Cisco Systems F2Q10 (Qtr End 1/23/10) Earnings Call Transcript

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Cisco Systems, Inc. (NASDAQ:CSCO) F2Q10 (Qtr End 1/23/10) Earnings Call February 3, 2010 4:30 PM ET


Blair Christie - Senior Vice President, Corporate Communications

John T. Chambers - Chairman and Chief Executive Officer

Frank Calderoni - Executive Vice President, Chief Financial Officer

Robert Lloyd - Executive Vice President, Worldwide Operations

Ned Hooper - Senior Vice President, Corporate Development and Consumer Group


Mark Sue - RBC Capital Markets

Tal Liani - Bank of America/Merrill Lynch

Jeff Evenson - Sanford Bernstein

Simona Jankowski - Goldman Sachs

Ittai Kidron - Oppenheimer

Brian Modoff - Deutsche Bank

Nikos Theodosopoulos - UBS

Sanjiv Wadhwani - Stifel Nicolaus

Paul Silverstein - Credit Suisse

Richard Gardner - Citigroup

Simon Leopold - Morgan Keegan

John Marchetti - Cowen and Company

Paul Mansky - Canaccord Adams Analysts


Welcome to Cisco Systems’ second quarter and fiscal year 2010 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.

Blair Christie

Great. Thank you Bridget. Good afternoon everyone. Welcome to our 80th quarterly conference call. I am joined by John Chambers, our Chairman and CEO, Frank Calderoni, Executive Vice President and Chief Financial Officer, Rob Lloyd, Executive Vice President of World Wide Operations, Ned Hooper, Chief Strategy Officer and Senior Vice President of Consumer Business, and Padmasree Warrior, Chief Technology Officer, as well as Laura Graves, our Director of Global Investor Relations.

The 2Q fiscal year 2010 press release is on US-High Tech Marketwire and on the Cisco website at www/ I would like to remind you that we have a corresponding web cast 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.

Additionally, downloadable Q2 financial statements will be available following the call, including revenue by product and geography. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet, cash flow statements can also be found on our website in the investor relations section. Click on the financials of the section of the website to access the slides and these documents.

A replay of this call will be available via telephone from February 3 through February 10 at 866-357-4205 or 203-369-0122 for international callers and is also available from February 3 through April 23 on Cisco’s Investor Relations website.

Throughout this 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 10K, quarterly report on Form 10Q, 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. I’d now like to turn it over to John for his commentary on the quarter. John?

John T. Chambers

Thank you, Blair, and welcome back, by the way. During the opening comments of the conference call, I will focus on what I view to be the key take-aways for Q2, fiscal year 2010. First, from a very candid discussion about what we are seeing in the market on a global basis relative to Q2 and its effects on our Q3 fiscal 2010 expectation; second, an update on our rapidly improving financial measurements and some interesting geographic and sequentially quarter metrics. Third, a high level summary of some of our investments and results in new market adjacencies in Q2, and then finally our revenue guidance for Q3 fiscal year 2010 with the appropriate caveats.

Following these opening comments, Frank will provide additional details on Q2. In the third section, we will focus on business momentum from a strategy, customer segment, geographic and product basis. Frank will then follow with additional financial parameters around our guidance. I will then wrap it up with some comments in terms of Cisco’s momentum going into the Q3 fiscal year ’10, and finally our Q&A section.

From a summary point of view, I think there were a number of key take-aways from the results in Q2 fiscal year ’10 and I will attempt to cover these at this time.

First from a financial perspective, the second quarter was very strong, well exceeding even our own optimistic expectations. The financial results were in my opinion outstanding. Revenues of $9.8 billion increasing 8% year over year were dramatically above the high end of our expectations of an increase of 1% to 4%.

Q2 revenues showed a 9% sequential increase over Q1 revenues, the highest fiscal Q1 to Q2 sequential increase I’ve seen in the last decade.

Non-GAAP earnings per share of $0.40, a 25% year over year increase was again well above our expectations.

Expense management was very solid with non-GAAP operating expenses as a percentage of revenue at 35.3% versus Q1’s 37%. Non-GAAP product gross margins were very solid at 65.6%. Cash generated from operations in Q2 was approximately $2.5 billion. And we repurchased $1.5 billion of stocks during the quarter under our repurchase program.

Non-GAAP operating income as a percentage of revenue was a very strong 30.3% versus Q2 29.3%. Non-GAAP net income of $2.3 billion was up 25% year over year.

To put the sequential dramatic improvements of non-GAAP net income as an example in Q2 into comparable terms, Q1’s net income was a decrease year over year of minus 15%.

Product book to bill was approximately one. Services continued its strong growth with year over year revenue of approximately 6%. In an area that we have not discussed since the start of the downturn for obvious reasons, productivity has increased dramatically during the last two quarters. The data behind this is going back to last Q1, revenue per employee increased to $558,000, which was up 8% over Q4 of fiscal year ’09. Q2 revenue per employee was $606,000, which was approximately a 9% increase over the prior quarter.

Parts of the increase was due to just raw revenue growth. But we believe an equal amount was due to our new organization structures and use of our own collaborative products. We were very pleased with this when you consider that out of the 30 plus market adjacencies we’re moving into, many of them do not have any material or measurable material revenue contribution at this time, even though we’ve allocated a large amount of head count to these new market adjacencies. In other words, we believe our real productivity was well above the hard numbers.

The market over the last year has evolved pretty much as we expected and indicated in our conference call. Q3 last fiscal year was the bottom. Q4 is our option, FY09, as we said at the time, was the tipping point, the beginning of the upturn from a capital spending perspective. Q1 fiscal year ’10 saw an acceleration in the first phase of the recovery. And in our opinion, Q2 marked the second phase of the recovery, with additional across the board acceleration, in other words, balanced across the board in all our geographies and market segments.

We saw very strong balance growth from a year over year perspective in almost all of these major geographies and market segment categories.

To give you additional detail on our geographic and market acceleration moving from Q1’s first phase to Q2’s second phase of the recovery, in Q1 from a theater perspective, only one theater, interestingly enough Japan, had meaningful product order growth, while in Q2, all five of the theaters saw flat to double digit product order growth.

In Q1, again from an order’s perspective, only two of our top 15 countries around the world saw year over year positive growth. In Q2, eight of 15 countries saw year over year positive growth.

From a Q2 market segment perspective, enterprise, service provider and commercial, all saw order growth in the mid single digits to low double digit range. While in the prior quarter Q1, all of these market segments were negative from a year over year perspective.

While most markets around the world are continuing to improve, we were especially pleased with our product order growth in the US, up approximately 17% year over year. Asia Pacific and Japan both grew in double digits year over year. Europe was up in low single digits and emerging markets were flat.

In our opinion, based upon our business momentum and prior economic recoveries, this would indicate that the recovery from a capital spending perspective is very strong and moving into the second phase of a reasonably balanced across the board growth.

In our opinion, Q2 FY10 results were remarkably well balanced from a product, geographic and market segment perspective, which should indicate a solid economic recovery. While the continued strength of the recovery and the eventual job creation may still be in question, we clearly are basing our decisions and investments upon an optimistic evolution of the economy.

If we get surprised, we will adjust. And we have a proven track record of being able to do so when appropriate.

Given our views of the economy expressed over the last four quarters, with the expanding role of intelligent networks in all forms of communications and IT, combined with our ability to catch market transitions and to move into new market adjacencies, we are proud of our ability to return to our prior financial operating model so quickly after the global economic slowdown.

Our new organization structure of councils, boards, and working groups, as discussed in the last few calls is operating very effectively and has been an important part of managing through the recent downturn and then position us for the acceleration of results achieved during the last two quarters.

These structures allow speed, scale, flexibility and rapid replication. We will continue to move into additional market adjacencies, which are currently at about 30. And of perhaps equal importance, many of our leading customers now are beginning to understand how this highly innovative management structure combined with new business models can launch this many product families and movement into new market adjacencies while still maintaining revenue growth and market share gains in our traditional areas.

We exit Q2 with a compelling financial position and an innovation engine from both a products and a business model perspective that should position us to expand our leadership in the marketplace.

Our internal start ups, partnerships, and our acquisitions continue to fill out our architectural strategy. And innovation in our traditional routing and switching product families have a very high probability of gaining market share.

I also believe that more of our customers are beginning to understand that the market adjacencies are interrelated. And as such will at first loosely then tightly be coupled together from both a technology and a business architecture perspective, enabled by the common theme to the network as the platform for all forms of communications and IT.

