Cisco Systems' (CSCO) Management Presents at Bank of America Merrill Lynch 2014 Global Technology Conference (Transcript)

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Cisco Systems, Inc. (NASDAQ:CSCO) Bank of America Merrill Lynch 2014 Global Technology Conference Call June 4, 2014 12:15 PM ET


Gary Moore - President & COO


Tal Liani - Bank of America Merrill Lynch

Tal Liani - Bank of America Merrill Lynch

Thank you very much, everyone, for surviving the second day or joining us for the second day. The next presentation is from Gary Moore, the President and COO. And we’re going to speak about some of the issues that Cisco has in running the transition, in making sure that it builds the right growth engine. But my interest is less about the technology direction because we beat this part to death.

My interest here is to really speak about the high level and speak about how do you manage a transition of such a big company from one state of mind to another state of mind and how do you do it in a way that you drive the entire organization up.

So, Gary will start with a few slides just to go over some high level topics that we discussed and then, I’ll take him through a few questions and of course at the end, we’ll open it up for Q&A.

Gary Moore

Thank you. So I’m going to spare you the slides. I do want to stay on track here, I’ve been to a few of these conferences and people get slided to death, if you will. So I think -- I mean, first off, I appreciate the opportunity to be here and I’ve been with Cisco, 13 years, the last three and a half of that as the Chief Operating Officer and then a year and a half ago President, Chief Operating Officer.

And our transformation really started, for those of you that follow Cisco, about three and a half years ago right as we were ending our second quarter of our fiscal year three years ago. We had the level set, and John and the Board asked me to be the COO to really focus on a couple of things; one, better visibility and what was going on, because the market was really shifting very fast.

We had become more, I would just call it, fat around the middle in a lot of areas than what we could afford to be given the new growth trajectory and we really were investing in too many things. So it was really a time to restructure the company, reset our OpEx. I think most of you remember we committed to take $1 billion out in three quarters. We did it in two.

We realigned a number of people and we got out of some businesses. And I think the important thing for you to know is that allowed us to build in a lot of new process, a lot of new discipline, a lot of new tools and financial systems, if you will, to give us better visibility, more process around looking at our portfolio and the performance of that portfolio and not only annualized planning but three-year planning, and then, in the last two years, we’ve actually tied a workforce strategy to that planning.

And I’m the kind of person that always looks for the bright side of every situation. And while it was very painful three and a half years ago for Cisco to go through what we had to go through, it really did set the foundation for what we’re doing now and I actually thank God that we had that crisis because today in the way the market is moving so fast, the pace of change, if we were operating in our old environment, we would be in a very difficult shape.

And I think what we’ve been able to do is continually make this transformation and it was how do we build ASICs faster and we’ve cut the time to develop ASICs pretty much in half, how do we bring products to market in a way that our customers actually want to buy them? How can we transform the company with all of the new things to make sure that we’re hitting on all the priorities that customers are looking for, whether that’s new buying models, whether that’s Cisco being more in front? Customers had never had as much choice as they do today, but they have also never had to deal with the amount of complexity that they have today.

And I think that’s an important opportunity for Cisco and our partners and one that we are very much focused on. So I think that where we’re at a high level, I would go on to say that everyone in the company really believes what this means for Cisco, is we have to operate differently.

John asked me about four months ago to look at the company horizontally. We had optimized the company on vertical functions and we were executing as well as we could across the company horizontally even though we had good planning and interlock and that kind of thing, it was slowing us down, so we were optimized for cost, optimized for functions, but we weren’t optimized at the company level.

So what we’re doing now is realigning more back to a customer around customers and we’ve made significant changes in engineering, not only in leadership, but more importantly in the portfolio and some of those investments. We’ve made significant changes which we haven’t announced publicly yet relative to product and services sales, especially as it relates to service providers and our large global enterprise customers and we’ll be announcing those changes more broadly as we go forward. But it’s not about those changes as much as it is the fact that we’re making those hard decisions to make Cisco a place that people really do believe we’re going to do what we say we’re going to do.

And I think I would actually close by saying that I don’t think I’ve ever been more confident and the senior team’s been more confident about our ability to make this transition, to focus on high-value growth and profitability, high-value offerings that drive a higher margin that will enable us to continue to do the things that we’ve been able to do through all of the transitions that we’ve seen through the course of Cisco, which is lead those transitions or when we fall behind, catch up very quickly and come out of those transitions very strongly.

