Cisco's CEO Discusses F1Q 2014 Results - Earnings Call Transcript

Cisco Systems, Inc. (NASDAQ:CSCO) F1Q 2014 Results Earnings Call November 13, 2013 4:30 PM ET

Executives

Melissa Selcher - Senior Director, Analyst and IR

John Chambers - Chairman and CEO

Frank Calderoni - Executive Vice President and CFO

Rob Lloyd - President, Development and Sales

Gary Moore - President and COO

Analysts

Tal Liani - Bank of America Merrill Lynch

Ben Reitzes - Barclays

Simona Jankowski - Goldman Sachs & Co.

Amitabh Passi – UBS

Kulbinder Garcha - Credit Suisse

Paul Silverstein - Cowen & Co.

Mark Sue - RBC Capital Markets

Operator

Welcome to Cisco Systems’ First Quarter and Fiscal Year 2014 Financial Results Conference Call. At the request of Cisco Systems today’s call is being recorded. If anyone has any objections you may disconnect.

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

Melissa Selcher

Thank you. Good afternoon, everyone. And welcome to our 95th quarterly conference call. This is Melissa Selcher, and I’m joined by John Chambers, our Chairman and Chief Executive Officer; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, President of Development and Sales; and Gary Moore, President and Chief Operating Officer. I would like to remind you that we have corresponding webcast with slides on our website in the Investor Relations section.

Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements and other financial information can also be found on the Investor Relations website.

As it’s customary in Q1, we have made certain reclassification to prior period amounts to conform to the current periods presentation, the reclassified amount have been posted on our website. Click on the Financial Reporting section of the website to access these documents. Throughout this call, we will be referencing both GAAP and non-GAAP financial results.

The matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent reports on the Form 10-K 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. All comparisons throughout this call will be on a year-over-year basis unless otherwise stated.

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

John Chambers

Thanks, Mel. In Q1 FY ‘14 Cisco delivered record non-GAAP earnings per share of $0.53 per share and revenue growth of 2% year-over-year. This level of revenue growth in Q1, while not inconsistent with some of our large peers was below our expectations for the quarter.

Over the last few quarters, I’ve shared with you what I’ve been seeing, a microenvironment that is inconsistent and very hard to read, with business leaders confidence slowing purchase decisions.

The last month of our quarter was during the U.S. government shutdown. The impact on our federal business was approximately $50 million. Our team there did an exceptional good job managing through this challenging period.

However the shutdown, debt feeling negotiations and delayed key decisions exasperated the lack of confidence among business leaders we had highlighted over the past few quarters. As we walk through our business in detail, you would hear many positives. Our strategy to solve our customers’ biggest technology and biggest business challenges is working. We delivered strong non-GAAP profitability. We are leading most of the major transitions in the market and our innovation engine is faring extremely well.

That said, we are managing through several cycles in our business. First, emerging market weakness; second, the introduction of several new generation platforms in high end switching and routing; and third, our service provider of business evolution.

Our intermediate long-term strategic view has not changed and we are continuing to lean forward and make investments that would drive our future growth. We are disrupting markets. Look at our Application Centric Infrastructure launch and Internet of Things and our NPS launch in just the last month to drive value to our customers and to our shareholders.

From where I see it, I believe we are well-positioned at the center as the long-term transitions shift into communications and IT market. We feel the momentum of our thought leadership in this market and we are experiencing our customers’ confidence in Cisco expand as we move to become their trusted business partner and hopefully the number one IT partner.

I know many of you speak with our customers and partners. And I'd be very surprised if you're not seeing and hearing the same thing. For Q1, I want to highlight five key takeaways. First, once again our financials are very strong. In Q1, we delivered record non-GAAP earnings per share of $0.53, non-GAAP operating margins of 29.3% and strong non-GAAP gross margins of 63%. We generated operating cash flow of $2.6 billion and returned approximately $3 billion to our shareholders, through the buyback and dividend. The one obvious exception is our revenue growth.

Second, our strategy is solid and we’re leading on the critical transitions in the market. I look at cloud as one example. We are the leading cloud infrastructure provider as measured by Synergy Research and our cloud services business, including Webex hosted collaboration, elements of our own security and wireless portfolio are showing good momentum. And last week, we demonstrated how we expect to lead the SCM market, delivering an integrated system that drives to the core of solving our customers’ top challenges. Speed of application delivery, virtualization, OpEx and CapEx reductions, complicity, security and scale in a single architecture. In every case, our ability to pull together the breadth of our portfolio to deliver architectures and solutions to meet customer outcomes that is apart.

Third, our innovation engine is executing extremely well. We continue to innovate through a build, buy partner strategy and are seeing the benefit. In the last quarter, we introduced game-changing core routing and core switching platform and took a significant step forward in our security business with the acquisition of Sourcefire. With these and other moves, we are uniquely positioned to help our customers navigate the demand of the cloud, mobility, the application economy and the internet of everything.

These platforms are expected to ramp over several quarters. But perhaps one of the things that I'm most pleased at and this is different than we’ve ever done before on the new product development, high end switching and high end routing. Each of this new product, for example, Nexus 9000 with ACR, CRS-X and NPS are in line with our current margins from day one. Just a really nice job by engineering.

Fourth, we are managing through some economic, technology and product cycles. From a macroeconomic perspective, in the last two quarters, our order growth rate in emerging countries, which is over 20% of our product business, has gone from a positive 13% in total in Q3 to a negative 12% in Q1 of this year. You can do the math but that’s a drag of between four to five percentage points on our growth for this quarter.

In service provider, we are managing through product cycles across our portfolio, including high end Core, Edge, and SP video. What you know about Cisco is that when we have focus on something we address it in IT and this is no different.

Fifth, we have a unique opportunity to be our customers’ number one IT company. Our customers are asking us to step up in new ways to take a broader role in helping them achieve their business outcomes. At our recent CIO meeting with 95 of top global CIOs, they confirmed our leadership position and increased opportunity for Cisco over the next years in their own individual companies. And this was at a much higher level than the other top IP players that we talked about with the CIOs. This is a tremendous validation and is pushing us to move faster to offer our portfolio of technology and architectures, add solutions to address the business outcomes our customers need.