If the market adjacencies play out the way we expect, it will be very similar to what we saw with the original advanced technologies being viewed as standalone, then over time becoming loosely and now starting to be tightly integrated.

For those areas that Cisco can control or influence, we feel that we are doing very well. The key market transitions relative to collaboration, virtualization and video networking which will drive productivity and growth in network loads for the next decade are continuing to evolve even faster than we thought just several quarters ago.

While we attempt to be very transparent with what we are seeing in the market and have established a good track record in terms of seeing trends early, our views do not tend to change every month or quarter. And even when they do evolve, to change dramatically is really the exception.

It is with this consistency of staying focused on the long term when not getting distracted by short term market activities that drives our strategy and in our opinion our future success.

While we believe the recovery is now occurring, no one knows for sure how strong it will be, how long it will last or the extent of new job creation. But as we said in prior quarters’ conference calls, we are going to continue to be very aggressive to position ourselves for an optimistic view of global economic growth, while continuing to maintain tight financial management and aligning our resources to new opportunities.

I believe Q2 was a very positive proof point that both our vision and our strategy for our industry is evolving as expected. And at the same time, our ability to execute the vision and strategy as demonstrated by very strong Q2 results.

Given our belief that the market is beginning to accelerate and our productivity growth in terms of revenue per headcount, the 17% increase in just two quarters is probably not a surprise to anyone that you will now see us start to grow our expenses at a faster pace as we continue to expand in our traditional business areas and move into these 30 plus market adjacencies.

We would expect with all the appropriate caveats about the continued economic recovery to add between 2,000 to 3,000 people to Cisco in the next several quarters. We will continue to be very aggressive in both our own internal innovation commitments, as well as our partnership and acquisition strategies.

For those Cisco employees listening, this growth in headcount will continue to be very targeted towards strategic opportunities, with focus on productivity improvement in many of our traditional functions, while adding resources to drive new market adjacencies.

Also as we said in conference calls over many years, Cisco will always be effected by major economic changes, capital spending patterns, new and existing competitors, potential issues affecting our suppliers, and our ability to execute or not on our strategy and other factors as discussed in our SEC filings.

For purposes of our long range goals 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.

With all this in mind, we will continue to provide our guidance with all the appropriate caveats one quarter at a time and encourage each of our shareholders to not get too far ahead of themselves on building on the positives of this quarter.

Given all the uncertainties regarding the strength and shape of the recovery, concerns about recovery possibly slowing, and an unknown extent of job creation, we encourage you to wait for additional quarterly data before becoming too optimistic. This is what you would expect from Cisco and what I would encourage from our shareholders.

Before providing guidance for Q3, I would like to remind you that Q3 includes an extra week, which occurs once every five to six years. As we have indicated in prior years, this extra week does not translate into a mathematical additional one thirteenth in terms of your modeling for Q3 orders. Although, as Frank reminds me regularly it does in terms of expenses.

Our best estimate of the benefit for an extra week from an order perspective is an incremental one time 2% to 3% of total product orders. With this discussion in mind, our revenue guidance for Q3 fiscal year 2010 including our usual caveat as discussed earlier and in our financial reports is for revenue to increase in the 23% to 26% range year over year.

As we’ve shared with you during the economic transitions, we continue to track sequential improvements quarter to quarter. As the transition however continues, you will see us move back to focus primarily on year over year comparisons.

In summary, we believe that we are very well positioned in terms of the industry from a vision, differentiated strategy and execution perspective. We believe we are entering the next phase of the Internet as growth and productivity will center on collaboration, enabled by the network Web 2.0 technologies. We will do our best to provide the product architectures and the expertise to partner with our customers in the implementation of these collaborative capabilities from a technology and business perspective.

We will also share with our customers how we’ve done this internally. In short, we’re going to attempt to execute a strategy over the next decade that is similar to what we did in the early ‘90s. And as we said before, it powered our growth for a decade.

Now, Frank, let me turn the call over to you.

Frank A. Calderoni

Thank you, John. I’ve very pleased with our very strong results for Q2 FY10, which demonstrates our ability to execute on our innovation and operational excellence priorities within our business model.

Our results include the completion of our acquisitions of Starent and ScanSafe, which did close during the quarter.

Total revenue for the second quarter was $9.8 billion, an increase of approximately 8% year over year, well above our guidance provided last quarter of 1% to 4% year over year. Total service revenue was $1.8 billion, up approximately 6% year over year. Total product revenue was $8 billion, up 9% year over year.

Switching revenue was $3.4 billion, an increase of 13% year over year. Modular switching revenue was up approximately 12% year over year, while fixed switching revenue increased 14% year over year. With sequential revenue growth of 19%, this reflects the highest Q1 to Q2 sequential switching revenue growth in over a decade.

Routing revenue was $1.6 billion, up 2% year-over-year representing an increase of 12% year-over-year in high end, a decrease of 14% in mid-range and a decrease of 11% in low-end. Advanced technologies revenue totaled $2.4 billion, representing an increase of 1% year-over-year. We saw increases in Unified Communications of 17% and wireless of 9%. We saw a year-over-year decline in video systems of 12%, and security was flat year-over-year.

Other product revenue totaled $604 million, an increase of 46% year-over-year. Growth year-over-year was driven primarily by the inclusion of our acquisition of Pure Digital, which we closed late last fiscal year, along with continued growth in emerging technologies, which includes TelePresence and Unified Computing Systems among others.

Sequentially, our total revenue was up 9% quarter-over-quarter. We saw sequential revenue increases across most product categories with good performance in fixed switching, up 21% quarter-over-quarter, modular switching up 18% quarter-over-quarter, high-end routing which includes our Starent acquisition is up 4% quarter-over-quarter, and video systems is up 26% quarter-over-quarter. We experienced an increase in total revenue across all geographic segments on a year-over-year basis with the exception of Europe. Year-over-year revenue ranged from a decline of approximately 3% in Europe to growth of approximately 16% for Asia Pacific theater, with revenue in the US and Canada theater up approximately 12%, Japan up approximately 12%, and emerging markets up approximately 1%.

Q2 FY10 total non GAAP gross income was 65.6% that's down 0.7 percentage points, quarter-over-quarter, and up 1.6 percentage points year-over-year. For products only, non GAAP gross margins for the second quarter was 65.6%, that was down 0.7% quarter-over-quarter. For the quarter-over-quarter comparison, unfavorable mix and other manufacturing related costs were partially offset by higher volumes and cost savings.

While we were pleased with our overall performance in gross margins this quarter, we recognize that variability and product mix and other factors will impact gross margins. On a year-over-year basis, non GAAP product gross margins was up two points.

Our non GAAP service margin for the second quarter was 65.9%, that's down from 66.3% last quarter and up from 65.7% in Q2 FY09. The service margin decrease quarter-over-quarter was primarily driven by increased cost and a higher mix of advanced services, partially offset by volume.

Total gross margin by theater ranged from approximately 63.2% for Asia Pacific to approximately 72.7% in Japan. We saw variability in our margins across the theatres due to unfavorable mix and discounting offset by cost savings and volume. Gross margins on a quarter-over-quarter basis in emerging markets in Japan improved, while Asia Pacific, U.S, Canada and Europe declined.

Non GAAP operating expenses were approximately $3.5 billion in Q2 FY10 that's up 4% quarter-over-quarter driven by increased investments in our growth opportunities. Non GAAP operating expenses were down 2% year-over-year. Our non GAAP operating expenses as a percentage of revenue was 35.3% in Q2 FY10 versus the 37% in Q1 FY10.

Non GAAP interest and other income was $23 million for Q2 and this amount reflects increased interest expenses on the $5 billion bond offering that we just completed this past November. GAAP interest and other income was a loss of $15 million for the second quarter, and also includes a $38 million mark-to-market loss related to the transaction to hedge a portion of the foreign currency consideration for our pending acquisition of Tandberg.

Our Q2 FY10 non GAAP tax provision rate was 22%. Non GAAP net income for the second quarter was $2.3 billion representing an increase of 25% year-over-year. As a percentage of revenue, non GAAP net income was 23.8%. Non GAAP earnings per share on a fully diluted basis for the second quarter were $0.40 versus $0.32 in the second quarter of the fiscal year of 2009, a 25% increase year-over-year. GAAP net income for the second quarter was $1.9 billion as compared to $1.5 billion in the second quarter of fiscal year 2009. GAAP earnings per share on a fully diluted basis in the second quarter was $0.32 per share versus $0.26 per share in the same quarter of fiscal year 2009.

