 2Q FY08, days sales outstanding or DSO was 39 days, up from 33 days in Q1. The increase was driven primarily by several large multi-year service agreements that were signed in January.
Total inventory for Q2 was $1.3 billion, approximately the same level as 1Q FY08. Non-GAAP inventory turns improved from10.0 last quarter to 10.5 this quarter. Our inventory purchase commitments at the end of 2Q were $2.7 billion up 10% from the end of Q1. Deferred revenue was $8 billion in 2Q FY08, an increase of $876 million from 1Q FY08, and $1.9 billion from 2Q FY07.
Deferred product revenue was $2.7 billion, up $235 million from last quarter, and deferred service revenue was $5.3 billion, up $641 million from last quarter, due to the addition of several large service contracts that I referred to before.
At the end of Q2, our headcount totaled 64,087 a net increase of approximately 1,000 from 1Q FY08. Our headcount increases were primarily the results of Cisco hires in sales, services and engineering.
In conclusion, I am pleased with our solid financial performance for the second quarter of the fiscal year, including strong top line growth as well as maintaining margins, operating expenses and operating income all within our target range. Cisco’s financial strength and stability gives us the ability to capitalize on and take advantage of market transitions. We will continue to invest in our diversified technology portfolio as well as new and adjacent markets to drive future growth and help us achieve our long-term growth targets of 12% to 17%.
As we announced back in Q4, I plan to retire on February 15 and I just want to take a moment to thank everyone participating in today’s call for the valuable working relationships that we’ve developed during my career at Cisco. Your insight and feedback over the years has made this job the most fulfilling of my career. Thank you.
Now with another strong quarter, a strong balance sheet, outstanding growth opportunities and my continued confidence in Cisco’s ability to drive long-term shareholder value, I hand over the CFO responsibilities to Frank Calderoni who will take you through our detailed guidance for Q3 after John’s additional commentary on the quarter.
John T. Chambers
Dennis, thank you so very much, in many, many ways. I’ll make a few personal comments later in the call thanking you appropriately for your many years of leadership here. You’ve done a great job.
Dennis D. Powell
John T. Chambers
In this section of the call we will cover our geographies, customer segments and product reviews for Q2 in more detail. The products review will be in revenue growth terms while the geographic and customer segments will be discussed in terms of orders unless otherwise indicated.
First, we will provide additional details from a geographic and customer segment point of view. There will be a number of positives from our four largest theaters and customer segments.
From a U.S. perspective, order growth was approximately 12% year over year. We had another very solid quarter in the service provider business in the U.S.; our traditional core service provider business not including Scientific-Atlanta grew in the high 20s year over year. Again this is the 12th straight quarter that this business has grown year over year in excess of 20%. Our Scientific-Atlanta portion of our U.S. business had strong revenue growth of approximately 20%. Orders dropped by approximately 5% when compared to last year’s strong quarter due in part to the 707 security requirements introduced in July of 2007. The combined U.S. service provider orders including both our traditional core products and Scientific-Atlanta’s products grew approximately 13% year over year.
The commercial market continued it’s solid growth of approximately 20% including our WebEx and IronPort acquisitions. Our enterprise business, which includes federal, grew 9% in Q2. Our federal business, after a very strong Q1, was relatively flat in Q2 year over year. The remainder of the enterprise business grew year over year approximately 11%. As a reminder this enterprise business, not including federal, was down slightly year over year in Q1.
Following last quarter’s conference call several of you asked for additional information regarding our large global enterprise accounts and to expand our discussion beyond what they just installed only in the U.S. As a reminder, in our Q1 call we talked about the challenges and lack of growth in our very largest accounts in the U.S. At this time, based on your feedback, I would like to give you additional information on these trends both in terms of the US enterprise business and the rest of the world for these large multinationals.
During last quarter’s conference call we shared with you that U.S. domestic orders were down year-over-year. However, for the rest of the world orders were actually up in mid-teens year over year for these accounts. However, in Q2 U.S. domestic orders from our largest enterprise accounts grew in the mid-teen and the rest of the world was above 40% year-over-year growth.
The mix of our business from large U.S. enterprise accounts has moved from over 50% of their total business for Cisco occurring in the U.S. two years ago to today where approximately 60% of their business occurs outside the US. I hope this provides additional detail that answers some of your questions from the last call.
The Asia-Pacific theater continues to be very solid in terms of its momentum with year-over-year growth of approximately 23%. There was good balance across the enterprise, service provider and commercial markets ranging from low 20s to high 20s year over year.
As we shared in the last quarter’s conference call, we like our expanding vision and strategy and commitments in both China and India. We were therefore very pleased with the strength of orders in Q2 in both of these countries with India growing year over year with an extremely strong 50% growth in Q2 and China growing approximately 30% year over year in Q2. We continue to expect these two countries businesses will fluctuate quarter to quarter due to the timing of very large orders from which we obviously benefit in Q2.
Our strategy and focus on our Globalization Center led by Wim Elfrink’s team based in India is working extremely well. Our Globalization Center concept in partnership with the Indian-based large consulting groups is working at the high-end of our expectations both in India and throughout the emerging markets. Our growth in China generally has been strong over the last several quarters as we made the decision to dramatically expand our commitment and our goals in China over the next five years.