Fortunately for Cisco, no one comes close and been able to meet their requirements and we are moving with speed to evolve, to capitalize on this opportunity. To provide additional detail on our Q1 FY ‘14 results, I’d like to turn it over to Frank. After Frank, I’ll then walk through some additional details and what we’re seeing in the business, Frank will then detail our guidance and will wrap the call up with Q&A. Frank, to you.

Frank Calderoni

Thank you, John. In Q1 FY ‘14, we drove solid profitability despite our lower than expected revenue growth. Our business continues to operate in an inconsistent and mixed macroeconomic environment and we had specific challenges in the emerging markets and service provider.

At the same time, we had relative strength in data center, wireless, security and our switching business. From a top line perspective, total revenue was $12.1 billion growing 2% year-over-year and non-GAAP EPS was $0.53 growing 10% year-to-year.

In this quarter, we continue to execute consistently without portfolio approach to acquisition aligned to driving long-term returns. We announced the WHIPTAIL acquisition to celebrate our UCS strategy. WHIPTAIL is the market leader in high performance, scalable, solid state memory system and we also closed two acquisitions this quarter, Composite Software and Sourcefire.

Sourcefire, a leader in intelligent cybersecurity solutions and brings industry-leading products, talent and an open-source approach to our security portfolio. Composite Software offers data virtualization software and services and will extend our next generation services offering. We also announced our intent to acquire the remaining interest in Insieme Networks as part of our application centric infrastructure-based data center and cloud solution.

Total product from a geographic perspective grew 4% for the Americas, 3% for EMEA and decreased 9% for APJC. The overall product revenue increased 1% and total services revenue increased 4%.

We delivered solid non-GAAP operating margins of 29.3% with consistent results in both gross margins and operating expenses with continued strong discipline in these areas. In Q1, our total non-GAAP gross margin was 63.0%, that compares to 62.7% a year ago and 62.1% last quarter.

We continue to see good stability over multiple quarters and product gross margins, with non-GAAP gross -- product gross margins at 62.0% compared with the 61.5% year ago and 60.8% last quarter. Our non-GAAP services gross margin was 66.6% compared to 67.1% last quarter and 66.9% in Q1 FY ‘13.

Total gross margins by geography where Americas were 63.6%, in EMEA it was 64.4% and APJC was at 58.8%. Our non-GAAP operating expenses were $4.1 billion or 33.7% as a percentage of revenue and this compares to 34.8% in Q1 of FY ‘13.

Our headcount grew less than 100 from the end of the fiscal year to 75,136. This reflects the addition of over 850 employees from the Sourcefire and Composite Software acquisition, offset by our workforce rebalancing that we announced in our Q4 FY ‘13 earnings call.

As I mentioned on that call, the workforce reduction plan provides us the ability to invest in key growth areas such as cloud, data center, mobility, services, software and security to effectively manage our business for the long-term. Other income and expenses with $85 million reflecting a benefit of higher investment gains during the quarter.

Now moving on to our non-GAAP tax provision rate. It was 21% and it was consistent with our expectations. Our non-GAAP net income was $2.9 billion representing an increase of 12%. As a percentage of revenue, non-GAAP net income was 23.7%.

As I mentioned earlier, our non-GAAP earnings per share on a fully diluted basis was $0.53 versus $0.48 in the first quarter of fiscal year 2013 and again this represents a 10% increase.

Our GAAP net income was $2.0 billion and GAAP earnings per share on a fully diluted basis was $0.37. GAAP net income included $257 million of pretax charge related to our intended acquisition of Insieme Networks as I previously mentioned.

As we indicated in our Q4 FY’13 call, as part of our workforce reduction plan, we stated that we expected to take pretax charges to our GAAP financial results in an amount not to exceed $550 million. During Q1, we recognized pretax charges to our GAAP financial statements of $237 million related to that announcement.

Our cash returns to shareholders, balance sheet and cash flows were once again areas of strength. During the quarter, we returned $2.9 billion to our shareholders, including $2 billion through the share repurchase and $914 million through our quarterly dividend.

Our diluted share count decreased slightly as a result of the timing of our share repurchases. The remaining impact of the Q1 repurchase will be reflected in the reduced share count next quarter. As disclosed in our press release today, our board has approved an increase to the repurchase program of $15 billion, demonstrating our commitment to our capital allocation strategy. The remaining approved amount for share repurchases under this program, including the additional authorization, is $16.1 billion.

Total cash, cash equivalents and the investments were $48.2 billion, including $6.2 billion, which was available in the U.S. at the end of the quarter. We generated solid operating cash flows of $2.6 billion, increasing 7%.

In terms of our key balance sheet metrics, DSO or days sales outstanding were 39 days and finally, our non-GAAP inventory turns were a strong 12.1.

In conclusion, we are focused on the near-term challenges. At the same time we are investing in our portfolio of growth initiatives and driving profitability through operational efficiency. We are committed to our capital allocation strategy through the support of the dividend as well as the buyback and our overall objective is to deliver long-term profitable growth and return for our shareholders.

John, I will now turn the call back over to you.

John Chambers

Thanks, Frank. I will now provide some additional detail on the performance in Q1 and trends we are seeing in our business and in the market. I’ll first walk through our product portfolio in terms of year-over-year revenue growth, followed by discussing geographic and customer segments in terms of year-over-year orders.

First, our switching business performed well with growth of 3%. Switching gross margins, including new products, continue to be very stable. We have introduced next-generation products across most of the entire portfolio, including the highly anticipated data center switching line in the Nexus family, the Nexus 9000. Developed by our recently acquired spin-in Insieme Networks. The Nexus 9000 began shipping in November and we will ramp over the coming quarters.

Wireless delivered another solid quarter with gross [ph] revenues of 8% and stronger gross margin. The comparison to 802.11ac is in the beginning stages with support now across our product line. Cisco’s networking platform or Rocky continue to perform very, very well.

NGN routing revenue was down 1% for the quarter. We saw declines in the quarter as we managed the product transitions in that business. We shipped a new NPS platform to our first customer this quarter and continue to manage the transition of our CRS platform to the CRS-X.

On the AS -- ASR 9000 had another record revenue quarter with growth constantly about 20%. But our Edge performance was impacted by declines in our traditional products, in both the Core and Edge we are focused on migrating programs that will drive upgrades to the new platforms over the coming quarters.

