Cisco Systems' CEO Discusses F2Q11 Results - Earnings Call Transcript

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Cisco Systems (NASDAQ:CSCO) Q2 2011 Earnings Call February 9, 2011 4:30 PM ET


Blair Christie - Chief Marketing Officer - Worldwide Government Affairs

Frank Calderoni - Chief Financial Officer and Executive Vice President

Ned Hooper - Chief Strategy Officer and Senior Vice President of Corporate Development & Consumer Group

John Chambers - Executive Chairman, Chief Executive Officer and Member of Acquisition Committee

Rob Lloyd - Executive Vice President of Worldwide Operations


Mark Sue - RBC Capital Markets, LLC

Nikos Theodosopoulos - UBS Investment Bank

Tal Liani - BofA Merrill Lynch

John Slack - Citigroup Inc

Jeffrey Evenson - Bernstein Research

Brian Modoff - Deutsche Bank AG

Ehud Gelblum - Morgan Stanley

Simon Leopold - Morgan Keegan & Company, Inc.

Ittai Kidron - Oppenheimer & Co. Inc.

Jason Ader - William Blair & Company L.L.C.

Simona Jankowski - Goldman Sachs Group Inc.


Welcome to Cisco Systems Second Quarter and Fiscal Year 2011 Financial Results Conference Call. [Operator Instructions] Now, I would like to introduce Blair Christie, Senior Vice President and Chief Marketing Officer. Ma'am, you may begin.

Blair Christie

Great, Thank you. Good afternoon, everyone, and welcome to our 84th Quarterly Conference Call. I'm Blair Christie; and I'm joined by John Chambers, our Chairman and CEO; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, Executive Vice President of Worldwide Operations; Ned Hooper, Chief Strategy Officer and Senior Vice President Consumer Business; and Padmasree Warrior, our Chief Technology Officer and Senior Vice President of our Enterprise Business.

The Q2 fiscal year 2011 press releases is on U.S. high tech market wire and on the Cisco website at I would like to remind you that we have a corresponding webcast with slides. In those slides, you will find financial information that we covered 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 geographic segment as well as product categories. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet and cash flow statements can be found on our website in the Investor Relations section. Just click on the financial reporting section of the website to access the slides and these documents.

A replay of this call will be available via telephone from February 9 to February 16 at (866) 357-4205 or (203) 369-0122 for international callers. A webcast replay is available from February 9 through April 22 on the Cisco's Investor Relations website.

Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results. The financial results in the press release are unaudited. The matters we will be discussing today includes forward-looking statements and as such are subject to the risks and uncertainties that we discussed in detail and our documents filed with the SEC, specifically the most recent reports on Form 10-Q and 10-K and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. Unauthorized recording of this conference call is not permitted.

And now I'd like to turn it over to John for his commentary on the quarter. John?

John Chambers

Blair, thank you very much. Based in part on the feedback from a number of, we are continuing to evolve the format of our quarters conference call. The objective being to share more information in a tighter format while leaving more time for Q&A at the end of the call. Please do not hesitate to give us feedback in terms of the effectiveness of this new format.

We will break the call into four sections. In the first section I will put out a summary of the quarter, focusing on key financials, geographies, customer segments and products. In this Section, I will focus on what went well and areas that we would like to see improve. We will finish with general comments on business momentum exiting the quarter as well as our guidance for both Q3 and Q4 fiscal year '11 with all the appropriate caveats.

In the second section, Frank will provide additional details about Q2 FY '11 as well as expand on our Q3 and Q4 guidance, investments, opportunities and challenges. In the third section of the call, I will expend on my opening comments on the second quarter as well as a discussion on how we're doing in the market, answering some of your key questions and what you can expect from us going forward.

And finally, in the fourth Section, I will provide some closing comments and then wrap up with Q&A.

Now beginning with the opening section, where I will cover some of the key results of the quarter in terms of highlights and challenges. First, from a financial perspective, the quarter evolved pretty much as we expected from a top and bottom-line perspective. Revenue of $10.4 billion, a 6% year-over-year increase was slightly higher than our guidance provided last quarter of 3% to 5%. Non-GAAP earnings per share were a little bit above our guidance at $0.32 to $0.35 per share at $0.37, which was a year-over-year decline of 8%. And GAAP earnings per share of $0.27 was a year-over-year decrease of 16%.