Now moving on to the balance sheet, our balance sheet continues to be very strong, providing us with significant financial flexibility. In any rapidly shifting supply demand environment such as the one we are currently experiencing, shifts in lead time, inventory levels and manufacturing outputs will occur. For this quarter, we did have a higher third month in terms of shipment than in previous second quarters, as evidenced by our results in AR and DSO.

As we mentioned last quarter we have experienced longer lead times on several of our products, this was a result of increased demand driven by the improvement in our overall market. While we may continue to experience longer than normal lead times, our lead times improved throughout the quarter and we expect them to continue to improve throughout the next quarter.

The total of cash, cash equivalent and investments for the quarter was $39.6 billion, up approximately $4.3 billion from last quarter. Of this total balance, $8.8 billion was held within the United States at the end of Q2 FY10. We had a successful bond offering in November of 2009, which contributed approximately $5 billion to the cash balance, additionally we closed our Starent and ScanSafe acquisition, which resulted in a net use of approximately $2.3 billion of cash. During the quarter, cash flow from operations was approximately $2.5 billion.

Moving on to accounts receivable, our accounts receivable balance was $4.2 billion at the end of Q2. At the end of Q2 FY10, days sales outstanding or DSO was 39 days as compared to 32 days in Q1 FY10 and 29 days in Q2 FY09. The increase in DSO was driven by the shipment profile during the quarter and the seasonality of our service billing.

Total inventory at the end of Q2 was $1.2 billion, up approximately 12% quarter-over-quarter. Non GAAP inventory turns were 11.7 this quarter, up four tenths of a point from last quarter and Q2 of last year. Inventory purchase commitments at the end of Q2 were $3.3 billion, an increase of approximately 19% from the end of Q1 FY10 and an increase of approximately 25% year-over-year. For the quarter, we repurchased $1.5 billion of common stock under the stock repurchase program or 63 million shares at an average price of $23.96 per share. The remaining authorized repurchase amount under the stock repurchase program was approximately $11.6 billion at the end of the quarter.

Deferred revenue was $9.7 billion at the end of Q2, an increase of approximately 4% compared with Q2 FY09. Deferred product revenue was $3.3 billion and deferred service revenue was approximately $6.3 billion, increases of approximately 3% and 4% year-over-year respectively.

At the end of Q2, our head count totaled 65,874, a net increase of approximately 2,100 from last quarter, primarily as a result of our acquisitions of Starent and ScanSafe, as well as our investment in growth initiatives. We expect our head count to grow in support of our additional growth investments and have authorized 2,000 to –3,000 incremental external hires. We anticipate adding this head count in the next several quarters.

In closing, from a financial perspective, we are very pleased with our Q2 results and the strong foundation from which we can continue to focus on growth and capturing market transitions in the industry. We believe we are well positioned to move into market adjacencies with tremendous speed, scale and flexibility. Our ongoing efforts to improve efficiency and productivity have allowed us to deliver a strong performance in Q2 but also position us well for the future. We will continue to make investments in innovation, operational excellence and our key growth opportunities.

I'll now turn it back to John.

John T. Chambers

Thanks, congratulations and well done.

Now moving on to chapter three in our strategy, customer segment geographic and product review. Q2 continued the trend of balance between innovation and operational effectiveness in almost every aspect of our business. In recent past conference calls, we have gone into a certain amount of important discussions of our strategy and we will continue this trend at most of our future calls. However, given the strong results of this quarter, we think the strategy speaks for itself, and we will focus on this conference call on the normal customer segment, geographies and product results.

Customer Segments and Geographies. Now moving onto the customer segments where the discussion is on a global basis as measured by orders for what we call booking from year over year and at times sequentially. During the month of January, I attended the World Economic Forum at Davos, interfacing with over a hundred key customers, government leaders and industry subject matter experts. I also traveled through a number of emerging countries where momentum is clearly starting to accelerate again, and attended the Consumer Electronics Show as we continued to expand Cisco's presence into many market adjacencies even within the consumer market itself.

The feedback from customers in all major geographies and customer segments is rapidly improving in terms of their view of their own country’s economic growth and their own business opportunities. While almost all of these customers indicated Cisco's improving status in their organizations from both a technology and a business partner perspective, this is especially true in our service provider, enterprise and government accounts.

On a global basis, our total product orders year over year were up 11%. This was a major improvement in fiscal year 2010 Q1 over total product orders which in Q1 of this fiscal year were down in the high single digits. And even more improvement when compared to Q4 -- boy, it seems like a long time ago, Frank -- fiscal year 2009 which were down year over year in the low 20's, from a positive 11 to minus 20. And that's what you're seeing from us is the comfort level that we're seeing in terms of the balanced performance across all key geographies and customer segments.

Our Service Provider business on a global basis in terms of product orders in Q2 was up 11% year over year. Our Commercial was up 10%. Enterprise was up approximately 7% and Consumer including our Pure Digital acquisition was up over 80%. To again put this in perspective versus just one quarter ago in Q1, while our Enterprise including Public Sector was down slightly year over year, Consumer was up approximately 20% and Service Provider and Commercial were down in the low double digits. This is obviously at an inflection point in the market in all customer segments.

First in terms of the U.S. It was a very strong quarter from both a year over year perspective and sequential improvements from Q1. Order growth was approximately 17% year over year compared to Q1 year over year order growth which was essentially flat. Balance was good across industry segments with Enterprise growing approximately 10%, Public Sector growing 2%, Commercial growing in the mid-teens and Service Provider growing in the low 20's from a year over year perspective.

I would like to comment specifically on the Service Provider market where orders just two quarters ago were down over 30% year over year, and last quarter were down in the high single digits. This is one of the most robust positive turnarounds I've seen in my career. I want to congratulate our Service Provider engineering, services and sales teams on just an outstanding result.

Second, our business in Japan, despite the very challenging economy, continued to show solid improvements with order growth in the high teens year over year. Congratulations, Edzard, well done.

Asia Pacific, after being down in the low single digits in Q1 grew in the low double digits year over year in Q2, with both India and China starting to take off with growth respectively in the low 20's in India and the high teens in China year over year. We also saw emerging markets start to turnaround, improving from Q1's negative growth year over year in the high 20's to this quarter’s flat growth year over year, led by countries like Brazil with growth of approximately 30%. And as you would expect in some very challenging economies such as Mexico, we are still experiencing negative growth which was in the mid-teens.

We continue to see the improvement in Europe that we shared with you last quarter. Our European orders were up approximately 4% year over year although the results vary dramatically between our large countries where you saw France grow year over year in the low double digits, the UK approximately flat year over year, Italy down in the mid-single digits and Spain down in low double digits.

From a product perspective, we saw a dramatic year over year and sequential improvements, part of which Frank covered earlier, but I wanted to spend just a couple more minutes on them. Again, in terms of products, we will discuss these in terms of revenue year over year.

As you would expect given product book to bill of approximately one, product orders and product revenues in each of the product categories were relatively close in terms of year over year numbers. Again, product revenues grew approximately 9% year over year while orders grew approximately 11%.

Switching revenues were up approximately 13% with very good balance in modular and fixed, each having almost identical growth year over year numbers. This is obviously a major improvement back to Q1 when Switching revenues were down approximately year over year 21%.

Routing revenues were up 2%, again with dramatic improvement from Q1's negative 17% year over year. High end routing as a reminder represents about two-thirds of our total routing business. And this quarter high end routing includes the results of our Starent acquisition grew 12%, again with an improvement versus Q1's minus 15.

The mid and low range router products were down in the low teens. With the usual caveats, I would expect to see continued improvement in the routing numbers for several reasons. First, given the uptake of our ASR 1000; second, early indications of successful pilots and customer commitments for the ASR 9000. And third, the very initial positive feedback and buy in by key customers to our Starent acquisition. I am pleased that the ASR 1000 was up almost 150% year over year, while the ASR 9000 results are still relatively low as expected in the early stage of the product life cycle. However, you can see the dramatic improvement starting to occur in terms of customer acceptance, where in Q2 orders for the ASR 9000 were twice the revenues.

Total advanced technology Q2 revenues were up approximately 1%, again a dramatic improvement from down approximately 15% year over year in Q1. The trend was also evident in each of our advanced technology categories. In terms of advanced technologies, Unified Communication was up 17% compared to Q1's negative 10%. Wireless grew in the high single digits continuing solid year over year results. The network home was down approximately 6% compared to Q1's down 18%. That doesn't include the flip numbers, obviously. Security was flat compared to Q1's down 9% and Storage was down 1% to Q1's down 19%. Video systems were down 12% compared to Q1's down 29% year over year, and finally Application Networking systems were down 7% year over year.