We saw decline in our ASR 5000 mobility revenues due primarily to timing of large orders. SP video revenues of $987 million declined 14% year-over-year. As we continue to focus on profitable growth, our set-top box business, which had an annual order rate of over $2.6 billion, declined over 20% as we evolved our business to the cloud and hold to our strategy to walk away from low profit deals. This obviously has a positive impact on margins that comes with some revenue pain.

Let me be very clear, we know that video is one of the top priorities of all of our service provider customers and we are committed to the business. We are evolving our portfolio and have made leadership changes, which will strengthen our ability to meet strategic requirement of our customers and maintain the right business program for Cisco.

Our data center business grew 44%, as customers continue to adopt our unified computing systems. We continue to see success with solutions such as SAP HANA that incorporates our UCS servers. Converged solutions from NetApp, FlexPod and EMC, VMware, Vblock are now each running at over a $1 billion run rate for their total business.

These solutions are fueling our industry-leading strong data center growth across all segments and regions. UCS is one of the best examples of our portfolio of an architectural approach, delivering differentiated value to our customers and driving our market success.

While most of our competitors in this area sell servers, with UCS we saw an architectural approach and in just four years have become the number one in the Blade Server market. UCS sets the foundation for our leadership data center, bringing together compute, networking and storage.

And as you think about where this is going to go in terms of the next-generation driving IT growth, we believe it is around application centric infrastructure, which will build on this success and expand our leadership for the next decade as we simply converge applications, networks and security at scale.

Overall, security revenues grew 8%, with particular strength in network security, up 12%. We closed the Sourcefire acquisition on October 7th and are already seeing the benefits of a focus and the assets we fully acquired.

Security is our customers’ top priority and according to them, we may be the only company capable of providing the full architecture they need to address their security challenges. We’re off to good start and it’s up to us to execute on this architecture.

Moving on to collaboration. Revenue was up 1%, as our strategy and execution continues to evolve. Unified communication revenue declined by 3% year-over-year, as we move to a different revenue model in the business, increasing the amount of business which is reoccurring.

Conferencing revenue grew 12% and Telepresence revenue grew 1%. Finally services revenue grew 4%. The technical services were up 4% and advanced services up 5%. Non-GAAP gross margins and services were very solid at 66.6%, down slightly from 66.9% a year ago.

As we discussed last quarter, service revenues are tied closely to product growth. We were very pleased with gross margin and the technical services growth given the challenging services market. We do believe there is further opportunity to improve our advanced services performance, as we move from transaction to driving our customers top business opportunity and the results they want to get in terms of outcomes.

I will now move on to provide some color on our geographic and customer segments. The following geographic and customer segment growth rates are in terms of year-over-year product orders for Q1, unless specifically stated otherwise.

In Q1, we saw growth, momentum and opportunity in global enterprise and commercial. U.S. enterprise and commercial were both very, very strong, growing in the high single digits in terms of year-over-year orders.

U.S. public sector actually grew 2%. However, the positive growth trends in orders were more than offset by the two factors mentioned earlier. Emerging Markets orders declined 12% and service provider orders declined 13%. As a result, total product orders declined 4% year-over-year with total product book-to-bill of less than one.

We did see the weakness increased conservatism and slower decision-making on a global basis accelerate beyond our expectations, due to back end of the quarter. In our leadership reviews in mid-September, we believe our orders in the quarter would translate to revenue in our guidance range.

To provide a geographic view of orders this quarter, the Americas declined 2%. In the U.S. in addition to the good enterprise and commercial momentum, we delivered U.S public sector growth of 2%, led by state, local and education up 13% and U.S. Federal down 3%. Service provider in the U.S. declined by 10%. The issues in the U.S. were similar to what we see globally in SP and I will expand on this in a discussion of SP segment.

Moving on to Asia-Pacific, Japan and China, similar to last quarter, we again experienced the same challenge as many our peers. Overall, Asia-Pacific, Japan and China was down 10%. China continued to decline as we and our peers worked through the challenging political dynamics in that country.

The Europe, Middle East, Africa and Russia region declined 4%, due primarily to the effect of the emerging markets public sector and SP. Central Europe continued to show positive growth. Southern Europe continues to be challenging. Europe, while there are positive trends remain challenging as seen in the recent ECB interest rate reduction announced last week. This action should help [indiscernible] economic recovery over time.

Across every geography, the impact of emerging market weakness was pronounced and accelerated to the backend of the quarter. Our top five emerging markets declined 21% with Brazil down 25%, Mexico down 18%, India down 18%, China down 18% and Russia down 30%. As we always had, we will continue to focus on emerging markets, investing through the challenges and expect to see return to growth in few quarters with all the appropriate caveats.

Moving on to the segment review. As mentioned earlier, enterprise grew 2% and commercial grew 1%. Public sector declined 1%. Service providers declined 13%. As a reminder, the service provider business continues to be lumpy and go in cycles, and our service provider growth rate is negatively impacted by the deliberate actions we are taking to manage the profitability of our set top boxes.

As we discussed before, the set top box orders which are approximately 20% of our total service provider business -- product service provider business was also down 20%. That means the service provider segment started the quarter down minus 4% to 5%, due to net decrease in set-top boxes.

Several factors negatively impacted the growth in addition to set-top box impact. First, we operate globally, the emerging markets challenge have some impact on the SP bookings. Second, we introduced two new platforms, NCS and CRS-X and the Core and are seeing slower growth than anticipated, customers to continue invest in the existing platforms and adopt these new platforms. As a reminder, NCS, like ACI on the switching side is an entirely new architecture requiring an additional time and test and evaluation.

And third, we lost some share on the low-end Edge which we need to win back. As you would expect, we have focused our leadership on what we can control to reaccelerate service provider growth despite the challenging macro over the next several quarters. We are focused on pulling together the breadth of our portfolio and innovation to solve our customers’ top business opportunities, just as we've done very effectively in enterprise over the last 12 to 15 months and we clearly saw the results in enterprise in doing that.