Case generated from operations was a solid $2.6 billion, bringing our total cash and investments to $40.2 billion. As we focused on expense reductions in Q2, and realigned resources to top priorities, we had very limited hiring and therefore our head count was relatively flat with an increase of only 300 people in the quarter.

At the very top of the list of highlights is the continued innovation and success of our new products across most all of our product families. For example, as we discussed in our Q1 fiscal year '11 last quarter's call, Cisco has grouped our newer technologies into a category called New Products. This new category aligns well to our strategic growth priority and allows investors to better understand our progress in the new markets we are entering. Our new product segments, just as a reminder, contain the following five subcategories: Data center, collaboration, security, wireless and video connected home.

In fiscal Q2, our New Product category revenue grew 15% year-over-year and now represents 39% of our total product revenue. I would like at this time to discuss two of these areas: Collaboration and second, data center virtualization based cloud. First, within the category from a collaborative perspective. Growth was again very strong with a 37% increase year-over-year in revenues to almost a $4 billion annualized run rate. This includes TANDBERG.

Balance was good across our entire TelePrescence portfolio and we continue to see an architectural approach with very large orders from key customers spanning our suite of video products from the high end TelePresence systems to the desktop and IP video enabled phones. Second, from a data center virtualization cloud perspective, we continue to make progress on our transformational approach to the data center. Our data center business grew 59% year-over-year from a revenue perspective in Q2 to over $425 million. Within this category, there was strong revenue growth with both the Nexus 5000 growing 56% year-over-year, and the Nexus 2000 growing over 150% year-over-year. The UCS saw year-over-year revenue growth of over 700% to an annualized run rate of over $650 million.

The data center evolution is playing out as we anticipated. Our Wireless business also contributed to new product growth with a year-over-year revenue increase of 34%, while security and video connected home both saw year-over-year declines of 9% and 4% respectively.

Moving on to our other two major product categories: Routing grew 4% year-over-year from a revenue perspective led by the high-end routing. ASR family 1000, 5000, 9000 achieved an almost $1.5 billion annualized run rate with revenue growth of 68% year-over-year in Q2.

Repeating the candor in last quarter's conference call, our routing architecture, while there's always room for improvement, is in the best shape from both an innovation and product leadership perspective in our history.

From the switching perspective, our movement into next generation switching products across the entire fixed and modular switching families positions us very well versus our competitors. Both from a product leadership perspective and even more importantly in architectural base. Make no mistake about it, we fully intend to own the transitions in the network specially in switching.

While I strongly believe we are very well positioned versus our competition, we are in the middle of a major product transition with dramatically higher price performance from these new products and architectural advantages versus our prior generation of products and that of our competitors. I will go into more detail in a moment, but with this environment in mind, we did see our switching revenues decline 7% in Q2.

This transition of the data center switching from the Catalyst 6000 to the Nexus 7000 is going well with the Nexus 7000 revenues growing almost 100% year-over-year to $1 billion annualized run rate. We have also experienced a very successful launch of new fixed switching products in the campus. The new Catalyst 2-K and the 3-K series. For example, the Catalyst 3750 family is now achieving approximately a $1 billion annualized order run rate, one of our fastest ramps we've seen in recent years.

We did experience in the quarter an overall mix shift toward the lower end products in the portfolio. But overall, we are growing our footprint and driving an architectural transition. What this means to me is that our new switching products are very strongly positioned with an architectural play while addressing our competition from a price performance perspective. This allows us to both grow our market and to continue to improve our margins over time with these new products, as you would expect us to do.

While expanding on new product announcements of both the 2K and 3K product families combined with the Nexus 2000, 5000 and 7000 product family, we believe we are now extremely well positioned both from a product leadership and again from an architectural, value add perspective.

As the transition to switching to products with dramatically higher price performance capabilities we are clearly establishing a differentiated value to our customers. And as you'd expect during this transition, we are seeing pricing pressures on our established catalyst portfolio. This is where our competitors are focused and in simple terms, this is where we are going to own our own evolution, and we're going to own the next generation in this space.

To be candid, these product transitions within our own product families are occurring even faster than we expected, especially in terms of the ramp of the new products in terms of growth rates. That said, we have managed such product transitions many times and Frank will provide additional details on specific impact and expectations for our gross margins later in the call.