We believe we are very uniquely positioned with both business and government leaders to create a major win-win scenario across multiple segments of their economy. Again the feedback from our business leaders from China and India at the World Economic Forum two weeks ago was that they expect their economic growth to continue to be strong and for Cisco to play a strong partnering role in their growth.
Moving on to emerging markets, product order growth rate in Q2 was approximately 24% year over year. This business by definition will be based in part on large orders and therefore growth rates will vary from quarter to quarter. This was solid across all four emerging market operations ranging from 22% to 32% year over year.
Moving onto Europe, our European operations had order growth rate in Q2 in the enterprise not including public sector and commercial markets as we said earlier with the combined growth of over 20% year over year. However, the service provider business in Europe after a very strong Q1 with growth in the mid-20s actually experienced negative growth in the mid single-digits in Q2. Therefore in total our European business grew approximately 8% year over year.
Moving onto products, as we discussed earlier our products business was well balanced. We will attempt to give you more details regarding this balance in the following discussion which will be covered in terms of revenue and will include our acquisitions.
Total revenue growth balance was once again very good in routing which grow 18% year over year; switching grew approximately 11% and total Advanced Technologies growing 25%. Our first wave of five Advanced Technologies in Q2 had year-over-year revenue growth of approximately 22% and in total is approximately $7 billion in terms of run rate from a revenue perspective -- and that is just the first wave.
Unified Communications including the addition of WebEx continued to lead the way with revenue growth of approximately 60% and just for a data point, Unified Communications without WebEx was 30% year over year.
Storage was up approximately 30%, wireless was up approximately 10% and the networked home was down approximately 5% while security growth was in the 12% positive year-over-year level.
Our second wave of Advanced Technologies that includes video systems, application networking systems, et cetera is now approaching a $2.7 billion run rate and grew 31% year over year from a revenue perspective. From a product perspective we are not aware of any other company in the IT and communications industry that is even close to these type of growth numbers and market leadership across such a broad array of products.
In summary, our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe that our differentiated strategy is also achieving the benefits to both Cisco and our customers that we thought were possible.
Finally, our execution is on target in terms of results as measured by customer partnership perspective, market share and share of our customers’ total communications and IT expenditures as the network becomes the platform for delivering these capabilities.
At this point in the call I’d like to take an opportunity and time to thank you, Dennis, for the last five years of service, integrity and results that we’ve achieved together here at Cisco under your leadership as CFO. Dennis, you’ve done a great job and you’ve been a very good friend and business partner. Thank you very much for a job done well and we will truly miss you. I appreciate you, Dennis. Thank you.
However, you’ve done a great job also in classical Cisco fashion with a smooth transition to Frank. So Frank, it’s with a great deal of pleasure that I now turn the call over to you for a more detailed discussion of financials regarding Q3 guidance.
Thank you, John. Let me remind you again that our comments include forward-looking statements. You should review our recent SEC filings that identify important risk factors and understand that actual results could materially differ from those contained in the forward-looking statements. The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP.
We anticipate total revenue growth for the third quarter to be 10% plus or minus 1% year over year. The unusual business momentum we experienced in January when combined with the uncertain economic business and consumer confidence outlook makes forecasting this next quarter’s business momentum extremely challenging.
With that in mind, we believe it is prudent and conservative to provide guidance for Q3 only; which means although we believe it is probable that we will be in the lower end of the 13% to 16% revenue growth range for FY08, we are not providing Q4 guidance at this time.
As we have said in the past, forecasting gross margin has always been challenging due to various factors such as volume, product mix, variable component costs, customer and channel mix and competitive pricing pressures. That being said, we believe total gross margin in Q3 will be approximately 65%. We believe Q3 operating expenses will be in the range of 37% of revenue. We expect interest and other income to be approximately $200 million in the third quarter. Our tax provision rate for Q3 is expected to be at approximately 24%.
While we expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. We are modeling share count to be down approximately 50 to 100 million in weighted average shares outstanding for EPS purposes.
In this estimate of share count, we are not taking into consideration any further change in stock price that could occur in the third quarter of fiscal year ‘08. As a point of reference, a $1 increase in the average stock price would increase the calculated shares outstanding for purposes of determining earnings per share by approximately 15 million shares.
Regarding cash flow from operations, we would expect to generate $700 million to $900 million per month at these revenue levels. For our Q3 fiscal year ‘08 GAAP earnings we anticipate that Q3 GAAP EPS will be $0.04 to $0.06 per share lower than non-GAAP EPS, primarily due to acquisition-related charges and stock option expense.
Please see the slides that accompany this webcast for further details.
Other then those items noted above, there were no other significant differences between our GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant.
I will now turn the call back over to John.
John T. Chambers
Frank, thank you very much. The following is a summary of my views of Cisco’s momentum and opportunities entering the third quarter of fiscal year 2008. In the areas that Cisco can control or influence, our momentum continues to be strong. Balance continues to be reasonably good across our geographies, products, services and customer segments. We clearly continue to see the same things each of you sees in terms of opportunities and concerns in the U.S. market and concerns about expanding to other geographies.
If the market does continue to slow, we believe this will not dramatically change our long-term opportunities with our vision of how the industry will evolve and our differentiated strategy. In fact, it is our intent to expand our market share during these corrections as we have done in the past. As we have done again and again we think we can gain more market share during the challenging times and estimate we can do that while maintaining our guidance on gross margin.