We are managing the evolution of our portfolio and aggressively moving to meet service provider requirements for greater virtualization of services across our mobile and wireline platforms. We are planning our resources to the opportunities for greatest growth. We are seeing very good customer traction in our new Core platforms, with active trials in many SP customers and moving from trial to production. I believe our global service provider stage is solid [ph] and we are unique in our ability to add service provider customer challenges with architectural solutions that deliver their business outcomes. We will continue to focus on the innovation and execution to drive the acceleration of the business. Managing through product and market cycles is part of being a leader in the technology industry. We feel very confident in our ability to work through these cycles over the coming quarters.

I’ll now turn it over to Frank for guidance. Frank to you?

Frank Calderoni

Thank, John. Let me now provide a few comments on our outlook for the second quarter. Let me remind you again that our comments include forward-looking statements and 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 statement. And that actual results could be above or below our guidance.

The guidance we are providing is on a non-GAAP basis with a reconciliation to GAAP. As we look to Q2 FY’14, we do not anticipate material improvement in our order growth. This is impacting our revenue guidance for Q2. Given our orders performance in Q1, our backlog is significantly lower than we anticipated. As a point reference, approximately 70% of our product revenue is dependent on new orders each quarter.

With that in mind, we expect total revenue to decline in the range of 8% to 10% on a year-over-year basis. For the second quarter we anticipate non-GAAP product gross margin – non-GAAP margin to be in the range of 61% to 62%. Our non-GAAP operating margin in Q2 is expected to be in the range of 27.5% to 28.5%. Our non-GAAP tax provision rate is expected to be approximately 21% in the second quarter.

Our Q2 FY ‘14, non-GAAP earnings per share is expected to range from $0.45 to $0.47 per share. Given the guidance for Q2 ‘14 and the shift in momentum in our business, we thought it would be helpful to provide investors and share more detail on the full year of the fiscal year.

We expect our FY ‘14 non-GAAP earnings per share to range from a $1.95 to $2.05. Within this, we suggest you model revenue conservatively. We have a strong handle on our gross margins, operating expenses and cash flow and we believe we can deliver this level of profitability even in an uncertain growth environment.

We are not changing our long-term financial model. We continually revaluate our long-term model as you would expect as the market changes. We will update you at our Financial Analyst Conference in December, if we see the need for any adjustments. We remain focused on driving profits faster than revenue.

We anticipate our GAAP earnings to be lower than our non-GAAP EPS by $0.10 to $0.14 per share in Q2 and $0.45 to $0.60 for the full year. This range includes an impact of approximately $100 million in Q2 ‘14 and $550 million for the full year, as a result of our anticipated restructuring charges related to our workforce reduction plan that we announced last quarter. Please see the slides that accompany this webcast for more detail.

Other than those quantified items noted previously, there are no other significant differences between our GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructurings and tax or other events which may or may not be significant. As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

I thank you and turn it back over to John.

John Chambers

Frank, thank you very much. There is no doubt that the pace have changed that we all feel and see is only accelerating. As I have been saying throughout this calendar year, things that used to occur in five years are happening in three. Things that used to happen in two to four quarters are occurring in one quarter. This is a new market reality.

Let me be very clear, change has always been good for Cisco. We used these times to get closer to our customers, transform our business and drive new opportunities. I speak with many of you, our shareholders during the year and appreciate the investment you are making and understanding our business, including attending our launches and events, as many of you did in New York last week.

I note from those meetings that you understand our strategy and where we can take this company. I also know that while we see these transitions as opportunities, these transitions can create unwelcome quarter-to-quarter volatility and can be frustrating for long-term shareholders.

As we have always done, we’ll commit to you to be transparent, letting you, our shareholders see the challenges and the opportunities as we see them. We remain very confident in our long-term strategy and are committed to managing the business to ensure we drive the greatest long-term value for our customers, employees, partners and shareholders.

What can you expect as we address the opportunities, cycles and challenges in our business and the market over the next several quarters? First, I realized many of you spend a lot of time speaking with our customers and channel partners. As you know, our relationship with the customers has never being stronger. We are winning and they know it. They have asked us to play a bigger role in partnering with them to drive their business outcomes. We will continue to move quickly to capitalize on the opportunities they have presented to us.

Second, we will continue to manage the business with focus on discipline, where we have challenges and cycles we will move swiftly and decisively to drive growth and continue leadership.

Third, we will maintain our momentum on Cisco’s innovation model of build, buy and partner. We planned to leverage our acquisition of Sourcefire to achieve our goal to become the number one security company and drive new product platforms and architectures like CRS-X, NCS and ACI to build multi-billion dollar business at Cisco.

Let’s discuss a bit deeper the application centric infrastructure launched last week. When we look back five years from now, I believe we will see ACI as a pivotal point in redefining IT. We were very pleased with the response to the launch but we were not surprised. We designed the system in ACI that would address the most pressing needs of our best global customer base, companies, government and service providers of all size.

A ecosystem as the major technology companies, our peers and competitors have publicly stated how strategic they believe the platform will be in their future priority and major cloud enterprise and commercial customers has chosen the ACI architecture to run their business. This is Cisco at is best. We delivered innovation on an entirely different scale than our competitors. A system that would drive revenue and productivity, reduce costs and mitigate risk, protecting their existing investment and future proof, and this is the first time I have ever used that word, future proof their solutions going forward.

To quote some of you, ACI is a game changer and a significant step in the realization of the Internet of Everything. The two will move closer together, both the Internet of Everything and Application Centric Infrastructure and move faster than many people anticipate. And Cisco will be there to lead.

First, we will continue to increase our commitment to you, our shareholders. As you can see from the announcement today, our board has granted a new share repurchase authorization of $15 billion, which we intend to put to work. You should expect that over the next several quarters, we will exceed commitment to returning at least 50% of free cash flow to shareholders, just as we did this past quarter.

In summary, I want to thank our shareholders, customers and partners for their support, especially those customers and partners that were integral to our success for the launch of ACI. In particular, I want to thank the Cisco family for working together as a team to ensure that our company is in a solid position to capture the opportunities we see in front of us. Let me turn it back to you, Mel.

Melissa Selcher

Thanks, John. I wanted to clarify one comment John made during his product statement. We are not quite yet number one in blade server market. We are number two in that blade server market.

All right. We'll now open the floor to Q&A. We still request that sell side analysts please ask only one question. Operator please open the floor to questions.