I'm extremely comfortable with our product leadership and architectural competitiveness of the new switching product versus our peers. And we are moving very aggressively to protect any erosion of our future market share from a port or revenue perspective.

Moving on to a more general picture of our products. Total product book-to-bill was greater than one and backlog increased. Product orders grew approximately 8% year-over-year, while total product revenue growth was 3% year-over-year in Q2.

Our services business had an outstanding quarter with revenue increases of 18% year-over-year. Services are clearly becoming a key integral part of both our sales and delivery capabilities. And services as a percentage of our total revenue mix in Q2 increased to approximately 21% from 19% of our total revenue last quarter.

At the same time, non-GAAP service gross margins increased to 67%. We are obviously very pleased with these results.

From a geographic perspective in Q2, the U.S. product orders grew 6%, Asia Pacific grew 8%, emerging markets continue with strong momentum growing 27% and the European markets grew in the low single-digits in Q2 year-over-year.

Total product bookings in our top 15 countries were reasonably good with only one country, Italy, decreasing. The U.S., U.K. and Switzerland out of the top 15 grew in mid single digits, China grew 10%. And the majority of the rest of our countries grew in the 10% to 30% growth range year-over-year.

From a customer segment perspective, enterprise continued with solid momentum on a global basis growing from an orders perspective approximately 10% year-over-year. The global public sector grew approximately 17% to 7%, although it was very mixed from country to country or even categories of government structures within the category. And the U.S. public sector, orders actually grew 9% year-over-year in this quarter. However, the challenges at a state, local and eventually federal level in our opinion will worsen over the next several quarters.

Service provider products grew approximately 9%. Our relationship with the top service providers from both a technology and a business architectural basis is going very well. However, as we discussed last quarter, our Set-Top business continued to be challenged and orders decreased by 15% from an order prospective year-over-year to an annualized run rate of approximately $1.6 billion.

At the same time, we announced in January of our Consumer Electronics Show our next-generation architectural approach to TV called Videoscape. Initial customer and industry feedback on this architectural approach to the market as opposed to an individual set-top box approach and has received very, very positive coverage. Commercial grew on a global basis at 11% year-over-year. Our consumer business decreased by 15% year-over-year in Q2.

Total gross margins on a non-GAAP basis decreased from last quarter's 64.3% to 62.4% in Q2. Non-GAAP services gross margins increased to 67% up from 65.7% in Q1.

Non-GAAP product gross margins decreased from 64% in Q1 to 61.1% in Q2 and we're primarily driven by pricing and favorable mix, including multiple product transactions in core routing and switching, as well as our consumer business. Frank will cover margins in more detail in his section.

In summary, there were a number of areas that we were pleased with our progress. Especially in our technology and business architectural approach. Success of innovative new products, momentum in our architectural approach to collaboration and data center virtualization and finally our very strong cash generation capability. Areas where we will focus on improving include public sector, consumer, video transition, in the set-top box area and increasing gross margins.

In the third section of the discussion, I will provide you more details in terms of architectures and comments about Q2, what is working and what you can expect from Cisco going forward. As we have said in conference calls over many years, Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors and potential issues affecting our suppliers and our ability to execute in that 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. We are very confident in our strategy.

Today, we will be providing both Q3 and Q4 FY '11 revenue guidance. This guidance is based on a conservative view of our normal seasonality trends, current pipelines and how we believe the market will play out based on the information we have today.

Given the uncertainties in the market, we could be above or below our guidance, and by definition are subject to all the appropriate caveats as discussed in our conference call and our SEC filings. As we said in last quarter's conference call, our year-over-year comparison for Q3 FY '11 will have one less weak than Q3 FY10. Depending on how you model the extra week, we believe it normally generates 3% to 5% extra growth in the quarter, i.e. 3% to 5% extra growth from a comparison point of view in Q3 FY10 versus this Q3.

With this discussion in mind, our revenue guidance for Q3 FY 11 including our usual caveat as discussed earlier and in our SEC filings is for the revenue to increase 4% to 6% year-over-year. And our revenue guidance for Q4 FY '11 is for year-over-year revenue growth to increase 8% to 11%.

Frank will cover detailed guidance in the next section. Now Frank, let me turn it over to you.