As we look at where we’re at today, we feel that we’re extremely well positioned to address these market transitions and I will get into some of that as we go on Tal. So thank you.

Question-And-Answer Session

Tal Liani - Bank of America Merrill Lynch

Thank you, Gary. So the first question is kind of a high level question about your priorities. What are you focusing on being the COO of the company? What are you focusing on? What do you think needs to be done in your department in order to ensure that the objectives are achieved?

Gary Moore

So, at a high level, John expects me to, and I work very closely with Frank Calderoni, our CFO, and Rob on this, but he expects me to drive all of the functions and make sure that we’re in alignment there, so from a budgeting point of view, from a cost point of view, to make sure that we’re making investments across all of the functions to really get the maximum benefit out of what we’re doing.

I think, as a company, about a year and a half ago, everything in the company, other than product sales, and CFO reported directly to me. And so, about a year and half ago I took the engineering organization and that reports to Rob, because we wanted a tighter integration between the market, the people in the field and engineering. I think that has really helped us accelerate the interface there and allow us to drive things.

I think short term, the most immediate things that we’re focused on today continue to be the data center and cloud and the opportunity there. I think the progress that we’ve made in mobility and the progress that we’ve made in security are, I would say those are the things that we’re really focused on today. We’ve taken the security both from an engineering point of view where we’re very comfortable with the roadmap.

We’re starting to fill in some things we were missing certainly with the Sourcefire acquisition. That’s given us a big boost. We’ve hired a world-class consulting, assiso, out of the market, who is building a very high-end security consulting practice. And one of the changes I referenced before that you may not have heard of, we put all of the security sales people out of the regions and made a one person responsible for all of our security sales, and the PSSs that go with that.

I meet with those three individuals personally. We made a decision Security was a priority, InterCloud was a priority and we’ll talk about that I’m sure. But I took Security and Rob took InterCloud as the sponsors for that to drive it forward. So, we’re making those kinds of changes that can make sure that today we’re maximizing the opportunity.

I think longer term, we still are investing heavily in emerging markets and that business will come back, certainly services as core product comes back, plus the things we’re doing with services and I know you want to – you’ve already told me you want to talk about services and then collaboration, those are things in our new portfolio in collaboration, not only the way they look and the awards that they’ve already won from an appearance point of view, but the fact that they inter-operate.

And we’ve created an opportunity for customers from different companies to really use our collaboration tools in the way they were originally designed to work and then longer term obviously IoE with a $19 trillion market, the investments we’re making there, we’ve been involved in IoT for a long time, seven years since we did one of their first projects.

We have about $2 billion worth of pipeline over the next several years that we see with large customers and countries. And I think the results of that are going to phenomenal. Obviously, data center cloud as we bring ACI on and full-fledged movement, NFV, the software-defined networking, those are opportunities that we think we can lead and really benefit from.

And then last but not least, how all that comes together with InterCloud, and if you think about InterCloud, it really ties a lot of the things together. So it’s really critical to it. So how do I -- my priority, how do I fund all that and how do I make sure that we’re in alignment.

Tal Liani - Bank of America Merrill Lynch

And you touched on -- in the last part of your answer you touched on InterCloud. And I want to take a broader question. One of the risks for Cisco is that the high end of the market goes to this SDN, NVF and the hardware is getting -- I'll use the term commoditized. But there is another risk and that you deal with -- you deal with it pretty effectively with technology, but there's another risk. And the other risk is that network will become a resource the same way or natural resource the same way that electricity is. And that means that smaller companies will just not build a network, but rather lease capacity from Amazon cloud services or whatever it is. How do you deal with that risk? Because these customers tend not to buy equipment from Cisco.

Gary Moore

I mean obviously that’s a -- it’s also an opportunity, it’s a risk and it’s an opportunity. And our position has always been, I mean first, eight of the global ten over-the-top providers like Amazon are huge Cisco customers. So we’re benefiting. I mean huge Cisco customers. If we look at our service provider customers which are also very large for us, we wanted to create an environment.