Question-and-Answer Session

Operator

Thank you. And our first question comes from Tal Liani with Bank of America Merrill Lynch.

Tal Liani - Bank of America Merrill Lynch

Hi guys. Your guidance is very low if I got the numbers right, it’s about 11% sequentially – 11% down sequentially for revenue. Then I went back to 2000 -- October 2000 and I've never seen such a low number outside of 2008 or 2009, I am looking at it January 2009, and at that time the world was about to collapse, January 2009. That’s when all the problems hit the financial system. And I am wondering why are you guiding so low for next quarter? It looks like the environment may continue to be weak but it's not as bad as it was in ‘09 and certainly not as bad as it was in October 2000 etc. So what are the components of the weakness for the next quarter?

John Chambers

Okay. Let me do both. Let me talk about the component of the weakness and the areas we feel the strongest, so on. There are no comparisons in a measured way to 2009 or 2001. You basically look at our business and let me answer that very crisply [ph], because I know it’s a thought on many people's minds given what we’ve just guided to. The U.S. enterprise and commercial, which are the areas that I watch for a long term U.S. economic growth, both are in high single digits. And we feel pretty good about their pipeline going forward.

Our federal team executed well in a tough environment, so our state and local government and federal government is solid. Service provider, we need to make improvement on and we have a multiple step approach to how we are going to do that in terms of direction. You look around the world, the emerging markets, I have never seen that fast a move in emerging markets and that is something that when I talk with our industry peers, while there are exceptions, most of my CEO counterparts can almost finish my sentence in terms of what's occurring. It's also occurring with many of our customers where if you were to talk about Brazil as an example, they can finish each other's comments to CIOs about their business whether it’s the consumer business or whether it's the manufacturing segment in terms of the direction.

We're very comfortable with our leadership and our share of spin gains in the marketplace. We do have to work in three areas. In terms of the focus on the emerging marketplaces, we are modeling for a challenging next couple of quarters. We believe that more than half the world’s GDP occurs there. But we’ve put in place a plan over a year ago that we will learn to continue to drive through the slowdown. Part of the reason, Gary, when we laid off people was to free up resources to move to emerging markets and you will see us increase our sales headcount in the appropriate emerging markets as we go forward to capitalize on that.

We will literally expand focus on a countrywide prioritization and if you watch what we did in Israel, which is clearly a developed country, we will do that across other emerging markets.

We will expand the executive contact and there will always be some unique situations where Cisco needs to execute well in one of our top 15 countries or there is unique issue like exist in China, that’s just part of what emerging markets go.

The service provider focus, we’re in the middle of product transition, when product transitions occur at the CRS-X and NCS level, you begin to see a hesitation on how much the customers buy the current products.

Rob, your sales team and Chuck’s sales team have gone through and walked through where we are in that, but there’s a natural kind of hesitation given uncertainty in the market and uncertainty business leaders about how fast they will move through these new platforms and how much they will continue to expand, which overtime they absolutely will the existing platforms in terms of the direction.

Set-top box, we’re going to take a 4% to 5% hit for a number of quarters in the future. What we’re going to do on that, however, is continue to accelerate the movement to the cloud which has much higher gross margins.

We made some leadership changes, as I said there earlier and we’re also going to work on really value-add engineering, Gary, which I think your supply team has done an amazing job, so that we can look on more deals that would have better profits as we move forward.

We are not going to change the organization structures that we have. We are organized in business entities to expand but we are going to change in terms of having a couple key leaders go across the whole company just like we did in enterprise where Chuck Robbins and Rob Soderberry with myself and [indiscernible] helped them to prioritize resources throughout that segment of the market and we will apply the resources to where areas that we had not moved as much resources, especially since now, we have done a good job at the high end core to other segments.

That’s kind of a summary of the position, Tal. What happened was we were $600 million to $700 million short of what we expected orders to be in this last quarter. It was almost all backend loaded and literally down to the last two weeks, we were disappointed by multiple hundreds of millions in terms of what we normally closed in the last couple of weeks.

You have that shortfall not being in backlog going into next quarter and when you look at your sequentials, Tal, you have to go off of this new number as you look going for it. You add the two together that’s a $1.2 billion challenge. Frank, would you add to that?

Frank Calderoni

No. I think you covered it, John. I mean, it includes the key things what you said, material shortfall and orders in the back half of Q1 and specifically as we saw in October. This immediately hits not only affected our Q1 performance with the revenue being shorter than what we had provided in our guidance. So you are looking at the mid range of our guidance but it also ended up with a significant shortfall in the backlog at the end of Q1 and that affects the business opportunity that we have going into Q2.

And then overall if you look at the business momentum now in Q2, specifically in emerging markets and service provider as you articulated earlier, those businesses as well the most challenged in Q2, when you look at that offset by the related impact that we have with the services business that ties to that as well that results in the guidance that we provided.

Melissa Selcher

Yeah. Thanks, Tal. Next question, operator.

Operator

Thank you. Our next question comes from Ben Reitzes with Barclays.

Ben Reitzes - Barclays

Hey. Good afternoon.

John Chambers

Hi, Ben.

Ben Reitzes - Barclays

Thank you. Hi. Couple of things that you didn’t mention but I was wondering in emerging markets especially there’s been a lot of concern out there about the NSA snooping and the impact that’s had on global IT and global IT brands like yourself? And you maybe alluded to this with regard to your comments on China and the political situation? But I noticed Russia was perhaps down even more than China and what not?

Do you feel that there’s something more going on, this -- we’re all floored by your guidance here? But is there something a little more to this that with customers outside of the U.S. thinking a little bit more about U.S. IT brands and is that impacting your business and if so or if not, then what do you do in the future? Thanks a lot, John.

John Chambers

Sure. Ben, I think, if you look at it, it is an impact in China. I think we’re all aware of that. I think it’s totally impact on the total emerging country business, however, is fairly nominal.

I do think we are seeing a slowdown in these emerging markets both in the decision making and their economies. And so I do not think it is a major factor across all of emerging. I do think it is a factor however in China. Rob, would you add anything to that?

Rob Lloyd

I would just add, John, that this issue has caused increasingly customers to pause and another issue for them to evaluate, in all of those complexities that you've already discussed. So it's not having material impact but it's certainly causing people to stop and then rethink decisions and that is I think reflected in our results.