Frank Calderoni

Thank you, John. Generally, our financial results for Q2 fiscal year '11 came in as inspected. We did see several positive areas across the business as well as a few challenging areas. Total revenue for the second quarter was $10.4 billion, an increase of approximately 6% year-over-year and above our guidance of 3% to 5%. Total product revenue was $8.2 billion up approximately 3% year-over-year. Switching revenue with $3.2 billion, a decrease of 7% year-over-year. Routing revenue was $1.7 billion, up 4% year-over-year primarily driven by a 5% and 6% increase in high end and low end respectively.

Mid-range routing revenue decreased slightly year-over-year. New Products' revenue totaled $3.2 billion, representing an increase of 15% year-over-year. We saw strong year-over-year growth in data center of approximately 59%, collaboration which includes TANDBERG of approximately 37% and wireless LAN of approximately 34%. Security and video connected home declined 9% and 4% respectively. Other Product revenue totaled $211 million, an increase of approximately 7% year-over-year.

Total service revenue was $2.2 billion up approximately 18% year-over-year. We experienced strong, year-over-year growth of 14% in technical support services and approximately 30% in advanced services. We saw an increase in total revenue across all geographic segments on a year-over-year basis. Revenue increased approximately 9% in European markets on a year-over-year basis and approximately 4% for U.S. and Canada. Rounding out the theater, we saw year-over-year revenue growth of 8% in each of our emerging and Asia Pacific markets.

Q2 FY '11 totaled non-GAAP gross margin was 62.4% down 1.9 percentage points quarter-over-quarter and down 3.2 percentage points year-over-year. For product only, non-GAAP gross margin for the second quarter was 61.1% down 2.9 percentage points from last quarter. Let me take you through the key drivers.

Approximately 1% of the quarter-over-quarter decrease was driven by our consumer business. Although we expected a seasonal mix impact from consumer, they there were further impacts including pricing and adverse inventory adjustments related to the broader performance of that business. We also saw a negative impact as a result of pricing and mix related to multiple product transitions, primarily in our switching business of approximately 1%. Additionally, the ramp of our UCF platform had a negative impact on mix of approximately 0.5%.

The remaining portion of the quarter-over-quarter decline in non-GAAP product gross margins was due to the expected impact of volume, mix and other factors. We did see a benefit from manufacturing cost-savings as a result of improved component cost levels. Going forward, we do expect to see further cost-savings driven by value engineering including those related to the multiple product transition.

So in summary, the effect of consumer was greater than the typical seasonal impact. In addition, although the multiple product transitions in areas such as switching are not unexpected, they are happening faster than we anticipated. We have managed such product transitions many times in the past, and I will provide an outlook of gross margin and our guidance for the remainder of the year

Our non-GAAP service margin for the second quarter was 67%, up from 65.7% last quarter and up from 65.9% in Q2, fiscal year '10. The increased service margins were driven by strong margins in both technical support and advanced services primarily as a result of achieving higher volume while maintaining a relatively stable cost base.

Service margins will typically experience some variability over time due to various factors such as changes in mix between technical support services and advanced services as well as the timing of contract initiations and renewals.

Total gross margin by theater, range from approximately 65% for European markets to approximately 60% in emerging markets. U.S. and Canada was 62.2% and Asia Pacific markets was 61.2%.

Approximately half of the quarter-over-quarter gross margin decrease of 2.2% to the U.S. and Canada was driven by the consumer business.

Non-GAAP operating expenses were approximately $3.9 billion in Q2, fiscal year '11. Non-GAAP operating expenses as a percentage of revenue were 37.9% in the quarter versus 36.3% last quarter.

Non-GAAP operating expenses were up approximately 14% year-over-year due to our planned increased investments in product innovation, strategic growth opportunities and our plan to increase investments in sales coverage as we have discussed in previous calls.

Non-GAAP operating margin for Q2 FY '11 was 24.5% which was at the high-end of our guidance as provided at the end of last quarter. Interest and other income was $46 million for Q2. Our Q2 FY '11 non-GAAP tax provision rate was 19.8%. This reflects the federal R&D tax credit extension enacted in December. The decrease in the non-GAAP rate represents a $53 million benefit for the first two quarters of fiscal 2011. The benefit for prior periods, prior to fiscal year 2011 of $65 million is excluded from our non-GAAP earnings.