From a geographic perspective, we continue to be optimistic about the majority of our global economies outside the U.S. Based upon what our customers are telling us and our balanced strength in these countries across customer segments, products, families and value-added services. We will continue to monitor closely any spread of the U.S. challenges to other geographies, especially Europe.
From a U.S. perspective, the service provider market continues to be the area where we are most comfortable. While we believe that these comparisons to prior quarters for Scientific-Atlanta growth will be challenging to the next quarter or two because of last year’s very strong growth enabled in part by the security requirements, our core service provider business projections continues to be strong. Our product roadmaps for both current and future products also look strong for the service provider segment.
As we discussed in prior conference calls, the strategic relevance of Cisco is increasing to our service provider customers and has the potential to evolve the same way our enterprise leadership evolved over the last 15 years with the associated business benefits to both Cisco and our service provider customers.
We are continuing to see from many of the world’s top service providers the willingness to partner with Cisco on both a technology architecture and a business strategy perspective. This is an opportunity that many would not have anticipated two years ago. The one that is clearly playing out in line with our vision and differentiated strategy the way that we had hoped.
The commercial market remains solid and well balanced on the global basis. We are continuing to expand our product, services, and distribution capability to this very important segment.
In our opinion, there are many things that are exciting about the second phase of the Internet as it enables collaboration and social networking through networked Web 2.0 technologies. At the top of list is both the speed and effectiveness with which these challenges can be implemented across all customer segments. Again, if we are right about the value it brings to both business and individuals, this is at the top of the first inning in a nine inning game in terms of its broad business acceptance and associated benefits.
We clearly intend to lead all companies in our implementation, organizational evolution, and associated productivity of these new collaborative technologies. The competitive advantage of how we ourselves will become the best example for what this means to a company’s future.
This type of collaboration enabled by the network will allow Cisco, instead of doing one or two major priorities a year that the senior management team aggressively led in a command and control style, to target 20 for this fiscal year in a collaborative style. We are reviewing the progress of these 20 corporate initiatives on a regular basis and I cannot be more pleased with both the speed with which we are moving as well as the strategy and execution that each of these groups are achieving at this point in time.
With these early successes in mind, you will probably see us expand a number of these initiatives over the next several quarters.
Our business and technology architecture strategy in emerging markets is working extremely well, barring some major economic or political surprises across many of these emerging countries, I would expect this theater on average to have the potential to grow more than twice the average growth rates as the other theaters we execute effectively. Our balanced product momentum across our core technologies and advanced technologies continues to be solid. But again, it is the loosely and then tightly coupled product strategies for these technologies that dramatically differentiate Cisco from our peers.
Our pipeline of potential new core routing and switching products looks to be very good. Our continued evolution of our first wave of advanced technologies and the emergence of our second wave of advanced technologies is evolving as we expected. At the same time, we are beginning to plan a potential third wave with our next-generation of early stage emerging technologies.
In summary, our product pipeline is in excellent shape and really looks exciting. Having said that, obviously the proof continues to be in the results. Again on a global and U.S. basis we see the same challenges and uncertainties from an economic, political and capital spending concern that made you to continue to witness. At the risk of stating the obvious and it’s a point we make every conference call, Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors and our ability to execute or not on our strategy and other factors we discussed in our financial reports.
We are also assuming that our vision of how the industry and the market will evolve will be accurate and we will execute effectively on that vision. Once again with the usual caveats, our Q3 fiscal year 2008 guidance is for revenue growth of approximately 10% year over year. Our long-term growth opportunities remain in the 12% to 17% range assuming our usual caveats.
We will focus on what we can control and implement and intend to position Cisco to gain momentum in market transitions whether they are industry consolidation, product transitions, market adjacency opportunities or economic. In summary, for those areas that we can control we believe that our vision, strategy and execution are in great shape and producing results.
As always I want to thank our shareholders, customers, employees and partners for their support and continued confidence in our ability to execute during rapid industry consolidation, market transition and challenging economic times.
Now, Blair I would like to turn it over to you.
Great, thank you, John. We are now going to open up the call to questions and answers. We still are requesting that sell-side analysts please ask only one question. If you have more than one question we’ll certainly call you back later. Operator, can you please open the call to questions.
Your first question comes from Mark Sue – RBC Capital Markets.
Mark Sue – RBC Capital Markets
Thank you. John, the guidance implies that not only did the situation quickly, but it will continue to deteriorate. Is that a fair assessment? And historically there were times when Cisco was not too correlated to GDP growth. Is it the magnitude of the contraction and the speed that is behind the weak guidance, and does that mean that things can actually slow even further for Cisco?
John T. Chambers
First, I am personally very optimistic that this market transition will offer opportunities for us and it will be relatively short-term in its implications.
Secondly, we did see the slowdown occur pretty rapidly between December and January in terms of our orders and one of the few times we’ve actually missed our forecast -- if I remember right Rick – in January in a very long time.
Having said that, no, I would not assume by anything we said that we expect it to deteriorate further. In fact, I think Frank’s comment in general in terms about where we see ourselves for this next quarter and for Q4 as well as the guidance that I give you in terms of returning in a reasonable short time period to our 12% to17% growth would look the other way.