Frank Calderoni

I think then what you articulate and we're trying to do too, the amount of inconsistent data is just causing customers to hesitate including at the country level.

Operator

Our next question comes from Simona Jankowski with Goldman Sachs & Co.

Simona Jankowski - Goldman Sachs & Co.

Hi, thanks very much. So it sounds like one of the issues you're dealing with is the transition on the routing side of the business and obviously you just introduced some fairly large platforms on the switching side, which is even larger than your routing business. Would you expect to see a similar top haul [ph] basically in the switching business in the next couple of quarters as you work through that?

John Chambers

That's what we have modeled into it. It won't be a haul, but the growth will not be what we would normally experience. Once again, the sales teams have set up our products by individual areas, but you combine with just a very slow spending environment. Simona, let me back for a second. When I talked to CIOs on the issues of Business Council, as an example. Half the CEOs that they surveyed, Chief Executive Officer they surveyed believed the economy is going to grow between 0% and 2%. They are modeling their budgets conservatively and as they think through this the CIOs will hesitate as they have product choices, doesn't mean they won't continue to buy our Core 7000s and other products, they will but they are going to strike a balance of what do they want to do in terms of the mix and as they commit through. So, yes, we had modeled this in Q2 and Q3.

And yes, to the indirect part of your question, as you come into Q4 and come up to Q1 of next year with all the appropriate caveats because of where we are on product cycles, where we are in terms of what we're going to double down on in some of the things that we need to address, my goal for our company is to get back to positive revenue growth in Q1 and ideally in Q4. But that's a stretch goal with all the appropriate caveats associated with it. So, you will have product cycles working towards that. You will have our momentum in the market working to it and I think that is kind of what our expectations are. You saw Frank's bookends on the earnings. We did it deliberately so that you could understand the areas that we are operating in, Simona.

Operator

Our next question comes from Amitabh Passi with UBS Securities.

Amitabh Passi – UBS

I was just trying to understand your guidance again in the context of your deferred revenue growth. I mean, it seems like you got pretty strong growth both sequentially and year-over-year in product revenue growth – product deferred revenue growth. So just want to understand again, I'm really perplexed by the guidance here. I understand some of the pain points you identified, but maybe if you could just shed some light there.

Frank Calderoni

So, if you look at the deferred revenue, Amitabh, the deferred revenue was up around 11%. If you look at underneath what that is, that shows a lot of the business that we have on collaboration side, which is moving to more of the recurring. So we have more deferral associated with some of the offerings that we have there. That's a majority of where that is. So that’s the good news from the perspective, it starts to show some of the momentum that we have in the collaboration businesses, is one of the businesses John mentioned earlier that we have been really investing in on the product portfolio over the past year and we're looking at this product set over longer period of time and also looking at some of the model that our customers are looking to purchase. And some of that is going to be more of a recurring revenue model which is kind of improving the deferred revenue.

John Chambers

An example on that, Amitabh, would be security and with the movements on Sourcefire. It was an area that really began to take hold this quarter. I think our customers realize we are very serious about moving to be the number one security player. You will see us expanding consultancy in this area, and as we did that, even our network security grew 12% which had not grown as you all know for a very long time. But in the security, if you look at this next year's reported, we'll report – Mel, I want to make sure we deliver on the commitments. We will report a booking growth and revenue growth. And it would not surprise me in these areas to see booking growth in the low 20s and revenue growth in the low – in 10%, 11%, 12% because of the conversion to future deferred revenues and licensing.

So we are moving as fast as we can because Gary is kind of hunting this model for us, it is a juggling act in terms of how do we move to recurring revenues to more applications, so that more and more of our business is a given each quarter and we can be more where most of our peers are, where they get the majority of their business already done before they enter a quarter. But it takes you a while to get there and that is also built into our factors, Amitabh.

Frank Calderoni

And the number I gave, that's 11% year-on-year for product and then the services was up about 2%, total deferred revenue up about 5%.

Melissa Selcher

Thanks, Amitabh. Operator, next question please.

Operator

Thank you. Next question comes from Kulbinder Garcha with Credit Suisse.

Kulbinder Garcha - Credit Suisse

The question, I just want to clarify on the guidance again and this is for John and Frank, I think. It sounds like, I understand the set-top box issues and how that’s impacting revenue growth. I understand the emerging market and macro issue in China is more than just a macros issue it sounds like. So I’m curious John how you fix that, it seems that’s a very complicated, highly political subject then?

And on the service provider side, did the actual product transition impact on your revenues or did it actually surprise you, I would have thought you would have known about that going into this period of time? Thanks.

John Chambers

Okay. So in reverse order, a series of questions but I think all very fair. I understand the way that we do our revenue and booking forecast is, we have a very good sales team and they roll up the forecast and we do it by regions and by countries and by products. We then based upon that forecast determine what our revenue guidance is for a quarter.

Now, they take into consideration what they see in the product pipeline, what percentage of the pipeline they expect to fill out very, very detailed approach to it. The field, of course, however, almost never get sale burst, up or down.

And the pace of change that you’re really seeing in this, Kulbinder is that, it’s almost what occurs in a quarter just a year ago will now be two or three quarters worth and it was almost, if you were to a pick a quarter, you didn’t want to end up here, it was in early October this year doing the uncertainties in terms of the balance on that.

But no, in terms of the product transitions just 120 days ago when we reported the last quarter, none of us anticipated the change in Washington, the uncertainties, the business confidence that would occur from this and I’m not making excuses, this is what the customers are telling us.

And in terms of their going into next year, their expectations are down for the year, their budgets are down for the year, they are not taking as much risk. Now the good news is this can turnaround just as quickly as it slows.

But in terms of the overall approach there were positives and there were negatives in the groups and it was a quarter of very inconsistent data, much like we articulated that our customers see in terms of the economics and other issues.

Melissa Selcher

Okay. Thanks Kulbinder. Operator, next question.

Operator

Thank you. Our next question comes from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank

Hi. Hi, John.

John Chambers

Hey, Brian.

Brian Modoff - Deutsche Bank

Couple of questions for you, first, can you just run down on switching in terms of how you see that capital versus data center switching how you see both of those doing over the next couple of quarters?