During the quarter, we recognized a charge of $155 million related to the impairment of certain purchase intangible assets primarily related to our consumer business. Consistent with prior periods, these non-cash charges are included in our GAAP earnings and excluded from our non-GAAP earnings. These charges are reflected in our GAAP operating expenses and product gross margin.

Non-GAAP net income for the second quarter was $2.1 billion, representing a decrease of approximately 11% year-over-year. As a percentage of revenue, non-GAAP net income was 20%.

Non-GAAP earnings per share on a fully diluted basis for the second quarter was $0.37 per share versus $0.40 per share in the second quarter of fiscal year 2010, an 8% decrease year-over-year. GAAP net income for the second quarter was $1.5 billion as compared to $1.9 billion in the second quarter of fiscal year 2010. GAAP earnings per share on a fully diluted basis on the second quarter were $0.27 per share versus $0.32 per share in the same quarter of fiscal year 2010.

Now moving on to the balance sheet. The total of cash, cash equivalents and investments at quarter end was $40.2 billion up $1.3 billion last quarter. Of this total balance, $3.1 billion was held within the U.S. at the end of Q2. As we disclosed on January 31, we entered into a $3 billion commercial paper program which may be utilized for general corporate purposes. Our cash flow from operations in the second quarter was approximately $2.6 billion.

Moving on to accounts receivable. Our receivables balance was approximately $4.6 billion at the end of Q2. Also at the end of Q2, days sales outstanding or DSO was 40 days compared to 38 days in Q1, fiscal year '11 and 39 days in Q2 fiscal year '10. The increase in DSO reflects the strength of our services business, which typically has higher DSO, and which for Q2 had a higher proportion of billings toward the end of the quarter. As a reminder, Q2 and Q4 are seasonally strong periods of services driven by year end contract renewals.

Total inventory at the end of Q2 was $1.6 billion, non-GAAP inventory turns were 10 this quarter down 8/10 compared to last quarter. Inventory purchase commitments at the end of Q2 were with $3.9 billion down approximately 4% or $173 million quarter-over-quarter.

For the quarter, we repurchased $1.8 billion of common stock under the stock repurchase program or 89 million shares at an average price of $20.15 per share. The remaining approved amount for stock repurchases under this program was approximately $12.7 billion as of quarter end.

As we have previously announced, we plan to issue a dividend during fiscal 2011 with the yield in the 1% to 2% range.

Deferred revenue was $11.8 billion at the end of Q2 FY '11, an increase of approximately 22% compared with Q2 FY '10. Deferred product revenue was $3.8 billion and deferred services was approximately $8 billion, increasing approximately 13% and 27% year-over-year respectively.

In particular, we were pleased with the growth in our deferred services revenue, reflecting the strength in our services business during the quarter. At the end of Q2, our headcount totaled 72,935 a slight increase quarter-over-quarter of 330.

Before I move to the guidance Section, I would like to comment on our financing business which is Cisco capital. In our Form 10-Q we will be filing for the second quarter, we will be including additional disclosures related to the credit quality of our financing receivables due to the new disclosure requirements of the FASB beginning this quarter.

We have provided a supplemental slide in the presentation material that accompany this call which summarizes this information. We are among the first of the large companies to report on this new FASB requirement.

At the end of the quarter, our total portfolio of financing receivables and guarantees was approximately $6.8 billion. Against this balance, we have deferred revenue and related allowances of $3.1 billion, which brings the net portfolio to $3.7 billion. The losses we have incurred historically with respect to financing receivables has been immaterial consistent with the performance of an investment-grade portfolio.

Cisco capital continues to provide a strategic advantage for Cisco by providing financing to our customers and channel partners enabling incremental sales of Cisco products, services and networking solutions.

The business volume in our financing business has increased over time in proportion to our overall business. We have adhered to consistently prudent financial practices balancing good business risks with approximately conservative -- with appropriately conservative accounting policy.

And now, for further details on guidance. 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. We believe it is helpful to provide a reflection of where we are headed for the rest of the year and help set your expectations by providing target revenue range for the full fiscal year. This guidance is based on our normal seasonality, current pipeline, and our view of business trends based upon the information that we have available today. For Q3, fiscal year '11, we expect revenue growth to be in the range of 4% to 6% on a year-over-year basis. As a reminder, our comparison for Q3 FY '11 will have one less week than the 14 week base we had in Q3 FY '10. And this extra week could be worth about 3% to 5% on a year-over-year revenue comparison.