So again, on things we can control or influence we feel pretty good but we felt the right thing to do given the challenges that we saw in the U.S. and with both the U.S. and Europe being under forecast in January was to extrapolate that out and we’ve always be transparent and conservative with in terms of our positioning.
Your next question comes from Tal Liani - Merrill Lynch.
Tal Liani - Merrill Lynch
If I look at the implied decline in your guidance versus consensus, it’s about $490 million miss for next quarter. When I look at how to allocate it, it means that either switching which was weak for the last quarter is going to be substantially weak next quarter, or that may be the weakness is more across the board between router switches and advanced technologies etc.
So I’m wondering if you can give a little bit more color about how you expect each of your divisions to trend over the next quarter?
John T. Chambers
Let me start with some general comments then I’ll ask Dennis to comment specifically on the numbers that you articulated.
When we look at our total forecast accuracy – Rick, you’ve done an amazing job over the years – it is almost plus or minus 1 on a yearly basis. As we looked at this we cut the data almost every way imaginable to look at the various trade-offs and what we thought would occur. But I want to say going in that our ability to forecast in total at the top line has been very accurate. If you look even during very strong quarters or okay quarters, our ability to forecast that mix by both geography and by product line it’s very common to see dramatic swings in it.
So to break this down into exactly what products we think will be at different levels would be much more difficult to do. If you were to talk about key trends in terms of strengths that I would watch, we are clearly signaling that the service provider market looks very solid and with the one exception in Europe after a very strong Q1, we see that on a global basis.
We will, Jim, because of Scientific Atlanta which had great growth numbers last year and candidly a very strong quarter this quarter, we are heading into two tough comparable quarters but we would look to see the growth return more to our normal rates as we go into next fiscal year.
So service provider is the area that I continue to remain most comfortable with. That’s obviously dependant upon competition continuing to occur in each of the key theaters around the world.
In terms of the data center and areas like that in the enterprise, this is the area where there’s going to be efficiency both in terms of productivity for collaboration of Web 2.0, so I would continue to look for those areas to continue to grow and you saw that with very solid growth in unified communications and continued good growth in new technologies like TelePresence.
In terms of our switching business you are right that switching tends to tie tighter to enterprise and commercial where routing tends to tie tighter to the service provider environment.
In terms of the commercial market, it looks solid around the world and we saw good balance in terms of its direction. But if you are looking for overall rough guidance you are right that routing probably if we were to extrapolate it out will be more stronger growth over the next two quarters and I think that’s what you and Tony are forecasting and I would expect to see announcements as well in terms of product leadership. It looks really good for the future.
In terms of switching while we had a very solid quarter with if I remember right 12% or 11% year-over-year growth in terms of switching revenues, we will probably see it be a little bit more challenging as we go forward. Booking growth was little bit less if I remember right on the numbers.
To break it down any further than that I think would head down a non-constructive bottomless pit because when we do it ourselves it’s more the macro and the combination that gives us the right answer.
Your next question comes from Inder Singh - Lehman Brothers.
Inder Singh - Lehman Brothers
I wanted to touch on some of the emerging markets. I think you mentioned continuing momentum out of the Middle East in terms of spending and it doesn’t look like there is material slow down in those areas.
I imagine at this point you are feeling comfortable that that momentum continues and its not going to suffer the slowdown that perhaps Europe is seeing at this point simply because of the infrastructure builds that are going on. Do you think that this is going to be somewhat insulated from recessionary fears in the West?
John T. Chambers
Well first let me be very upfront. We are not talking about that dramatic a slowdown in terms of our forecast. A 10% bump in the road is still pretty good growth in terms of direction and we do think it will be relatively short-lived in terms of its implications.
The second part is the emerging markets and I’ve just mentioned to you a large number of the countries in the last couple of weeks look very, very solid and while none of us know for sure the interdependencies between those, I would be surprised if you didn’t see emerging market growth not only be twice the growth of our traditional markets as I said in my commentary, but I would expect them to grow this next quarter and quarters thereafter.
I think we’re positioned remarkably well as the government and business leaders and we are not only providing infrastructure, we’re providing thought leadership, market transformation, making their economies more competitive, and partnering with both the business leaders and the service provider leaders and the government leaders at a scale that I’ve never seen a high-tech company do before.
I would look for that to continue to expand even if there are some bumps along the way in terms of the overall market.
There was a third part of the question that I missed on that?
We will follow up with you Inder if we miss something.
John, this is an interesting part on emerging markets. We talk broadly about emerging markets, but we refer to that in these conversations as a theater. When we talk about full emerging countries, we include China and India in that. If you go back and you look at those trends adding in China and India which we do, it’s been fairly stable in that growth and of course as you mentioned already on the call, China was up 30%, India was up 50%. So it’s not just the Middle East and Africa that we define and Central Eastern Europe as our emerging markets theater; it’s also emerging countries of China and India which everyone pretty much includes in that bucket overall.
John T. Chambers
Inder, the third part of your question was around Europe. I would not assume at this point in time that what you’re seeing in the U.S. has spread to Europe, at least not in terms of our data. What we did see, however, was a slowdown in service provider spending in Europe, which was little bit of a surprise to us, off of a very strong Q1 where if I remember right our top six accounts grew 50% year over year in terms of positioning and service provider as a whole grew in the mid-20s.