Other product areas that might be of interest to you would include Pure Digital's flip which had revenues of approximately $130 million, an improvement from $50 million in Q1. The Nexus 5000 and 7000 showed extremely strong year over year improvements as their customer acceptance dramatically increased with revenue growth of approximately 450% for the Nexus 5000 year over year and 140% for the 7000. Our UCS numbers are still in the early stage of customer acceptance and pilots, but again showed sequential order growth rates of over 100% and now over 400 customers have ordered from Cisco.

In summary, although we would like to avoid the downturns, our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe our differentiating strategy is also achieving the benefits to both Cisco and our customers that we thought were possible. And finally, our execution is on target in terms of the results measured from our 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.

Now Frank, I'd like to turn it back over to you for additional details on financial guidance and other financial highlights.

Frank A. Calderoni

Thank you, John.

John T. Chambers

You're very welcome.

Frank A. Calderoni

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 a reconciliation to GAAP.

As John indicated, while we are optimistic about the recovery of the economy, the variability that still exists within the marketplace makes it challenging to predict demand and other related matters beyond a quarter at a time. As such, we will only be providing guidance for our third quarter at this time and are approaching the second half of the fiscal year outlook with the realization that these remain at unknown levels of sustainability.

We would encourage each of our shareholders to be equally careful as they model the second half of the fiscal year. For Q3 FY10 we anticipate total revenue to be up approximately 23% to 26% year over year. Every five to six years, Cisco has an extra week in our third quarter. In our guidance, we have factored this extra week in both our revenue as well as our operating expenses. Although it is difficult to forecast the revenue impact of this extra week, we have anticipated a 2% to 3% sequential increase in revenue in our Q3 revenue guidance attributed to the extra week. As we have done previous quarters, we will provide the details of the full impact of the extra week when we exit this quarter.

At this point, let me remind you that in light of regulation FD, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Now let me give you additional details on the Q3 financial guidance. As we have said in the past, forecasting gross margins has always been challenging due to various factors such as volume, product mix, variable component cost, customer and channel mix and competitive pricing pressures. That being said, we believe total gross margin in Q3 will be approximately 64% to 65% reflecting the revenue guidance I just shared with you. With recent acquisitions and our continued growth into some lower margin markets, gross margin could be negatively impacted by product mix.

We believe Q3 operating expenses will be approximately 36.5% to 37% of revenue. We expect interest and other income to be approximately negative $10 million to negative $20 million in the third quarter, taking into consideration the interest expense associated with our debt offerings.

Our tax provision rate for Q3 is expected to be approximately 22%. We are modeling share count to be down approximately 25 million shares quarter over quarter 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 '10. While we expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. As a point of reference, a $1 movement in our average stock price would change the calculated shares outstanding for purposes of determining earnings per share by approximately $17 million.

We are extremely pleased with our Starent acquisition and the positive customer acceptance. As a reminder to our previous announcement during the close of the transaction, on an average moving forward in the near term we expect the impact of Starent to be slightly dilutive to our non-GAAP EPS by a little less than $0.01 per share on a quarterly basis. Regarding cash flow from operations, we would expect to generate $2 billion to $2.5 billion during the third quarter.

For our Q3 FY10 GAAP earnings, we anticipate that GAAP EPS will be $0.06 to $0.08 per share lower than our non-GAAP EPS primarily due to stock compensation expense and acquisition related charges. Please see the slides that accompany this webcast for further detail.

Our GAAP guidance could vary significantly depending upon the potential positive or negative mark-to-market fluctuations relating to our transactions to hedge a portion of the foreign currency consideration for our pending acquisition of Tandberg. Other than those items, there are no other significant differences between GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring, and tax or other events which may or may not be significant. I will now turn the call back over to John.

John T. Chambers

Frank, thank you. The following is a summary of my views of Cisco's momentum and opportunities entering Q3 of fiscal year 2010. In Q1, it was a pleasure for the first time in over a year to say that our optimism applies as you would expect to not only the areas where we can control and influence, but also with all the appropriate caveats, those areas we cannot control and influence.

Q2 clearly was another tipping point and highlighted, in our opinion, movement into the second phase of economic capital spending recovery marked by very good balance and very strong sequential year-over-year improvement in almost every area of our business. Everything from our organization structure and business models to our acquisition strategies to our products and geographies and customer segments are delivering the results that we had hoped for.

While no one knows for sure the strength of the recovery, job creation opportunities and the possibility of another downturn, we will continue to set our strategy and execute being very aggressive in both our investments and continued expansion in our 30 plus market adjacencies. We are assuming an optimistic view of the economy and our execution capabilities. If we get surprised, as I said earlier, we will simply adjust. And I think most of you agree we know how to do this effectively if necessary.

As we said before, even if the market slowdown was to reoccur, we don't see this change in our long-term growth opportunities if we execute the way we have in prior slowdowns, and assuming that the global economy continues to recover GDP growth rates similar to those in the middle of the last decade. We continue to maintain our longer-term expectations of growth rates and the normal GDP growth time periods to be in the 12%-17% range year over year with all of the appropriate caveats.

It is also a pleasure to see our forecast returning to this growth range as well. However, it is important to remember that we could be wrong and we will adjust if we are. On a global basis and a US basis we saw improvements and at times dramatic improvements in many areas. We also continue to see the same challenges and uncertainties from an economic job creation, political, and capital spending perspective that many of you continue to witness. However, on a global basis, the trends were clearly at an inflection point in a very positive way across almost all of our geographies, theaters, products, major countries, and customer segments.

Again I want to thank the Cisco family for working together as a team to ensure that our company is in a solid position to not only weather the challenging economic environment, but even more importantly to be ready to continue to accelerate our investments assuming the current trend continues. I know it has not been easy and we are all working hard to maintain our culture of innovation, trust, a stretch goal mentality, and giving back — all during tough time periods, a time for ourselves, our families, and our friends.

As we continue to aggressively invest, we will also continue to maintain our focus on financial models. Once again with our usual caveats as discussed earlier in our financial reports, our Q3 fiscal year 2010 guidance is for year-over-year revenue of 23% to 26% range. However, it is simply too early to know what will be the rate of magnitude recovery and the extent of sustainability and what the recovery will look like throughout 2010. While we expect a continued recovery throughout the entire year and clearly gave a very aggressive forecast for Q3, it is important that expectations do not get ahead of market realities, especially until we see job creation. We can see economic growth bounce up and down over the next 12 months and we will strongly urge our investors to not dramatically change their models beyond Q3. We will continue to share with you what we are seeing in the market and our own expectations for our business as transparently as we can. We will focus on what we can control and influence and attempt to position Cisco to gain more momentum in market transitions whether they are industry consolidation, product transition, market adjacency opportunities, or economic.

In summary, for those areas that we control and influence, we believe our vision, strategy, and execution are in great shape and producing results. And for those areas that we do not influence or control, at the present time, we are also seeing positive improvement, solid improvement.

We were extremely pleased with our very strong Q2 results and saw a number of positives signs this quarter in the economy and in our business, especially comparing the sequential financial results and improvements from Q1 to Q2 fiscal year '10. If we continue to see these positive trends for the next several quarters, we believe there is a good chance we will be back to solid sustainable global economic growth.

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.

On a topic that touches all of us, our hearts go out to those affected by the devastating earthquake in Haiti. It is in times like these that individuals and companies should continue to ask what can I do to help? So far Cisco, the Cisco Foundation, and our employees have donated more than $2.3 million with additional investments in people, dollars, and technology to relief organizations. In partnership with the US government and NATO, we are also leveraging our Internet routers and space technology with satellite access now up and operational for voice data and TelePresence access to remote areas across the region. I want to thank the Cisco family for the investment and time we've given as a company so far. And as we continue to contribute, I am very proud of the team's broad support of our corporate social responsibility initiatives. I would also like to encourage all of those listening on this call to contribute and encourage your employees to match your donations. Together we really can make a difference.

Now Frank I'm going to surprise you on this one. One of the reasons I go to the World Economic Forum is you get to see a broad group of government leaders, business leaders, and others. At the Forum, as you know, President Obama had asked prior President Clinton and prior President Bush to focus on helping to lead the efforts in Haiti. President Clinton, when I was meeting with him one evening, he said John, you’ve all traditionally have been able to think out of box in places like what was done in Lebanon or what was done after Katrina and Louisiana and Mississippi or what was done in China after the earthquake. And he said what we need most is not immediate relief at this time from companies such as yours, although you're doing a good job on that, he said think out of box about how you really do job growth and sustainability after the rebuilding starts to take place, much as we've done in other areas. We put Randy Pond, I gave him a call that Thursday night after the session with President Clinton and we got a working group there, and Frank, I'd like to challenge us to think out of box and kind of put you on the spot here in terms of adding a little bit of money, and silence will mean agreement here, towards these efforts.