Going forward, as we have provided previously, we will continue to provide financial guidance for the next fiscal quarter on our Earnings Conference Call. The financial guidance going forward will provide revenue, non-GAAP operating margin and non-GAAP EPS guidance.

For the next quarter with reconciliation to GAAP in order to provide a perspective to investors regarding our anticipated quarterly performance.

For Q3, FY '11, we expect non-GAAP operating margins to be in the range of 23% to 24%. Our non-GAAP tax provision rate for the third quarter is expected to be 21%. Q3 FY '11 non-GAAP earnings per share is expected to range from $0.35 to $0.38 per share. For our Q3 FY '11 GAAP earnings, we anticipate that GAAP EPS will be $0.08 to $0.10 per share lower than our non-GAAP EPS. Please see the slides that accompany this webcast for more detail.

Other than those items noted above, there are no other significant differences between our GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant.

For Q4 FY '11, we expect revenue growth to be in the range of 8% to 11% on a year-over-year basis. Based upon the revenue guidance for Q3 and Q4 FY '11, the FY '11 revenue growth for the full year is projected to be in the mid-to low-end of our previously mentioned range of 9% to 12%.

For the rest of the fiscal year, we anticipate non-GAAP total gross margin to be in the range of 62% to 63% with GAAP total gross margin to be approximately 2% lower. Our gross margin outlook will vary as a result of factors including product mix, cost-savings and pricing and we will adjust our guidance accordingly. Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Our financial strength and cash position is clearly a major competitive advantage for us and we will continue to manage it for flexibility in the business. As a collective team, we remain focused on execution and moving the business forward to deliver strong results for our customers, our shareholders as well as our employees.

I'll now turn the call back over to John. John?

John Chambers

Frank, thank you very much. At this time, I would like to provide a more detailed discussion of the second quarter of fiscal year '11. The first area that I want to cover is the strength of our business momentum in the enterprise markets with a specific focus on U.S. enterprise. This review does not include our large global financials which I will cover shortly.

There was very strong order growth in U.S. enterprise accounts, growing year-over-year in the high-20s to an annualized run rate of over $2.5 billion. Customers are increasingly buying both our technology and business architecture. The large global U.S. financial organizations, as you would expect, were hit hard from the regulatory effect in retail and investment banking areas, as well as write downs on bad debt. As a result, our sales in these financial organizations decreased in the mid teens.

Next, I would like to expand our discussion in the enterprising commercial segment in more detailed terms, in terms of data center, virtualization, collaboration and mobility. As discussed earlier, our strong commit to the data center strategy is playing out as we had planned with strong growth in UCS, Nexus 5000, 2000, Nexus 7000, MDS, and the VM EMC Cisco partnership. Also, the EMC Cisco VMware partnership, our joint venture, has outstanding momentum in our customers, seeing value in the high, highly innovative and fully-integrated solution. We sold to 40 new customers in this past quarter alone, doubling the number of deals quarter-over-quarter and now with a pipeline of more than $1 billion. We are very pleased with the performance and look forward to our continued partnership.

In our opinion, Cisco is leading the transformation of the data center market with a network-based approach to IT infrastructure in support of rapid IT services delivery, backed by a significant innovation. Cisco's unified fabric architecture has gained traction as the basis for the data center transformation.

Cisco is also gaining share in related areas such as sand switching, where revenue grew 19% year-over-year. Cisco's vision for the integrated, collaborative architecture is gaining traction as more customers are deploying enterprise-wide video. Cisco is continuing to gain share in key product areas like Unified Communications and TelePresence.

Cisco TelePresence is now deployed at 85% of the Fortune 100 and 75% of the Fortune 500. A recent survey shows intent to purchase Cisco TelePresence solutions of those potential customers surveyed with 86% favoring Cisco. Our end-to-end video architecture from TelePresence to desktop video, built upon our Medianet architecture is continuing to gain strong momentum both as individual products and as an architecture.

AT&T and BT announced the commercially available inter-exchange services for their respective customers for TelePresence. This is after only five years since the introduction of TelePresence in the market. To many of you, it might sound like a long time. But in fact, it is a key milestone announcement done remarkably fast versus prior history, as it enables the AT&T and BT customers to call between the respective TelePresence exchanges. By comparison, the telephone network, PSTN if you will, took 62 years to achieve inter-exchange service, and the internet took 10 years to achieve inter-exchange connectivity.