And then with regard to your guidance you do talk about gross margin still being kind of in the 60%, 62% range even with revenues down like this just mix, lower set-top box sales or is it something else with regard to what you are doing to manage the margins in that range? Thanks.

John Chambers

Sure. So a number of questions and I want the first one and I’m going to ask the gross margin question. Gary, we have done very good job on gross margins. We are focusing on that across the Board. Our guidance has been very consistent 61%, 62% gross margins for a long time, Frank. And we don’t see things material in the market that that cause us uncomfortable with that.

We have done a very good job of value engineering, a very good job of modeling this path, a very good job of designing our new products and it might have slipped by some people, when we say we design then for the current gross margin level, we’ve never been able to do that before and we did that following some of our experiences back in 2011 and 2009.

So, we learn, we do it different in terms of the direction. We are continuing to anticipate set-top boxes falling and that is built into our next several quarter phenomena. Now I missed the first part of the question, I apologize.

Brian Modoff - Deutsche Bank

It was switching mix?

John Chambers

Oh! Switching, Mel, won’t let me talk about a specific quarter in terms of the guidance. So let me fast forward to summer this next year. Summer this next year we will have the best switching architectures in the industry by ourselves. We basically would take all of the advantages, merchant silicon and custom silicon and put them together.

We will bring the promises of SDN to life literally in an open and simplistic way. It won’t be slideware. This will be complete production and it will literally accomplish the separation of applications from the infrastructure with a common policy.

So if you looked across all of our switching lines for the Nexus in 5000, 7000, you begin to look in terms of what we’re doing with the 9000 within semi and you begin to look at Rob Soderbery’s product group, which I think he’s completely refreshed Rob Lloyd, if I remember right.

Our switching portfolio is the strongest it’s ever been in the marketplace and looks really solid. To the indirect part of your question, on the routing side we feel equally as good. I like where we are with the high-end products. And remember, NCS is an architecture. It's kind of the nervous system of making all this work. And with the CRS-X, it has the new capabilities that the same chip designs, et cetera we put on NCS. So high-end, we're never going to let that get taken away from us again. It happened 10 years ago, never going to let it happen. But now we need to move the resources to be able to address the access level, where it’s an area at the low end we have to do better than couple of our competitors are doing well.

At the high-end VPN capability, ASR 9000 actually is growing comfortably over 20%. But as other legacy products we have to do better. So in terms of product portfolio, it really looks good. Our ability to bring them together looks good. We got to I think pick up our game in a couple of areas in service provider to think of solution selling as opposed to box-type of selling and that we are going to have Pankaj Patel, who is our Head of Engineering and Nick Adamo, who is the Head of the Americas two together with myself and Pankaj flying cover for them to be able to address this.

And when we started on this on enterprise, Gary, a year ago, enterprise at this time did not really have the pieces together, because the business entities are great on products but not combining them and you combine that with, Gary and as to our services you can certainly provide a solution service provider the same way. I have run this strategy off of several of the top CEOs in the country and in the world on the service provider side, they will buy into it if we can execute.

Operator

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

Paul Silverstein - Cowen & Co.

John, I apologize, I know this question has been asked ten ways till Sunday. But I am trying to parse --

John Chambers

Okay. We knew it would be asked again.

Paul Silverstein - Cowen & Co.

In trying to parse out your commentary about emerging market, service provider is a general proposition in terms of as being the bulk of the weakness. In your commentary from a timing standpoint regarding the last two weeks of the quarter, two questions here. One, I know – assuming what you saw in the last two weeks of the quarter has extended into the first two weeks of November; and secondly, can you give some additional color on top of what you have already said in terms of those two different issues that collapsed in the last two weeks, the very recent Vantage collapse and the more generic commentary about emerging markets and service provider?

John Chambers

So the first two weeks of the new quarter are not really indicative of where you go. But the last two weeks of last quarter was really tough. So, no it did not carry over in that type of format. I think you deserve a fair answer to that. Not deserve. We want to be very transparent on it and I think it's the right way to answer your question in terms of the direction. The second part of the question was --

Paul Silverstein - Cowen & Co.

Mainly around the last two weeks of the collapse and I don't think you characterized it as a collapse. It was more around the last month being slower and normally we pick it up and we didn't.

John Chambers

Yes, Paul, if you look at it, just using Q4 as an example, we went into the last month a little bit off the numbers we expected. The forecast came down and the last two weeks of the quarter, they actually came up $300 million over their forecast. That did not happen. This sales team is really good and so, the fact that we missed it that much in the last month and that much during the last two weeks, we clearly factored in assuming that we're going to continue to see challenges in this quarter and the next quarter. So we did build that in. Hopefully, it'll be conservative, but we always believe when you see trends on this broader basis, especially in the emerging, you have to adjust to it and say it'll last for a couple of quarters.

What we saw in emerging was very consistent across the board. Every one of our top 10 emerging countries missed their forecast and was off by a fair amount. So it wasn't just that it was down, the last couple of weeks, they kept dropping and dropping. I think, Rob, if I remember right, it was over half of our shortfall, the last couple of weeks versus forecast.

Rob Lloyd

Yes, it was John, and our top five emerging countries all had negative performance in the quarter between – I think it was a low of 18% to a high of 30% down. So it was -- those are the big ones that really contribute to the numbers and it was consistent across all of those major countries.

John Chambers

I would rather there have been a couple of countries, Paul, because then you can say let's go fix them, and there are always a couple of countries that we'll either have issues on, some we create ourselves, some of them are done to us, some of them are way beyond our control. But the consistency of that number is what concerned me. And we usually unfortunately see things couple of quarters ahead of our peers. This time we were little bit surprised. We saw the softening in Q4 and we were very upfront with it to every one about what happened in our top five emerging countries in Q4 where we said they went from 13% growth the quarter before to flat in Q4. The other 15 countries continue to grow in low teens. This time all of them came down and so out of our top 10, it was pretty brutal on that.

The fact that a player like IBM saw -- too has probably 60% of their business given in the quarter and saw that this extreme indicates what we think is going to be more of an industry phenomenon, not affecting everyone but currently affecting lot of people.

Melissa Selcher

Thank you, Operator. Next question.