In terms of the enterprise and the commercial market, they actually had very constructive growth year over year in the low 20s. So I would watch another quarter before I’d make assumptions about things expanding or not. We’re just being cautious and being very open and transparent about what we saw in Europe and we did miss our forecast in Europe for the first time in a very long time.
Your next question comes from Brant Thompson - Goldman Sachs.
Brant Thompson - Goldman Sachs
John, could you give us some more detail with regards to which verticals in the U.S. market and enterprise market saw the most weakness or took you by surprise? What’s changed with the European carrier environment?
John T. Chambers
In terms of the U.S. verticals, the one that surprised us was actually after last quarter’s question on the financial markets, the financial accounts both in U.S. spend and spend in rest of world were up very solid. So you did go through a quarter or two earlier this last calendar year where financials were down. This quarter they were actually up, Frank, I want to say almost 20%.
John T. Chambers
21% in terms of the business. You are seeing areas like retail and transportation, some of the others a little bit softer this quarter, and what you’re almost seeing is a confidence issue with many of the CEOs saying I feel pretty good but what I’m reading and other’s experiences I’m a little bit concerned. It is that cautiousness and depending on the industry, even a little bit of pessimism, that is our concern in the U.S. But the enterprise numbers were actually up versus Q1 of this fiscal year.
In terms of the European issue, there are two ways to look at it. We would tend to look right down the middle. If you watch the service provider business in Europe, those areas that did well in Q1 it doesn’t surprise me that they had a slowdown this quarter, because we have deferred revenue on large orders. We have that going on in some of the very largest of those top five or six that we talked about.
In terms of some of the challenges, however, we did see in the January time period very often those challenges are funded by venture capital or private equity or may not have the deep pockets that the incumbents do. So when you saw the economic issues occur during the January time period in terms of the stock markets, et cetera we saw some of those orders slow or take a lot more signatures or actually slide out a little bit.
So in terms of Europe I would at this point wrap it around the service provider segment, watch what occurs in the enterprise and commercial, and then I’d watch for a quarter or two what we see in service providers.
John, just one more quick thing there in the last week of our quarter, which of course was a black Monday internationally, when that hit in European markets when we were all closed here with Martin Luther King, it was the last week of our quarter when some of these signatures that might typically flow very smoothly, people were certainly taking another look in Europe and the UK places like that; that is something that should be considered.
John T. Chambers
Obviously the same in the U.S. While the pipeline and let me say this very strongly, while our pipeline of opportunities is increasing with our order growth rate that we saw, our pipeline is not showing anything that is overly concerning. However we are anticipating that our close rates and the pipeline might stretch out in terms of how long it takes us to get it closed.
Your next question comes from Ehud Gelblum - JP Morgan.
Ehud Gelblum - JP Morgan
A couple of clarifications on the numbers, I want to make sure I got them right. My question is trying to understand a little bit more about the guidance of 10%.
Even though U.S. enterprise seems to have been okay for the full quarter and Europe minus service provider seems to be actually quite good, what actually slowed down in January down to that 10% order rate? Was it U.S. enterprise slowed down so that U.S. enterprise was actually strong in November-December and then that slowed down in January? Did U.S. commercial also slow down? Did European?
What are the actual segments because I’m having a hard time understanding which of the segments have slowed to 10% in January and therefore because the other numbers sound like only European service provider was the disappointment but it’s sounding like something else slowed down considerably in January.
If you can give a normalize number for emerging markets, last quarter we had the issue with Brazil that made the year-over-year growth rate under the new revenue classifications for emerging markets 19%, now it’s 24% once it is accelerated. If you normalize for Brazil can you just give us a sense as to what the emerging market year-over-year growth rate looked like? That would be helpful.
John T. Chambers
Well, the year-over-year growth rate for this quarter would be compared to a quarter before a year ago which we did not have any unusual bumps on. In terms of the emerging markets we do expect that theatre to grow at about twice the rate of the rest of our theaters do, not counting China and India into that type of number, as Rick articulated earlier.
I feel good about the emerging markets growth and I have just been through a lot of the countries and so I think that you will see them lumpy and often tied to large orders which slide from one quarter to another and this is why I would not watch revenue. As you saw, revenue went down into the teens and the next time in the 50% range.
The orders in the emerging market you have seen about twice our growth rates; it would not surprise me to see the orders in the emerging markets over the longer run at the end of 30% plus type of numbers.
We did do a better job in terms of watching our discounts in the emerging markets and I think negotiating Frank and Dennis a little bit more effectively on both revenue recognition issues as well as discount issues and I want to give credit to Paul’s team in terms for that number.
But if you’re looking at the growth numbers I would probably go two plus what the rest of our company is growing at.
Ehud Gelblum - JP Morgan
But if you compare this quarters’ year-over-year growth in the emerging markets to last quarters did it accelerate or was it basically the same if you normalize for the Brazil anomaly?
John T. Chambers
I’d have to look at the numbers but I would say it accelerated in terms of the overall approach. I’m not seeing anything in terms of any concerns about the emerging markets and what we are seeing with the business momentum. There may be some interdependencies and those interdependencies at least at the present time in our view we are picking up in terms of additional business or additional architectural plays and just doing the classics in terms of running a little bit more focused on profit contribution not just revenue growth and productivity.