We’ve been working on the strategy with some of them for a couple of years, but where we created a federation, if you will, of clouds, what we have now because of customer demand -- customers want a lot more flexibility than what an Amazon gives them in my opinion and what they tell us and so InterCloud is based on Cisco architecture, but it’s open stack, it’s a very open architecture, it’s hypervisor independent, so what does that mean?

That means we can help customers build private clouds, which we’re doing. Service providers build public clouds and we can also build hybrid clouds, but what InterCloud does is facilitate the movement of applications between any one of those three. The value in that is really something that our service provider partners like Telstra, NTT DATA and Dimension Data, Sungard and there is a number of others that are in play right now that I can’t disclose until they are signed.

But we see this federation building out and we’re also building our own managed service cloud that is part of the services organization, not because we want to load it up and compete with those guys, but we have to have the knowledge, we have to have the capability where some customers have said, we want you to run this until we get more comfortable.

So giving the customer the flexibility to build it in a hybrid cloud or a public cloud and then move it back to a private cloud as it goes from small to big gives them more flexibility they don’t have today. In addition to that, just a last point on InterCloud, is the fact that we already have cloud offerings, we have Meraki, we have WebEx and those are things that can run on InterCloud and bring revenue to those partners.

If you think about that, that’s a pretty compelling thing for that, for an NTT DATA, Dimension Data to be able to offer in their markets, the ability to offer that especially where there is sovereignty issues because of everything going on around the NSA and the leaks and that kind of thing, I think that’s a huge value that they see as well. That gives --.

Tal Liani - Bank of America Merrill Lynch

And the question is in order to deliver this, does it mean that you have to build an operation like Microsoft Azure jour or Amazon? Does it mean that you have to put billions and billions in building a cloud? Or can you go another way about it?

Gary Moore

So, obviously there is no way I was going to allow or Rob or John we’re going to allow us to go okay we’re going to start building and spending billions and billions of dollars four and five years after everyone else was already invested tens of billions of dollars to build an infrastructure. Our position and I think one of the great strengths of Cisco has been our ability to leverage an ecosystem of partners and find a way to make it a compelling business case for them.

And when you can talk to them about a federation, when you can talk to them about delivering apps that they can add additional value to to the market, that precludes us from having to do that. Now, we did say that we would spend a little over $1 billion in the next two years, building out cloud capability, but that is not just infrastructure.

First off, I actually think we can save money on infrastructure because we have engineering data centers all over the place that’s not part of our IT where they’re building cloud offerings. They are also using public clouds to do some of that, which is not in our best interest. So we’re going to consolidate a lot of that, so some of that expense is that. We’re also spending a fair amount of money, bringing capability into Cisco.

We’ve hired people with software experience. We’ve hired people with cloud experience and running large managed services and I mean senior people, people that were the original architects at some of the companies you just mentioned and building out their cloud capabilities. So we are very comfortable that we have this positioned correctly and we think time is of the essence, and one of the things you’ll hear me talk about over and over again is not only speed to innovation, speed to results in revenue and profits, and this will help us get there. So we know we don’t have to spend billions.

Tal Liani - Bank of America Merrill Lynch

So switching to another topic, which is relevant to growth, services -- I asked this question on the conference call we had recently and services growth declined quite remarkably over the last three years and in consistent ways, kind of in the teens or mid-teens to 8% to 2.5% the last four quarters. Is there -- the question I ask -- there are two parts to the question. Number one, is there anything structural that moves revenues from service to products and that's why service revenues grow, which is counterintuitive to what you're trying to do, or if not, if this is just because of declining product revenues, what can you do in order to accelerate it?

Gary Moore

You’re right, that is a long answer. We were joking earlier. So, for those of you that aren’t familiar, it was good news and bad news in a way because for the 12 years that I was in the services organization, we grew a compound average of 12% a year for that period of time, which is pretty phenomenal even when Cisco’s product revenue dipped in some of those cycles.

I think one other things that I talk about now is those dips back then were two and maximum three quarters and we have a $180 billion installed base, you have renewals, it wasn’t that hard to keep that going and especially as people when they were holding back did deployments, they didn’t have the resource so our advanced services revenue, which we don’t report separately, but it grew significantly higher than the average.

What we see now with the core routing and switching of being flat or even down in some quarters for an extended period of time, what we have now from a core technical services point of view is more related to renewals and up-sells because we transitioned to Smart services, SMARTnet Services which are very analytically based and all that.