Operator

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

Mark Sue - RBC Capital Markets

Thank you. Frank, just a quick one, does the guidance include Sourcefire and -- a question for you, John. If I think about Cisco as a company has a lot of product, a lot of regional breadth and your portfolio approach typically gets you balanced, so if one region or segment underperforms, that’s usually offset by some -- another region or segment that is outperforming.

So we’re not getting that historic offset and instead we’re getting this deterioration. So just wondering if you feel that this is maybe a structural change to the switching and routing in data networking market. And it does sound as if it will take several quarters at least to refill the drained backlog, was there some consideration to reset your 5 to 7 long-term top line growth rate and should we also plan for some more OpEx cuts as you protect your earnings?

John Chambers

I’m going to have Frank comment about overall view on OpEx. I’m going to address first the structural change. It’s actually reverse. If you watch what we’re doing, the architectures take time to sell, our customers buy into it. Mark, if you had been at the CIO conference and I encourage you to go watch it, now it’s up on the website. In that, we had 95 of the top CIOs around the world in the session. We asked them about every major high-tech player. Now, we delivered into their hands because that would’ve been fair. But we asked them where they were out of the whole room and it shocked me because I knew it was a couple critics.

When I asked them how many of you are going to be more committed to Cisco and we’re going to be your key partner, more of a key partner, year from now than you were a year ago. The whole room raised their hand and I walked out to the audience and a couple of people asked and they said, John, we’re a believer and when we asked about other IT players on that, no one more than 10 raise their hand on any of the other top six IT players in terms of that type of commitment.

Mark, what that says is we got our vision and strategy right. We mailed it, they know we mailed it and they said now let’s see you execute and then they said by the way, security would be one you ought to go after much more aggressively because we can’t solve on it and it’s our top issue in terms of the direction. So the structural change, the answer is no.

We got it right in terms of the products. Our customers know they actually saw from the ACI launch. Look at the ecosystem that was up there with us. I mean it was commanding. It was powerful. Look at the customers out there with us. When you have the top cloud players from Europe, they are already on the stage with you and talking about why they are committed to this architecture, when you have players such as EMC and NetApp there in terms of -- here they see the opportunity.

You have a Microsoft nearly sit on stage and if you watch that for 5 minutes, it was probably the most articulate view of where they see the industry going and why they are going to align with this on ACI from Satya who is one of the top players there and he gets it.

So no, it’s not a structural issue. We do however any structure that you have in the engineering has strength and limitations. And so when you’re focused on product and we have done amazing job, Gary, on the product verticals that’s a very effective structure you have. We now need to leverage across it to combine these and be able to move resources around to where either our opportunities are or our exposures.

And so when you finish in high-end routing and you’ve done extremely well and you’ve got your leadership, how do you align resources quickly, they say, let’s go to very low end access. And this is very unique and this is why we’re putting two of our best on it. By the way, those are the same two who did this 3.5 years ago. They got our leadership and service provider to be able to save work across the group, combine it with services and combine it in terms of go-to market. In terms of 5% to 7%, you would be disappointed and shocked in us. If after just a quarter and a cycle here with emerging markets and something that service provided that we can and will crack if we suddenly say, we’re going to change things.

We will listen very carefully. We will provide more guidance in December but in terms of winning, we’re winning big and you all know this. You talked to customers, you all go to channels. We had some issues that we can do better. We’re going to address that but you have issues in terms of the emerging markets which are largely in our opinion macro driven and we will power through that. We're going to do exactly what we did before during slowdown, other people will pull back. We will put more resources in, we'll come out of it stronger and larger market shares. You never say, no pressure, because I know Frank would get me, but we have no abnormal pressure on gross margins. Gary, what the team is doing across the board on that, the execution is world class. Even our low-margin stuff, we continue to do value engineering on it and the direction.

The reason I'm going on a little bit longer is we have all the pieces here. Barring a huge surprise we're going to be the number one IT player and none of our customers say, you haven't got a shot at it. They say you got to execute, but if you watch none of our players are aligned with that, and none of the other players are able to look you all in the eye and say on gross margins we aren’t facing major pressures. We have done extremely well there. So I don’t think it’s a structural issue on it, I think it's really the three issues we talked. New product transitions which by the way we are not going to ever get behind again at the high end. I have done that once, that is painful and it took us four or five years to get it back. We are now at the high end switching, nobody matches what Insieme does on this.

High end routing, nobody can touch what we did in terms of the routing, the throughput, the download, the whole NetFlix library in one second across your technology. So I feel very comfortable with where we are and very comfortable on it. We will always be transparent. We promised you all when we see something we'll tell out exactly like it is even if it is painful and I'll ask you again today you want to be sure you want to but this is what we are seeing. Hopefully we're being conservative and Frank to the question I think it was on expenses.

Frank Calderoni

There were two questions. One, Mark asked if Sourcefire is included in the guidance and the answer is yes. And secondly, as far as looking at, you were asking about op expense and restructuring. We talked last quarter about the portfolio that we were carrying into FY’14 making the adjustments to ensure that we're making the investments and being able to afford the acquisitions that we did like Sourcefire, like Composite Software to make sure that we are emphasizing areas in the portfolio [indiscernible] growth opportunities like security, like mobility, like cloud, like services. And we put plans in place to be able to do that.

We feel right now we've got to continue to execute to that. We do have more just continuing on what we announced on the restructuring, we did some this past quarter, with some another quarter, outside the United States which was part of the plan. And then the other important thing is to make sure that as we go through the fiscal year, that we continue to make sure that we follow through on those investments both the acquisitions as well as the internal investments. So that we can see the ability for a long term growth.

John Chambers

Mel, I know we ran a little bit over versus our goal being through about 2.30, but thank you for that [ph]. Let me turn it back to you.

Melissa Selcher

Yes, absolutely. Thanks John. Cisco's next quarterly call, which will reflect our FY’14 second quarter results will be on Wednesday, February 12, 2014 at 1.30 p.m. Pacific Time, 4.30 p.m. Eastern Time. Again, I would like to remind you that in light of Regulation FD, Cisco plans to retain its longstanding policy to not comment on its financial guidance during the quarter unless it's done through an explicit public disclosure. Please call the Investor Relations department with any follow-up questions from this call. Thank you for your participation and continued support. This concludes our call.

Operator

Thank you for participating on today's conference call.