Dennis, did you want to add something.
I think that we need to remember this is an early market that is still yet developing and we will see lumpiness. To put this into what is a normalized growth rate I think it’s a little bit too early to call.
John T. Chambers
I do want to reiterate that both the U.S. and Europe I would not read so much into what a company did within a three or four-week time period, but we did see softness in both categories in the month and I wouldn’t break it out by individual segments; that’s not how we look at it from our earlier comments from Rick as well.
John, just reinforcing what you said earlier the pipelines, we don’t see a difference in the pipelines. We have a January experience and we are being prudent in terms of back lighting it forward. But the pipelines as you said John, the pipelines are still there. The question is times like this do you have the same conversion rates.
Ehud Gelblum - JP Morgan
So that January experience will cut across more than just service provider? It was U.S. service provider but also commercial and enterprise across U.S. and Europe?
John T. Chambers
I wouldn’t draw that conclusion because that’s not how we look at it, but I do think it’s fair to say it was just not one vertical in January that was affected in each of the theaters.
I think it’s important that we not draw inferences about what we expect to see for the future based upon such a short window in terms of data.
John T. Chambers
It’s fair to say that if your quarter was ending on January 26th, that was not an ideal date to end it on. If you are having your normal very strong close which we do the last two or three weeks of a quarter, your ability to work things through board of directors, additional sign-offs, people are taking a second and third look, I think it’s fair to say that was occurring across multiple geographies and multiple industries regardless of the health of the organization. Dennis and Frank I’d be surprised if you all weren’t doing the same thing at that point in time.
Your next question comes from Nikos Theodosopoulos - UBS.
Nikos Theodosopoulos - UBS
A question on the guidance of January, if I strip out WebEx the implied organic year-over-year revenue growth is about 8% to 8.5% yet your bookings, even in the worse month in the quarter, is up 10%.
The question there is are you just concerned that this is going to spiral down even more into the next quarter or do we have an issue here where you’re transitioning CFOs, your stock is already down quite a bit, just set the bar under as well as you can here and lets move on? Or are you just concerned having seen this in the past that it is going to spiral down? As part of that, why not manage OpEx lower? You’re actually managing at higher next quarter -- if things are deteriorating?
John T. Chambers
Well you’ve asked three or fourth questions. First is I don’t mean to imply in any way that we see things spiraling down beyond what we just said to you in terms of the guidance. In fact if you look at it I said the reverse, that I think this is going to be relatively short term based upon what we are hearing from our customers and from other groups. Whether that is a one, two, three or four quarter phenomena none of us know for sure.
To the second part of the question, we always share openly and transparently what we are seeing and that’s a hallmark of who we are and what we are about so we share the exact numbers we see with you. Its’ the first time Rick in many years we’ve actually missed the forecast in January – we missed it by 4 or 5 points.
John T. Chambers
So that certainly was a flag being raised; at the same time you see the things going on in the market. At the same time there are some issues with comparable Scientific-Atlanta being an example on that. But no, I would not set the hurdle lower so that Frank is off to a fast start. I wouldn’t do that to him in terms of the direction.
So my confidence in the market is good. I do think we are seeing a slowdown here. I think that is what you hear from the majority of CEOs in America and in Europe and I think that most of us believe that in that environment that it’s a market transition and if there’s one thing Cisco does well we execute on market transitions remarkably well.
I’d love to come back and apologize to you next quarter and say we were a little bit too cautious. We are sharing with you the data we see at a point in time. I’d love to have another month of data prior to making the projection, but I think like we’re calling it like we see it.
Now in terms of year-over-year growth, we always have acquisitions every year. So the prior year had acquisitions as well, Scientific Atlanta and others, and so when you compare apples to oranges we probably had more leverage in the prior year in terms of our growth because of acquisitions than we do in the current one.
So that’s kind of how I look at it, Nikos. I’m very comfortable with our long-term guidance of 12% to 17%.
In terms of the OpEx, make no mistake about it. We’re going to do what we’ve done every time before. We view this, as I said earlier, we try to determine where we are on our strategy, make sure our strategy was right, we believe firmly that it was. The second thing we do is how long do we think it will last? We think it will be short term and we think it will be relatively small on the implications of that.
Given that, we get ready for the upturn and we have a bunch of market adjacencies that we can go into and while its very easy to say well let’s not fund some new R&D opportunities on new products or some of the things we’re doing in the consumer or some other things that Martin is doing in the emerging technologies, this is actually the time when you ought to be doing that.
Make no mistake about it, we will be constructively and well thought out the business risk focused, but we will be aggressive both in our internal development and in terms of our acquisitions in this market because it does give us some opportunities in the market.
We clearly would not be doing that if we thought this was a long issue. We are doing it to gain market share. This is what we’ve always done. If you watch whether it’s a very short-term bump or a little bit longer, if we execute right with a very seasoned team we come out of it in stronger position both in terms of market share and in terms of profits and we have done that through every transition over the years.
Your next question comes from Scott Coleman - Morgan Stanley.
Scott Coleman - Morgan Stanley
John, what gives you confidence that the slowdown here will be short-lived and at least one of the takeaways that I have from your comments is that you don’t expect the commercial market to be impacted by a slowdown. Correct me if I am wrong on that later point, but I am just wondering if you can share with us some of the data points on why you think this will be a short and may be shallow slowdown?