This announcement, along with our continued commitment to interoperability will accelerate mid cash flow effect for all TelePresence customers. Mobility, what we classify as wireless continues to expand in the enterprise in terms of its importance with recent polls showing that 40% of employees use Wi-Fi as their primary way of connecting to the network.

We continue to expand our leadership in this area and saw our overall orders increase 39% year-over-year. Again, showing share gains in this market. In our service provider customers, Cisco technology and business architecture continues to gain traction. And most of the world service providers, we are gaining both market share in key product areas as well as shared wallet. On a global basis, the service provider increased by 9% year-over-year despite challenges in North America's set-top box business.

From a revenue perspective, the ASR 9000 grew almost 500% year-over-year. The ASR 5000 as projected grew comfortably over 100% [audio gap]. The ASR 1000 grew approximately 7%. And therefore, the combined ASR product family grew approximately 68% to almost a $1.5 billion annualized rate.

Our cable set-top box revenue was down 29% year-over-year, while our IP set-top box revenues were up 47% year-over-year for a combined decrease of 11% in Q2. Our Videoscape product announcements, as I said earlier, heat off the January Consumer Electronics Show, outlines a clear strategy on where we are going in terms of reinventing the TV experience. Enabled by Cisco, and with very tight partnerships with our service provider customers on delivering the Videoscape architecture.

Videoscape brings entertainment together from an infinite sources of content and combines it with the social media, communications, and mobility to create a truly immersive TV experience. Our clear focus is to catch the market transition from client-centric architectures to the Videoscape network client based cloud architectures. Managing this transition remains our [indiscernible] and yet our challenge. Service providers focus on the data center virtualization and evolution of the cloud is resulting in an increased traction from Cisco, both from a technology and a business architecture.

We are doing extremely well in challenging traditional data center incumbents in an approach from both a business innovation and a strategic partnership with the service provider partnership as they transition this cloud architecture into new revenue generation opportunities for them.

Cisco is viewed by many as the preferred vendor of choice in part because of our technology and business architectural approach, including our BCE alliance, while at the same time being viewed as the more strategically aligned with the service providers with strategy rather than competing with them.

At this time, I'd like to move into a discussion of several areas that you might have questions evolving from our earlier discussion.

First, from public-sector perspective, we believe that we are not losing market share in the developed world governments. However, we believe that you're going to continue to see a rapid decrease in discretionary spending including IT and a majority of these governments.

While 7% growth in public-sector orders year-over-year was not bad, our view is that this growth will be severely challenged over the next several quarters and will most likely grow in the mid- to low- single-digits. As you would expect, we will try to quickly transition sales focus to a share wallet, move into new opportunities or opportunities on the architectural basis in areas such as data center or collaboration within the government accounts, as well as focusing on, how do you invest in this technology? Do we save in the future opportunities to help these governments to address the challenges in cost reductions, education, healthcare and other areas?

We believe that the growth in enterprise and commercial will be bound to public sector challenges in terms of growth. Second, in regards to switching revenues, we believe we are experiencing major causative product transitions in both our modular and fixed switching families and the accompanying architecture. Based upon what we're hearing from our customers, we are winning the architectural battles in our enterprising commercial accounts.

A number of you asked at our financial analyst conference our views about market share challenges in terms of switching ports and questions on how we're doing on the low end of our product line and especially in terms of ports. We did aggressively address our challenge especially in the murky markets over the last quarter and reversed the trend in terms of ports market share.

While expanding on the new product announcements at both the 2K and 3K product family, as well as the Nexus product families, we believe we are extremely well positioned from both a product leadership position and architectural value add perspective.

Bottom line, in our opinion, we're winning in the market. But we need to focus more on selling architectures and value added at the higher end products to show switching revenue growth and improved margins.

Now moving on to gross margins. As Frank discussed in the second Section, our decrease in gross margins was driven by a number of factors: Our primary focus in the areas that we contributed to a net favorable decrease and what we intend to do about it. As you'd expect we're forming a working group to expand our focus on improving gross margins and on becoming increasingly comfortable with our progress and future plans in this area, having reviewed it just last week after work on it for good little while.