So I never ask our shareholders or our employees to do something we don't do ourselves, but I'd like to think really creatively on what the two prior presidents have challenged a little bit about and think about people that are involved here because it is less difficult to apply energy and focus to help at the time the challenge occurs, but really the people need your help even much more to change their lives afterwards. So we'll try to lead by example. Blair, you can be candid as always about how well we're doing that or not. With that, let me move onto our Q&A session and a healthy give and take.

Question-and-Answer Session

Blair Christie

Great. Thank you, John. We're now going to open up the call for questions. We do request that sell side analysts please ask only one question. So Bridget, why don't you go ahead and open it up to the first one.


Thank you. Our first question will come from Mark Sue of RBC Capital Markets.

Mark Sue - RBC Capital Markets

Thank you. John, your confidence on the sustainability of your newfound strength and why so aggressive? Are you going after share gains and do you feel there is an underlying switch upgrade cycle on top of this broad regional recovery which implies less seasonal trends in the first half and accelerated top line trends in the second half?

John T. Chambers

A mouthful. Let me go in the sequence that you raised them. The reason for the confidence is when you see this type of balance across every single market segment, across all of our major theaters, across all of our key product areas, and you see the products begin to tie together, that combined with having talked to the government leaders -- that's the great thing about traveling around the world in January in emerging markets and established markets, but also meeting with the leaders from India, China, Mexico, the other parts of Latin America, Europe -- you get a good feel for their business as well and you see both their confidence in their economies as well as their job creation and focus occur. So mathematically, this should indicate a very solid recovery.

That doesn't mean we couldn't do things to misstep in the process, but you look at the numbers and every time we've seen anything close to this we've seen very solid recoveries. This time it was across the board in every category and while I think there are some areas that we could probably be more critical on our sales team about getting more after, it feels very good.

And then I think also, Mark, the other reason that you're seeing optimism on Cisco is our technologies tying together, customers get it. And our relationship and the service providers, and we probably talked to 50 of the top service providers in the world in the last two months, and almost every situation, both our technology role is dramatically changing and our business partnership role is dramatically changing. The same thing is true in government and other accounts. So what we can control or influence, room for improvement, and boy, it's really gone very well.

You see the almost skyrocketing -- Blair, I hate to use that word, operating income, and you twitch when I say it, but we're back to record profits, and we did that during a very tough time and that's still with allocating a huge amount of our resources to parallel areas, new market adjacencies that don't generate any revenue. So our collaboration model is working.

So longwinded answer to your question, Mark, what we can control or influence, we're hitting on all cylinders and the market overall feels very solid. And I see this across government and business leaders around the world.

Mark Sue - RBC Capital Markets

Thank you.


Our next question will be from Tal Liani of Bank of America/Merrill Lynch.

Tal Liani - Bank of America/Merrill Lynch

Hello. If the stock market is not going to reverse on these results tomorrow then we do have a problem.

John T. Chambers

I'll take as a compliment. And it's not just results, Tal, it's the balance. It's what you're seeing on a global basis.

Tal Liani - Bank of America/Merrill Lynch

Yes. My question is, first of all just clarification, so it doesn't count as a question. You spoke about the impact of Starent, investors do ask this evening, how much of the result improvement is related to Starent and Tandberg acquisition. If you can go back to this section and clarify it?

John T. Chambers

Okay. Let me answer that and then we'll get your question. If you look basically, Tandberg is not going to be part until approved by regulatory approval which will occur hopefully and obviously it's not a given, in the next three to four months and that's pretty much on case with where we're headed, so none of the results had the Tandberg directly or not directly on that and that's still an open issue.

In terms of Starent, it was just before Christmas when it closed, so again from an overall results perspective, you had just about a month in terms of this contribution. Having said all of the above, I am going to make a question out of it. What you are seeing is between our moods and mobility, what we're doing at the edge of the networks in video and wireless. You are seeing an architectural play, where a year ago, perhaps, we were exposed in terms of our overall mobility strategy, and today there's not a service provider in the world that doesn't feel we've got our act together pretty well here.

So let me stop there and go to what your question is.

Tal Liani - Bank of America/Merrill Lynch

My question is about raw material inventory. It went up nearly 50% and we heard throughout the quarter about risks of component shortages. First of all, can you comment about components, availability of components, and then explain the raw material inventory? Thanks.

John T. Chambers

I'll take the easiest part, the general question. I'll ask for Frank to comment specifically as it relates to inventory. When you rethink about what occurred during this quarter and in prior quarters, both for suppliers to Cisco and suppliers of the market, it always occurs this way. As you start out the market cuts back too much on capacity including losing the people that are able to produce it. As you start back up, you have more challenges with capacity and you also — it's basically on products that might be unique to one vendor or another where we have perhaps 50% more of the market and the challenges get a little bit more in that area. That's just a normal economic recovery.

Our lead times did stretch out more than we would like and you saw us bring those back toward the end of the quarter. So let me have Frank comment specifically on the inventory.

Frank A. Calderoni

So, Tal, as I mentioned in part of the script, we, as many in the industry have done over the past year, year and a half, pulled down very dramatically on our inventories last year based on what was happening in the economic downturn. And what we've seen in the last couple of quarters is increasing that. If you look at the profile of our inventory overall, it has increased in the last few quarters. It's related primarily for the upturn or the higher volume that we've been driving as well as, as John just mentioned, the continued improvement in our lead time. So if I look at that profile, whether it's raw materials or finished goods, it's nothing unusual based on what we're expecting over the next couple of quarters.

John T. Chambers

Yeah. And the number one challenge that I've asked Frank and Randy Pond and Angel Mendez to address is customer sat. I want the lead times tighter. We made good improvements toward the end of the quarter. I'd like to see us continue that. Thanks, Tal.

Blair Christie

Thanks, Tal. Next question please.


Our next question will be from Jeff Evenson of Sanford Bernstein.

Jeff Evenson - Sanford Bernstein

Hi. You had a strong quarter in fixed switches this quarter, wondering what factors led to that and in particular if you could comment on the role of a vendor backed financing program that you've introduced and how you're accounting for that.

John T. Chambers

Okay. I think what you're seeing is that switches are often tied to success in the enterprise, government, and commercial markets, all of which went well for us on a global basis. Secondly, I love our product, the market leadership looks good, our innovation engine is going very well. Third is, as you do collaboration and as video starts to take off in integrated data voice video, most customers are looking at switches more than just a concentrator for one element of that. It is the base on which we build our strategies for collaboration, security, video strategies and integration strategies.

So I think part of it is just very good product execution. And Tony, if you're team's listening, we're all excited about the innovation you have planned, and I think it's good execution in our accounts on it. And so I think while it tends to be a little bit lumpy occasionally in this market, I'm very comfortable with where we are in the switching. And I said that last quarter when the numbers were tough, so I think we feel pretty good about it. Rob, anything you'd add to that?

Rob Lloyd

Just John that we've obviously through the downturn continued to focus on the profitability with our channels and with our partners. I think they've responded very well to those programs. So in addition to end user focus, we've also been focusing on our partners and ensuring that they've got appropriate liquidity around the world and I think that's paid off for us.

John T. Chambers

It really does, because it's basically as you all read, and it was true in the market, for small businesses getting access to capital was a problem both in this country and around the world. And so, Frank, your team has done a very good job on this and it continues to be a good business as well as the right thing to do.

Blair Christie

He was looking for a clarification on our vendor.

Frank A. Calderoni

Yeah, so as far as how we account for it, we do the vendor backed financing. We've had that program in place for a number of years. It runs through our Cisco capital organization where we do offer various types of financing, either directly with Cisco or through of our partners. We account for it based on how we look at making the appropriate reserves based on the credit rating of the vendor that we're working with. We are very conservative in how we account for it over a period of time. We normally take reserves and defer it for the duration of the financing period. So we feel very comfortable with how that continues to be accounted for.

Blair Christie

Great. Thanks, Jeff.

Jeff Evenson - Sanford Bernstein


Blair Christie

Next question please?


Our next question will be from Simona Jankowski of Goldman Sachs.