John T. Chambers
My reasons are in part because that’s what our customers say and if you watch going into this area if there is to be any slowdown and I obviously believe that there will be, you’ve never seen businesses in as good a shape as they are. There is a lot of cash in the businesses, the PE ratios are logical; most of the companies we do business with are very well financed, so it isn’t like we’ve seen in prior economic downturns etcetera.
Secondly, the role of the network has absolutely changed and we are no longer plumbing we are literally enabling people’s strategy in IT and communications and you are beginning to see Web 2.0 and collaboration start to take off and it will be a gradual five to seven year run but it will drive productivity for five to seven years and you will see people have to spend on that.
Third is you do have good balance across service providers and as long you create competition among service providers in each country, you are going to see them have to build out because merely commodity-like behavior, value-added services on top of that and while people might hesitate for a quarter or two, if they hesitate too long when the incumbent or the challenger is moving, then it takes you a year to catch up with it .
The third part of the question, however, Scott I would not assume that commercial market will not be impacted. It absolutely will and if you watch commercial I would watch the commercial market in the U.S. and in Europe in terms of its momentum or not within that.
What we clearly saw in enterprise was a dip, especially in some of the large multinationals, then it came back; not to a great level but to a good level relatively quickly then you’re seeing a second dip that occurred in the other enterprise and it’s too simple to say by specific industry there was just a hesitation there that will probably be more than one month type of hesitation on it.
But I would go back to watching commercial as an element and I don’t mean to imply in any way they will not be affected. It’s just the best balance in terms of a global basis in terms of what we are doing. Jim?
John, I would add in the service provider space if things slow down a little bit or not isn’t really the issue. What you find is if your competitor doesn’t slow down in capital spending, you need to keep it up because this is all about shifting long-term customer bases. Because the value in most of them is associated with the value of the subscribers and the revenue stream so there really isn’t much ability in the service provider market to tune this thing back very long.
Yeah, but we did see some of the players here in the U.S. and in Europe tune back at least for a couple of quarters in terms of their projections for capital spending this calendar year.
Ari Bensinger, Standard & Poor’s.
Ari Bensinger - Standard & Poor’s
Thank you. I was wondering if you could give me an employee headcount quarter to quarter and was there a hiring slowdown during the quarter? How are you going to handle growth in that front?
John T. Chambers
…quarter, we added 1,000 people. I think you will see us watch a little bit more whether it’s resources [inaudible], you and Tony have done a great job of moving resources around from one group to another. And one of the things we did with the reorganization of engineering, we set it up structurally so that that could occur. It takes usually a couple of quarters to be able to look at where we are going in terms of -- you’re moving around your resources, because you do that through attrition or otherwise. But I think you will see us add headcount in terms of the key emerging market areas. We’ll hold them very tightly to profit contribution. We absolutely are going to be aggressive in engineering in terms of new product areas to move into and while you are not going to see the results of those expenditures for usually two to three years after we do them, it’s a lot cheaper for the shareholders to do an internal start-up than it is to do an acquisition.
Having said that -- Ned, your thoughts on acquisition, given that I challenge you regularly on that and given the PE ratios and some of the other implications, [suddenly are getting interesting again].
Absolutely, John. We believe very strongly that the best companies maintain a consistent acquisition strategy throughout the economic cycle. And in fact in challenging times, and particularly as we see the global equity markets reset themselves to more rational valuations, we expect to continue to be active in looking at M&A opportunities to expand our business.
But the core focus, as you’ve highlighted, is identifying those market transitions and looking at the best mix of build, buy, and partner to position ourselves for those transitions.
John T. Chambers
One of the huge advantages we have is clearly our cash position and our strength and we will be active both in repurchase and active as appropriate in terms of investment internally and externally on the opportunities.
Paul Silverstein, Credit Suisse.
Paul Silverstein - Credit Suisse
John, given what’s going on in the United Kingdom, if I remember correctly, historically that’s been your second-largest country and 2X the size of Germany and France. Given what’s going on, the objective data points coming out of there, there’s reason to believe that’s going to become weaker, not just the service provider issue but also enterprise and commercial and how much of an impact does that have on your European business?
John T. Chambers
Okay. The U.K. during the quarter in total grew about 12% in terms of orders. In terms of -- not counting the large multi-nationals like BT, et cetera, it was in the 7% range. It was the exact opposite of what we saw in the rest of the company, however, curve wise and it was kind of fascinating when we did the data to look back and see that what actually occurred in the financials in the U.K. mirrored what we saw in the U.S. We saw the financials in the U.K. in January actually have a reasonable, respectable January and that was not true of some of the other elements. And this is why trying to cut the data too fine can sometimes lead you to the wrong conclusion, but the financials both in the U.S. and the financials in the U.K. actually had a good January in terms of, if I remember my data right, on the positioning.
Accounts like BT and others, I think you are seeing us get dramatically closer to the service providers and remember, I don’t make any decisions on the next quarter or most of the time on the next year. I make all my decisions looking out beyond a year or two or three. That doesn’t mean we won’t tweak on expenses or be tighter but the clear message here that we see as an opportunity for growth, we will go for it aggressively and we will use good business judgment in how we do it.