So even though they have higher margins, they don’t have the impact on growth that when you are selling new equipment and you have those renewals. The other piece of your question is something that we are watching very carefully, but it is what it is. Meraki is a solution although the services with Meraki are accounted for in Meraki, all of the services in MDS and our solutions that we’re delivering to service providers are part of MDS.

I actually lifted the services -- some of the service provider architects, video architects out of the advanced services and moved them into that. So it is having some impact but not substantial. More importantly, what we’re doing in services is we’re creating a platform, so platform-as-a-service is going to be a driver.

We’re creating consulting services under Martin McPhee we brought in to bring both our IBSG, our free consulting around business and verticals together with Advisory Services to come at the market with vertical expertise and help customers define solutions and then go build them. So it’s no longer -- let me show you -- let me tell you what to do, we are actually going to do it for them. That piece of his business grew 100% quarter-over-quarter.

There is a big demand, the hard part now is how do we fill up the people. Security consulting, I mentioned same thing, growing very, very well and it’s a matter of how many resources can we bring in. And then, the whole area of the analytics and some of the acquisitions we’ve made, if you look at JouleX, if you look at Composite Software, some of the other acquisitions we’ve made that are services related, they are not only adding value to services but how our management is especially in countries where green is so important, that’s a differentiator for us for any kind of campus switching or any kind of rollout we’re doing.

And we’re integrating very tightly with product engineering and some of those capabilities so that we can make the trade-offs about what do we put in the product and gain margin there, what do we build as service to go over there. So the problem is it’s the fish, right? Before this one, they were coming up like this, this one is going down like that.

And quite honestly even though we started some of those things way back here, that’s a slower ramp than what we’ve seen in the dip in the core technical services, as well as advanced services because in advanced services even though we’ve built out cloud services and are helping service providers build public and private clouds, the issue there is, is just not as much revenue as what dropped off from huge, big deployments where you are building out next-generation network for a service provider or a large enterprise.

Tal Liani - Bank of America Merrill Lynch

And questions from Marilyn, are we -- do you disclose the proportion of services that are between the three buckets?

Gary Moore


Tal Liani - Bank of America Merrill Lynch

No, we don’t.

Unidentified Participant

You have the disclosure between technical services and advanced services with technical services being roughly (indiscernible) of that mix from a revenue standpoint, that’s about it.

Tal Liani - Bank of America Merrill Lynch

That’s about it. Is there any -- I don’t know if I can speak about the notion of pricing decline in services but is there any notion of pricing decline in or do you see that, for example, for maintenance that you -- because the markets are quote unquote commoditizing or maturing, there is any pressure on or maybe even a decline in the renewal rates of service contracts?

Gary Moore

So we have a couple of part questionnaire, the service renewal rates are always tough. You have to continue to innovate your service offerings and add more value so that customers are seeing what they are getting for that money. Everyone starts with I want a 20% decrease or a 10% decrease, and quite honestly if -- quite honestly if they want to lower the SLA or lower what they’re paying for then we can make that adjustment.

We typically can demonstrate to them that because of our analytics, because of the automation and the things that we bring to value, we can actually upsell them. The other part of your question is I said for the three years that I’ve been really allowed to speak broadly publicly about margins is services margin is going to be in the 65% range on average, right? Now, it may be less than that, may be more than that.

The facts are they are running 69%, 67% depending on the quarters. So if you would just do the math, there you go well, they are not under pressure and it’s not hurting our growth because we’re not losing more prices, I think customers see the value, it’s really a key differentiator for Cisco, but it’s tough.

Tal Liani - Bank of America Merrill Lynch

As you go -- last question on services. As you go into more cloud based services, more product to the services instead of product to the product sales, are services going up or is it more like Meraki that service revenues are not going to be impacted by it, we're going to see it on the product side, not on the service side.

Gary Moore

I think it’s some of both, but for the most part, services will go up because we’ve built four different brand-new offerings around this and for the partners that are joining us through InterCloud, we’re doing everything from very -- the original design and architecture, all the way through how they are managing the M&O, the management and orchestration as well as application identification and migration and a whole suite of things.