Simona Jankowski - Goldman Sachs

Hi. Thank you so much. John, you made a comment on the call that you sound more excited about share gains in routing and switching going forward. I think you talked a bit about that on switching, if you can expand there? And also in particular on the routing side because it looks like routing was flat quarter on quarter despite what seemed to be a budget flush by a bunch of carriers and also pretty good results from other telecom facing vendors, so if you could just give us a little more color on your optimism there?

John T. Chambers

Sure. Going in, Simona, in the reverse order that you’ve raised it, our service provider business was very strong around the world. In the US, it was actually, as I said in terms of orders, up over 20% sequentially. In terms of the product side of the house, you are seeing our strength in the core routers. I want to say the CRS and I want to check to be sure on this numbers, we’re up 30% sequentially. So doing very well in our core router segment.

The Edge Router, the 9000, is really a hot product, but it takes a while to work through the product cycle. So as you start to put that into carriers, they put it into key pilot locations, then it begins to expand out beyond it, but we are, I think, by far and away the industry leader now at the edge in which Rob, we were not before. The ASR 1000, I gave you the numbers. Between the ASR 1000 and 9000, I think if I remember right, we had about 1,200 customers a quarter ago, 1,600 today. So we're doing very, very well. We're probably going to break a little bit more the lower edge access into different categories in future calls, so we can talk about the CRS, the Edge routing, the access routing a little bit differently.

In terms of our business and service providers, we've moved to an architectural business partner with them and while it might surprise you, I gave you the numbers of service providers. Only about a third of our business in service providers is now routing. About a fourth of it is now switching. You then talk about security and services and others. We're playing architecturally across the board very, very well with them.

To the first part of your question, even though the numbers for us are very large in service providers, I think there's some quarters where video might have a good quarter. That was clearly this quarter. There are other quarters that if I were to call next quarter, I'd be surprised if our router volume was not up very strongly in service providers. So even as big as we are, it might swing in groups, and I think the key takeaway here, relationship with the service providers, you talk to any of them, our relationship almost without exception is improving and share of wallet is improving and market share is improving. So, very comfortable in our strategy interaction, but I very much appreciate the healthy, healthy constructive questions, Simona.

Blair Christie

Great, thank you. Next question please?


Thank you. Our next question will come from Ittai Kidron of Oppenheimer.

Ittai Kidron - Oppenheimer

Thank you and congratulations, guys, on a great quarter. I wanted to dig in a little bit with regards to your guidance, Frank. You mentioned a headcount increase 2,000, 3,000 over the next few quarters. If I just take the midpoints of your guidance, there's about a 1% drop quarter over quarter in gross margin, and about 2.6% in operating margin, which implies you're clearly loading a lot here in the OpEx. Can you give us some more color on that ramp of 2,000, 3,000 people? How much of it is front loaded, the linearity of it, and some more color on functions and verticals, where is the focus?

Frank A. Calderoni

Sure. So, Ittai, specifically as it relates to the OpEx from quarter to quarter, as you can see in Q2 over Q1, we have increased our OpEx significantly, 4% quarter on quarter. And that was as we articulated a quarter ago, we were starting to invest in the growth opportunities, and you can see that kind of starting to come through. In addition to that, we also, John, last week said, and he reiterate on this call, talked about 2,000, 3,000 of incremental hires that we intend to do over the next couple of quarters. We've already started some of that hiring, authorized that throughout the quarter, and many of those hires have been extended, some are still in process, and we'll continue to work through that. So that additional cost will begin to come on this quarter.

The second thing I will say, and if you look at the magnitude of 2,000 to 3,000, that is fairly significant from quarter on quarter. 1,000 individuals per quarter could be in the range of about, for a full quarter, about $70 million right there in additional fully burden cost. The second thing is we have some other non headcount related costs associated with the growth investments that we're continuing to invest in. Advertising for one, we began again last quarter with a whole campaign around Flip, as well as our video. We're going to continue that throughout the year. We've got prototypes and demos associated with some of our newer products as well as many of the architectures that we're rolling out across our geographies.

We've got costs associated with ERP upgrades. This is on the whole point of operational excellence, investing in capabilities that are going to allow us to continue to improve our business model over this period of time. That's substantial. And then the last thing that I would mention that's factored in there is $125 million in the quarter is related to the extra week that we talked about, that 14th week.

John T. Chambers

So on a transactional level, we got aggressive in our hiring over a quarter ago. This last quarter, our headcount increased by about 2,100 people and about half of those were from acquisitions, about half from regular hirings. But what I'm most comfortable with is, Frank, with the job you're doing in terms of, we used to do this within sales and as an afterthought to do it to engineering and then if the product really did well, we did it in service, then we'd think about channels. We now move as a group and we make investment across the entire company at the same time and Frank does that unbelievably well, best we've ever done in terms of as we put incremental money in place, it isn't just about one aspect. It goes across the board on it. Ittai, thank you.

Ittai Kidron - Oppenheimer

Very good. Good luck.

Blair Christie

Thank you. Next question please?


Next question will be from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank

Hi, John. Question around datacenter switching, specifically Nexus, some pretty strong growth there in your numbers year on year I think you were talking. Can you talk about how Nexus looking into this quarter, when will this become significant? Do you see it as $1 billion in revenues this year for the platform? And then also I think 400 customers for UCS, that's doubled from last quarter. How's that coming along?

John T. Chambers

Yeah. I don't know if we gave you the customer numbers for last quarter. We gave you the revenues. We said the business doubled from last quarter, but I would expect probably the customers more than doubled, but let's keep the math simple. The business doubled from last quarter and our customers are up to 400 and on the next quarter we'll give you a little bit more detail.

In terms of the basis for the Nexus, in terms of a $1billion run rate, I feel very comfortable we'll be on that in this calendar year. In fact, we are rapidly closing on that already. So in terms of the datacenter area, we're starting to win the architectural battles, you're seeing the value on DCE with EMC and VMware, you're seeing that it isn't about server standalone technology. We have no interest in that, but architectural plays. We're off to a good start. We've got some tough competition there, but I like the way the hand plays out. And even Frank would say my forecast I just gave you on a billion this year was probably sandbagged Frank even more than your cash flow projections periodically are by quarter.

Frank A. Calderoni

Yeah. We go back and forth on cash flow.

John T. Chambers

Thanks, Brian.

Blair Christie

Great. Thank you, Brian. Next question please?


Our next question is from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS

Okay yeah, thank you. Just a quick clarification and then a question. Was there any revenue benefit on the accounting change? You mentioned last quarter it was about $50 million. And my question is, if I look at the revenue guidance for the April quarter and I adjust -- well, if I look at it historically over the last five years and I strip out last year due to the recession, it's typically up about 3%. So if I look at the guidance you gave and adjust for the one extra week, it kind of implies something much less than that. Any reason why we shouldn't look at the historical average? I'm just trying to get a sense of how you came up with this guidance based on the strong orders and the momentum, and then if I look at the historical average it seems to be lower. Thank you.

John T. Chambers

Right. So a couple of general thoughts. I'm going to answer the easy part and Frank you can get the number one because I'm not sure on that one. If you watch, remember, Cisco's always going to be conservative. We are very comfortable with our momentum and direction at this point in time and we're hitting on all cylinders, but also understand everything went our way this last quarter, every geography, every product area, et cetera.

In terms of the economic environment, still a little bit challenging, and we're still watching supply chain lead times, but we did do improvements into this quarter, I think it was Mark challenged us a little bit on. So book to bill, we're usually with a little bit higher book to bill going into the next quarter than we are. I would read it just as very solid growth opportunities, very comfortable returning to our guidelines, that I know many of you perhaps challenged us, would we be able to hit, which I now feel pretty good about being able to hit. And I wouldn't read anything negative into it. All positives from my perspective, just we don't want people to get too far ahead of our ability to deliver in terms of direction. Frank?

Frank A. Calderoni

So your question related to the accounting change that we implemented at the beginning of the fiscal year, so last quarter, the first quarter, we said it was approximately $50 million of benefit. In the current quarter, it's about half that, so approximately $25 million.

But if you look overall, to the second part of your question, we during periods of economic change up or down, we encourage you to watch sequential numbers. But just once we get into our normal rhythm, which we are back in, we go right back to year over year. So rule of thumb, during the elbows up or down, what we call the tipping point, sequential is important. During normal operations, which I would now say we're moving into, I'd watch year over year numbers in terms of the direction. I would not read as much into a couple of points one way or the other on sequential.

Nikos Theodosopoulos - UBS

All right, thank you.