But the European scenario is still very difficult to read for us and the U.K. is classic of that, where I would have expected the financial services group in January to be softer, given all that was going on. And actually, it was a fairly good quarter.
Now they are seeing the same thing that we saw in the U.S. multi-nationals -- a large amount of their business is going outside the country for the large multi-nationals. I think we are seeing that in Germany and others as well, Paul.
Tim Long, Banc of America.
Tim Long - Banc of America
Thank you. A different question on the guidance -- could we talk a little bit about the gross margin line? I appreciate the comments that it’s tough to predict, looking for it to be down slightly, at least at the midpoint. However, it sounds like from a mix standpoint, service provider and routing, which I think are generally higher gross margin products, seem to be in a better position heading into the April quarter. Could you talk a little bit about some of the puts and takes on that line? And the emerging markets gross margin did tick up sequentially, but it’s still down fairly significantly from what it was the last two years. Is that one of the key contributors to your thoughts that it will be down sequentially in April? Thank you.
John T. Chambers
Okay, so breaking it into a bunch of questions, again, it’s hard to comment on each of the variables and then add it up into a total but if you look at our overall trend, I think we’ve done a very good job, and Randy Pond played a huge role in this, Pankaj, the engineering teams did a very nice job, Angel did a great job in manufacturing, the financial team, Frank and Dennis, to refocus on it. We put a lot of attention starting about six to nine months ago in gross margins and a lot of attention constructively in terms of the positioning on it.
In terms of the emerging markets, we are going to be more aggressive there than we will in some of the other areas in terms of resource investment but I think you saw the discount level come back the right way this quarter and we are focusing on measuring them on profit contribution.
So I don’t see anything here that makes me particularly nervous on the mix, the gross margin mix. It is high in routing, which has a lot better margins than some of the other type of products do, but gross margins overall, Frank and Dennis, I don’t know if you want to make any other comments, but if I look at the total, I don’t see anything that makes me unusually nervous. In fact, we think we can, if we execute right, gain market share regardless if this is a couple month phenomena or a several quarter phenomena without much impact on the gross margin line.
I would agree, John. I think we would expect that we are going to see the mix factors be relatively small in terms of its impact on gross margin. What we are really looking at in bringing that down just slightly in terms of the forecast is that we usually see some benefits from volume related and obviously if we are bringing the volume down a little bit, then we’ll see not as much benefit from that. So that’s the main difference that we are seeing from Q2 to Q3.
I think we have time for one more question.
Phil Cusick, Bear Stearns.
Phil Cusick - Bear Stearns
John, I wonder if you can clarify a little bit -- as you talk to customers, and it sounds like you’ve talked to a lot of customers in the last few weeks, do you think that there’s a budget issue and they are reducing budgets overall? Or do you think it’s just they’ve got a budget set which is fairly healthy and they are looking at the market and they are looking at CNBC, as you said last quarter, and they say you know what, I think I’m going to hold off. And whether that’s for January or for the first half, we’re in that sort of slowdown rather than a reducing budgeting situation.
John T. Chambers
I think your question is an excellent one and it’s something that I personally agree with very strongly. I think we are actually talking ourselves into this slowdown. And I use the example, I usually run in front of one of the key media organizations in the morning, so I get on the treadmill and run and over the last three or four months, I felt pretty good about business until I got on my treadmill and then I quit early because of the pessimism that exists in the market.
When I talk to many CEOs, most of them would start off with I feel pretty good about my business but I don’t like what I’m hearing and seeing. And that increases when you see the large movements on their stock.
And so it’s probably as cautious or very cautious as I’ve seen CEOs in the U.S. and Europe in many years and it isn’t that they’ve change budgets dramatically at all. In fact, I think you are seeing and understanding that especially the networking segment can have a major impact, not just on keeping their business running but where productivity and differentiation will occur. But I think they are hesitating and also putting people through their exercises stronger in terms of approval. And I think that could occur in commercial markets as well in terms of the confidence.
So when you really talk about our numbers, part of what we are building into this is we do think there is a very cautious attitude in the boardroom and that’s different than six months ago. And we do think that people tend to hesitate and maybe put people through more hurdles to get approval, more signatures, and a little bit tighter return expectations until they figure out how does this look.
I think that’s a great question to end on, Phil. In summary, I want to thank you all for taking time to join us today. I feel very good about our long-term guidance and things we can control and influence, looks very, very solid, but we will always share in an open and transparent way, even though it makes us sometimes uncomfortable to do so, exactly what we are seeing and try to articulate it the best of our ability.
So with that, Blair, let me turn it back to you.
Thanks, John. So as a reminder, Cisco’s next quarterly conference call, which will reflect our third quarter fiscal 2008 results, will be on Tuesday, May 6th, at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time.
Again, as a reminder, we have posted full GAAP to non-GAAP reconciliation information along with our financial statements on our website in the investor relations section and additionally, just following this call, the downloadable Q2 financial statements will be available, including revenue statements by both product and geography. Just click on the financial section of the website to access those.
Again, I’d like to remind you that in light of regulation fair disclosure, Cisco plans to retain its longstanding policy not to comment on its financial guidance during the quarter unless it is done through a public disclosure. Please feel free to call the investor relations department with any follow-up questions from this call and thank you again for your participation and continued support. This concludes our call.
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