So that’s actually pretty good revenue coming into advanced services and then some of what we’re building, we’re going to license to them so actually see an opportunity for not only the platform revenue to come into services, but also licensing revenue for some of the unique things that we build and we’re going to license to those partners.

Tal Liani - Bank of America Merrill Lynch

Before we go to margins and expenses, I have a philosophical question for you about cloud. When I speak to the Bank of America technical guys, they say that SDN will enable us to reduce the costs, and they talk about certain types of costs, but as much as 50%. And they say that it's -- they do it for the flexibility it provides, but also the decline in costs. And I understand that you're trying to be better than others. And let's say that you have the best SDN portfolio for switches out there, switches and software and application. How do you avoid this desire to decline or reduce spending by as much as 50%? And we can argue if it's 20% or 50%, it doesn't matter.

Gary Moore

So I think if you think about the application-centric infrastructure, if you think about the ASIC controller that we will ship this quarter, the early customers and just to remind everyone we went from this is now the start of the third quarter of shipping this, we went from 30 customers to 175 customers with a 1,000 in the pipeline and I won’t go any further than that, but a big take-up on that.

On average they are seeing 35% improvement in costs and it’s not the cost of the product, it’s not the cost of the software as much as it is the operational savings from the simplicity that it brings. And then, just take that up to routing, the same thing, we’ve integrated things into NCS and CRS-X in a way that it’s more simple for our service providers to operate those environments.

And while it’s not Domain 2.0, it is a real value to them and at the end of the day whether it’s Domain 2.0 or whatever it is, service providers are looking for one thing, I need to lower my costs, because they got a lot more traffic and I got no revenue coming with it. So we are working very closely there to make sure that they see the total value of everything we’re doing.

Tal Liani - Bank of America Merrill Lynch

You have over the next three quarters, you have tons of products coming out. Lots of products and there's going to be a great product cycle starting from routers to switches to even WebEx. And you go throughout the product lines, there are lots of new products. What happens to margins in our -- and I'm not asking to quantify the number, but I'm asking just conceptually, what happens to margins with all these new products? Are these new products launched at margins that are below average, above average or below the previous level of the same product or above? And how do we think about it?

Gary Moore

I think and you’ve followed us long enough you know that when we launched the [7-K] back when, it came out with margins that were very sub below where the product it was replacing was operating. We’ve took us a little while but we got that back up. The new products we’re launching, NCS, CRS-X equal to or better than the products that are replacing.

So value engineering, design engineering and just the value that we put into those products are allowing us to do that. It’s early days, but we’re very comfortable that we can hold that. We’ve said for a long time now and I don’t look for it today when I back off of this, but we are very comfortable with what we said a couple of years ago 61% to 62% gross margin plus or minus 1% or 2% in any given quarter, but that’s the range and we’re very comfortable with that range, that’s impacted by mix from quarter-to-quarter and a whole bunch of other things, but in general we’re very comfortable with that and I’m very comfortable with that today.

Tal Liani - Bank of America Merrill Lynch

What if things go wrong? And let's say margins go down because there's pricing pressure, or whatever. Things go wrong and you just don't get what you're trying to get. How much flexibility do you have with the organization to still maintain an operating margin at the levels that you have today, even if things go wrong?

Gary Moore

I should have said this in the beginning and I’ll get flogged by Marilyn for not but I mean obviously I’m making some forward-looking statements, and they are in line with the subject we’ve put in our 10-K and 10-Q. I still compelled to say that now given the margin question, but I think we are going to continue to manage the company for the long term.

We are not going to react to a dip or a spike. We’re not going to over celebrate when we blow something out, we’re not going to flog ourselves when something goes wrong. But we’re always going to maintain the opportunity to adjust our expense levels based on market conditions. The old system, might you have not done that, maybe that’s why you’re asking the question.

I think clearly you’ve seen me and the leadership team make some hard choices based on where the markets out over the last several years, that’s not the culture we want in the company but there is a lot of other things we can do. We’ve done our workforce strategy where we’re bringing in many more university hires. We have got a site strategy where we’re not moving people out of the country as much as moving people to where the business is at and lower cost locations and even in the U.S. like Raleigh, North Carolina.