Blair Christie

Great. Okay, next question please?


Our next question will be from Sanjiv Wadhwani of Stifel Nicolaus.

Sanjiv Wadhwani - Stifel Nicolaus

Thanks. Congrats on a great quarter, guys. John, quick question on service provider, orders were up really nicely, can you talk about the April quarter and just in looking at the orders, was that CRS-1 related ASR switching, video, Starent, any color over there? Thanks.

John T. Chambers

All of the above. If you look at the quarter coming up to us in front, it's traditionally a very solid quarter for service providers for us from a seasonal point of view. It also speaks to the service providers feeling more comfortable with their business and more comfortable candidly with government regulations within their business. And I do think you'll see a very good balance although it tends to be a little bit more this next quarter, Rob, if I were looking out, more routers if we look into our forecast and begin to break it down. But no, I think it's a very good balance across the board and remember again the mix that I gave you earlier with only about a third of service provider business being routing, substantial part being video, substantial part being switches, et cetera.

Sanjiv Wadhwani - Stifel Nicolaus

Got it, thanks.

Blair Christie

Next question, please?


Our next question will come from Paul Silverstein of Credit Suisse.

Paul Silverstein - Credit Suisse

John, if I could ask a clarification and then a question. First off, tell us what the TelePresence contribution was and what do you expect ScanSafe or what ScanSafe did last quarter? And then the question is, it looks like the strength or — I understand your comment about broad base, but it looks like US is leading and it's also switching and routing, which if that trend continues into this quarter from a product mix perspective, putting aside Flip and the other lower margin stuff you've acquired recently, one would think that would actually benefit margins. And I'm trying to understand, maybe Frank, if you could give us a breakdown or some type of quantification of the impact of the geographic, the expected product mix, and the volumes? That would be appreciated.

John T. Chambers

Okay. So if you look overall geography wise, the US absolutely led early in the economic recovery, and if you watch on the numbers with our growth being up approximately 17% year over year, that was an extremely strong number. But it was very well balanced across our enterprise, commercial accounts, federal business, et cetera, within the category. But you saw very good movement in the emerging markets being from down in the high 20s just a quarter or two ago and very painful to flat. And as I shared with you on the tours I made through the emerging markets in meeting with a lot of the government and business leaders in emerging markets just last week, that's headed in the right direction.

Asia Pacific is beginning to pick up very good balance using our approach. And China and India, China did the best stimulus spending in my opinion in the world and positioning for that. They spent it quickly, they realigned their resources quickly. You saw the business turn up earlier, their growth this quarter was in the high teens. India, their elections occurred in May. They needed to get stability. We said that's going to cause a little bit of lagging. You did see the last quarter their growth in the low 20s. So I think you are seeing very good balance around the world. Japan, I'm not quite as optimistic on the economy, but candidly Edzard and team are executing off the charts over there in terms of direction.

Blair Christie

He asked about TelePresence.

John T. Chambers

And so if you look at TelePresence, it is the tip of the iceberg for catching what collaboration means, and so it is the way of getting people to understand collaboration, expansion. We're up over 550 customers. You'll see us announce this year our first customers in the 100 million and probably well beyond type of announcement. Customers do get the balance between the value of Cisco TelePresence at the high end and Tandberg at the middle and access level and the interoperability and the openness between the two. So I'm very comfortable with where we are in TelePresence and the momentum and it's accelerating within our own use.

Paul Silverstein - Credit Suisse

John, can you give us a dollar number for TelePresence for the quarter?

John T. Chambers

No, but I'll give it for you for next quarter.

Frank A. Calderoni

Yeah, back on -- Paul, on the question as it relates to margins…

John T. Chambers

I'm sorry, Paul. I'm usually not that direct. Blair kicked me underneath the table. We will do an in-depth discussion of TelePresence for the next quarter. Forgive my directness on that.

Frank A. Calderoni

So back on the gross margin, I think your question related to the geography and as you know when I mentioned in the script the improvement in margin overall and some of the geographies, I think you're probably referring to the improvement that we saw in the emerging markets which probably had the most dramatic improvement from a quarter-over-quarter standpoint. That clearly has to do with the business that John was just talking about in emerging markets. That business was down for a couple of quarters and based on the volume and based on some of the challenges from a credit perspective overall, that puts pressure on margin. As that business starts to come back, as we saw this past quarter, and the solid business that we had, it really helps us from a margin perspective. That was driving that.

Answering your question overall from a margin perspective, as I said, when you start looking at some of the dynamics, a lot of it has to relate to the variability on the mix with some of our business over a period of time as we've seen the last couple of quarters and you saw that going from Q1 to Q2 and the overall margin drop. We start to see consumer, we start to see UCS, we start to see the video business with set top boxes start to have more of a play in that variability.

Over a longer period of time, as we said in the guidance for this coming quarter, as well as longer term, as I mentioned back in December as part of the financial analysts conference, we really have to look at our margins in that 64% to 65% range because of that variability on mix, because of some of the dynamics that occur with pricing as well as with costs on the manufacturing side, and we feel comfortable over that period of time that that range is a reasonable range for us and for you to assume.

John T. Chambers

It's a fair question, Paul. If you look at it, basically in the emerging markets and some of the areas that aren't emerging, we're seeing some very good but very tough price competition from some of our competitors out of China, and we also are anticipating successful launches in home TelePresence, I don't avoid your topic, and the implementation and in the early movement into new markets. And each time we've entered new markets and product areas where we've not been before, at first the margins aren't quite what we would like, but then they build up over a period of time. So when I'm modeling Cisco, I would hold us accountable as a leadership team to stay in the 64%, 65% range. There might be short periods where we're a little bit above and short periods below, but that's kind of what Frank and I are trying to balance on it. So I don't get particularly excited or over concerned in a quarter when it's just a little bit above it or below it.

Paul Silverstein - Credit Suisse

John, the position you referenced, that's in switching and routing in your core platforms?

John T. Chambers

The question, Paul?

Paul Silverstein - Credit Suisse

The pricing pressure you noted coming out of Asia, that's in switching and routing platforms?

John T. Chambers

No. It's across the board and it's often in turnkey scenarios. Somebody can go in and bid a whole architecture for mobile and we're hitting per piece of it. So pricing pressure, that's how a certain set of competitors will come at you. Some others will come at you with specific products, especially startups. Others will come at us on the total systems integration type of approach and I think we're just seeing more systems play than before and within the systems play there's going to be more advanced services and other categories, Paul.

So we're really positioned well in this, but I think we are seeing different ways that competitors are coming at us and price will always be one of the elements they come at us on.

Blair Christie

Great. Thanks, Paul. Next question please?


Thank you. Our next question will be from Richard Gardner with Citigroup.

Richard Gardner - Citigroup

Okay, great. Well, most of my questions have been answered, but I did want to ask you where you're seeing the most success in UCS? You're obviously on a pretty good trajectory there quarter to quarter. Where are you seeing the most success in terms of applications in workloads? Can you talk about who you go up against most often in competitive bidding situations? And why customers choose UCS over competing products when they (inaudible) your product?

John T. Chambers

Let me take a little bit of cut at it, but I want to also not mislead you. We’re just up to 400 customers. Most of those are doing pilots and implementation. How the first couple dozen go in the big account service providers and enterprise to determine how your next wave goes. Why we’re winning, it’s an architectural play. First, it’s a very world class product which in my opinion, one that is well ahead of our competitors at this point in time. But it’s the architecture and how the network and processing capability and storage capability comes together with the applications and the cloud. And the ability to build the architectures where many of the costumers are doing this.

Others are doing it and we’ve been surprised a little bit we’re off in the commercial marketplace with some real leading edge commercial customers just saying, hey, you save so much in terms of my storage costs, so much on flexibility, and you’re headed to where you’re going to go without locking me in and best in class products in each category, we’re going to align with you.

I probably would say, I owe Paul a discussion on TelePresence for the next quarter call. We’re probably two quarters out from being able to do the same meaningful discussion on the UCS side of the house. So what I think you can say is that we’re not only holding our own in the data center and virtualization. Padma, what you started with Cloud and what we’re really driving through, we’re having very good success with.

But again, in summary, we’re going to have a great set of competitors in each product category area. And the good news is, we do not lack for competitors at all across many areas, talking literally dozens of different competitors in different product categories.

Blair Christie

Thanks, Rick. Next question please?


Our next question will be from Simon Leopold of Morgan Keegan. Your line is open.

Simon Leopold - Morgan Keegan

Thank you very much. Sticking on this theme of competitors, John, many of us have worried about the shifting competitive dynamics, specifically the reactions to your data center initiatives by IBM and Hewlett Packard. Can you help us quantify your exposure to these past partners and help us understand how this trends over the next number of quarters?

John T. Chambers

I have a huge amount of respect for both HP and IBM. HP is clearly a competitor. IBM’s a partner and a competitor at times. Rob and I were reviewing the impact that it has had. Remembering again, we usually create the demand and fulfill it through partners. I would say our impact, Rob, when we looked at the numbers was not major at all. We’re doing extremely well. And we also were doing very well with our new introduction of new systems integrators and new partners. I think it’s just part of normal evolution. It speaks to how key the network is to whether you’re doing a cloud strategy, whether you’re doing a video strategy, whether you’re doing a security strategy, whether you’re combining so that any device gets any content and it’s transparent to you where the processes are, the data is stored, the application occurs. Intelligent network is what makes it go.

And that’s in part the reason you see us being so successful in service providers. We have the same goal, intelligence throughout the network and the ability to route any information from any device to any content in video, data or voice. It’s a nice way of saying it, that the shifting competitive landscape, that’s when you move into good markets, when your top competitor is focused on you, that’s a complement. When Apple brings maybe for the first time that I remember, the Flip product on PhaZeNet [ph], on one hand I said, oh, to me that’s a complement. And I thank Steve for that. Then he whacked us as I knew he would. But we’re more than holding our own there as well. We got our second generation product out. And Ned, maybe in that just as an example, and I asked you to comment about how we’re doing in the consumer space. As an example, where we’re facing new competitors we haven’t seen before and a little update on the home. But we can have the same discussion on security. We can have the same discussion in terms of where we’re going in service providers, the same discussion in cloud. The great news is, we have a lot of different competitors in each category.

Key take-away is, we have a lot of different competitors in each category. We’re playing architecturally across them and changing our business models.

Quick update on the consumer where it is something, Ned, that we want to see, not counting set top boxes go from the billion to our strength goal three to five to ten, how we’re doing and what kind of grade would you give us so far?

Ned Hooper

Thanks, John. So as you mentioned, John, in your remarks, we spent some time together at the Consumer Electronic Show at the beginning of January, and I think what we saw at CES was the strategy that we have laid out where we’re focused on that intersection of video and networking for consumer experiences is really starting to resonate, not only with consumers, and we saw that in the results this quarter relative to our video products, both the flip products as well as the overall video systems products, as you talked about.

Also our story resonating strongly with our partners, media companies, the service providers and some of the fantastic meetings we had. Our focus is to deliver compelling experiences around personal video, branded video and video communications for consumers. And we feel very good about how that’s playing out right now.

John T. Chambers

The exciting part is, we started in each of these market adjacencies, and very few people, I think, both inside and outside the company understood how sports and entertainment ties to music, ties to film, ties to Flip video, ties to the home entertainment capability and then the virtual capability itself, installing capability, any device to any content. And that’s clearly the road that Ned’s taken us on in terms of the architecture. But each of our groups are now starting to come together on it. And customers get it, that’s the exciting thing.

So we’ll see if it plays out as well as we think. This is a new arena for us. And I’m sure we’re going to do some things brilliantly. And then we’re probably going to make some mistakes. If we knew what the mistakes are, we wouldn’t make them. But I feel very good with where you’re taking us, Ned, but also how well you’re working with Dan Scheinman's group, how well you worked with our core group, the service providers as well.

Blair Christie

Great. Thanks, Simon. I think we have time for two more questions, John. So can we take the next question, please?


Our next question is from John Marchetti of Cowen. Your line is open.

John Marchetti - Cowen and Company

Thanks very much. John, just a quick question for you. As you're looking into the second half of your fiscal year here and maybe even a little bit further into the calendar year, I know you're not giving guidance, but given the product sets that you've got coming out now, a lot of new product traction, how should we look about maybe service provider versus enterprise, where are you expecting strength there?

And then secondly, on that service provider business and of relatively conservative guide here given everything we’ve seen, is there any concern at all in that guide or anything factored in there about some concerns around budgets maybe being delayed in terms of approvals or where you’re seeing those numbers fall out amongst some of your larger customers?

John T. Chambers

Well, the exciting thing is, John, I feel very good in terms of the growth in all the categories that we talked about. And while the consumer is still a relatively small percentage of our business, actually I think what Ned and Jonathan have been able to do there looks very good as well.

Some quarters tend to be more service provider oriented, some tend to be more enterprise oriented. Some of them, depending on which countries and it swings up or down or not, but I think you now see why we’ve been so comfortable with the 12% to17% long term growth guidance is that we are very well balanced across each of these categories. And we’re the only player that has not only invested and bet across each of these segments from the consumer to the commercial to the service provider to the enterprise with a strategy that actually ties any device to any content anywhere in the world. That’s going to be hard to replicate by others.

So when you think about my view of saying growth in the 12% to 17% level is just a B plus, A minus type of execution for us over the next two to three years assuming no more GDP growth, you see why the confidence is there.

I don’t look too much to one quarter slightly up or down, or did we pull -- do we have a little bit of capabilities in this quarter as we load lead times versus another quarter. You put the two quarters together, they are extremely aggressive. And I think our trends are very good.

So assuming there’s not a surprise in the market, I feel very good about our direction and momentum, John. Wouldn’t read anything into caution on any category. And I don’t see a problem with any of our major market segments or candidly any of our major countries. I think we’re executing pretty well in most of them.

Blair Christie

Thanks, John. We have time for one final question.


Thank you. Our final question will be from Paul Mansky for Canaccord Adams. Your line is open.

Paul Mansky - Canaccord Adams

In under the wire. Thanks a lot, I appreciate it. Obviously the successes you’re seeing are pretty clear to all of us. So if I could, can I play a bit more of a devil’s advocate here. And that, sure, we’ve heard about inventory bill based on what you’re seeing over two to three quarters. You’re hiring again. You’ve historically been very contemplative about hiring practices up and down, or shifting back to year over year growth focus. What is it that you need to see to actually go back out and reestablish, kind of, more of a fiscal year annual guide?

John T. Chambers

Well, we’re moving to a fiscal year annual guide in terms of a 12% to 17% number. And that’s during normal times. We have some quarters coming up that have very good comps year over year. And we clearly forecast with that with 23% to 26% growth this next quarter.

And we said there, and thank you for the clarification, Paul, on it, that we wanted a couple quarters more before we begin to think about are we in that range sustainable. I think we will be, barring an economic surprise or barring a missed execution from our side on the over approach.

So again, if you take a step back, the quarter was probably as balanced as I’ve ever seen at Cisco, especially given the trends sequentially as well as year over year. We’ll now move back into thinking a year at a time. We don’t run this company on this month or this quarter or even this year. We are going to run it on the growth rates for the long term and growth rates to the top and bottom line within the balance, that we are going to move aggressively on movements into new market segments, market adjacencies, and we’re going to spend the money to get there.

And we’ll try to give you a better feel for when we’re more comfortable with the overall global economy being sustainable. Clearly, the signals to us were extremely good this quarter. And I’m hard pressed to think of a single country leader or government leader, business leader that I’ve called on that wasn’t more optimistic about their country momentum or their business momentum now versus just even six months in terms of direction.

So a couple more quarters net and I think we’ll give you a long term guidance. We’ll have to decide, Frank, do we -- yeah, we want to give long term guidance and by quarter. That’s kind of, I think, more than most, what other people are doing. But we’ll take a hard look at the balance.

So, I want to thank everyone today for the time. I am very much appreciative of the confidence you’ve shown in Cisco. We’re doing our best to show you the results from it. And I want to congratulate the Cisco team on a very good execution.

So, Blair, let me turn it over to you for the close.

Blair Christie

Great. Thanks, John. Cisco’s next quarterly conference call, which will reflect our third quarter of fiscal 2010 results will be on Wednesday, May 12, 2010 at 1:30 pm Pacific time, 4:30 pm Eastern time. Additionally, downloadable Q2 financial statements will be available following the call, including revenue segments by product and geography.

Income statements, full GAAP to non-GAAP reconciliation information, balance sheets and cash flow statements, can be found on our website in the Investor Relations section. Click on the financials of the website to access the web cast slides and these documents.

Again, I would like to remind you that in light of Regulation Fair Disclosure, Cisco plans to retain its long standing policy to not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Please call the Investor Relations department with any follow-up questions from this call. Thank you for your participation and continued support. And this concludes our call.


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