But there are a lot of leverage that we still have, the alignment work that we’re doing will yield. When you take a sales organization here and bring it together with a sales organization here, you can think about well there is -- we don’t need a finance team, we don’t need a separate HR team, we don’t need that kind of thing and that doesn’t mean we’re going to go lay those people off, but that does mean that we can slow down hiring or stop hiring, let attrition take care of itself. Our attrition is still below industry, 6% overall, even lower in certain places.

But I think we have those levers that we’re going to do what we need to do. We are focused on driving profits faster than revenue. We are going to continue to focus to do that and if I slip a quarter, it will be because of some circumstance but that doesn’t mean that we have given up.

Tal Liani - Bank of America Merrill Lynch

Cash, I get this question all the time, so I’m going to ask it in different ways.

Gary Moore

I got a great answer I hope.

Tal Liani - Bank of America Merrill Lynch

Yes. Some companies started bringing back the cash and pay the taxes. I calculated that your US cash flow is roughly half of your cash flow. Maybe I'm wrong here or there, but it's about half of the cash flow. So that means about $5 billion. And if I look at what you've committed at the minimum to buy back stocks, which you've done way more than the minimum commitment. Buy back stocks and pay dividends, you're short by $1 billion a year. So that means you will need to take from your cash $1 billion a year unless you raise more debt. And your cash levels will end in five to six years if you do that without raising debt. So just calculation. The question is what are your plans? You obviously have a very strong financial position. A lot of the cash is trapped overseas and you said two years ago, not you personally, but John said that he will do something with it. He's not going to let it stay there without accumulating any return. So what are the possibilities that you have and is there any desire to bring the cash here? And let's say you bring the cash here, what do you do with it?

Gary Moore

So a couple of points, one, I think our current balance is $50.5 billion in cash. We have a lot of different things we can do given that strong cash position. Last quarter, we announced an $8 billion debt offering. We took $3.8 billion of that, retired some prior debt. We did, so far this year in the first three quarters, returned 140% of cash to our shareholders both in terms of increasing the dividend yet again as well as taking the opportunity given where the stock had dipped to do some fairly larger stock buybacks.

Our commitment is to return 50%, minimum 50% of cash to our shareholders annually. That doesn’t mean that we will be 140% like it is right now or where it will be when we decide what we’re going to do in Q4, but I think to your point, we have a hard time bringing cash back and having it double taxed. We’ve already paid tax on it in the countries where we earned it. On the other hand, we do have previously taxed cash offshore that we’ve brought back some from that.

We have been able to do a lot of things with our operating expenses and quite honestly we think we’ve done a pretty good job of positioning ourselves to return to growth. And when you return to growth in the way that we think we will which we’re not over communicating, I think that takes a lot of burden off of that.

Obviously, if that doesn’t happen, and this doesn’t happen, that doesn’t happen, then we have to rethink the capital allocation, but right now I would tell you that we have many more options other than bringing a bunch of cash back, paying tax on it and then deciding do we buy this company or that company, but it’s not going to stop us from doing what we think we need to do either through giving back to shareholders or doing acquisitions.

Tal Liani - Bank of America Merrill Lynch

And you have, from memory, I didn’t check it before, but if I’m wrong, I’m wrong. $20 billion of debt roughly, $16 billion before and new $4 billion debt that you issued. Maybe I’m wrong with the numbers, right okay. What’s the right level of debt? What is the right structure of the balance sheet?

Gary Moore

I think the way we have it structured today is we are comfortable. It still gives us a tremendous amount of flexibility to raise more debt yet it’s not so under leveraged that it creates an opportunity for someone to come in and go. I’m going to do something here just because of the cash balance.

Tal Liani - Bank of America Merrill Lynch

Any question from the audience? No? Great. Thank you very much.

Gary Moore

Tal, thank you very much. And look I don’t think, as a company, we’ve ever been more confident about our ability to execute, the way we’re aligned, the way that we see the market unfolding. This is a rough market and we normally see things before other people and this was the same case here. We normally see things when they start to turn up before other people and I would just say that we think we are extremely well positioned as a company to take advantage of the market transition. We are making the changes and the hard decisions both from a resource point of view and then the investment point of view to maintain the leadership that we have in the market.

So thank you, Tal.

Tal Liani - Bank of America Merrill Lynch

Excellent. Thank you very much.

Gary Moore

Thank you.

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