After our hope there will always be pressures in terms of product mix, in terms of areas such as UCF, which will continue to grow dramatically faster than most of -- the rest of our business. This is actually a good problem to have in this instance.

Next, in regards to the challenges of our operating expenses growing faster than the orders. We will obviously continue to bring order growth and operating expenses more in line. You saw some of the improvements with our headcount staying approximately flat from Q1 to Q2. And as you would expect, we realigned resources and dramatically tightened and prioritized our primary areas of focus. In short, we are committed to protecting our long-term profitability models, and yet we will continue to add resources to growing areas of the business as needed.

Before moving on to Q&A session, I would like to focus on five important key messages from today's call. First, Q2 evolved from the top and bottom line pretty much was expected. Strong growth in some areas, some challenge in others. Strengths we are in the global service providers, enterprise and commercial. Balance was reasonable across the U.S. and the rest of the world. Emerging markets continued on their strong run. Service providers showed strength in Europe and emerging markets while commercial showed strength in the U.S., emerging in Asia Pacific.

New product revenues grew 15% year-over-year and now represents 39% of our total product business. Collaboration continues on a role with revenue growth in the high-30s and an annualized run rate of $4 billion. Data center virtualization cloud continues to be a very key area with growth of approximately roughly 60% revenue growth year-over-year.

Wireless revenue year-over-year was off 34% while we continue to expand our mobility strategy, and our mobility strategy is a hole in the group as an annualized run rate of approximately $1.3 billion.

There are several areas that we are watching and continue to face challenging. Some we can control, and some we cannot. Unfortunately, our concerns in public sector will continue to be challenged -- challenging in the developed world for the next several quarters. We saw the same challenges in the number of U.S. European and Japanese government accounts in Q2. Our challenges continued in our set-top boxes. However, our Videoscape architecture announced in January which focus on the new innovation TV experience is off to a good start and we are pleased with the overall service provider growth of 9% year-over-year.

Consumer was more challenging than we anticipated, and you will see us adjust appropriately to bring efficiencies to the customer segment. However, it's important to remember that our consumer experience continues to bring leading-edge consumer expectations and products to our enterprise, commercial, and service provided customers.

In terms of what is working, it is our strategy and architectural approach. Clearly, our strength in new markets such as collaboration, data center, virtualization, cloud, wireless and video architectures are gaining increased acceptance from our customers. Our service provider and enterprise partnerships are also strengthening and our pipeline of new opportunities will be the prove points. Our strategy in emerging markets including our continued resource investment in our emerging markets around the world is resulting in strong order growth.

Our innovation cycle is very strong as witnessed by the transaction of new product and new market share gains in many of our key product areas. We are extremely comfortable with our product leadership and innovation in each key major product family. What can you expect from Cisco moving forward? As you saw this quarter, we expect backlog will increase and deferred revenue will decrease as well. We will continue to move aggressively in the market with our architectural approach and leverage the tight integration across our multiple product families.

Internally, we will further prioritize our top opportunities and realign resources to ensure that we have the right level of investments and focus to lead in these key market transitions. As we said last quarter, we are going to do this with a higher level of accountability across our businesses, to ensure that we are meeting our targets. While I expect that over time our expense growth will at least match our order growth rate. We do believe our strategy is working and continued investment in innovation is essential to lead and create the future growth.

Five. So how do I feel about the business? I believe that our strategy is right on course and we are beginning to utilize our services portfolio to assist our customers in achieving their business goals. Our timing and market transitions appears to be pretty solid. Our financial strength and case position is clearly a major competitive advantage, and we will use it as such. Our growth projections we believe reflect reality of today's business, for example on the public sector, where we've done extremely well over the last several years. However, I also believe we need to execute better with more focus on [indiscernible] and execution excellence, tied to our strategy and vision. This last remark is primarily for the Cisco family who is listening.

Bottom line, I think we will look back on this period of time and wish we could have avoided it. And yet, it will make us stronger in the long run. As always, we expect and encourage you to provide field feedback on the areas where we are doing well and areas we need to improve.

At this time, I would like to thank the entire Cisco family for their dedication, loyalty and sacrifices as we navigate these times. I could not be more proud or excited about how we are positioned for the future. 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 in challenging economic times.

Blair, let me turn it back over to you for the Q&A.

Blair Christie

Thank you, John. We're now going to open up the call for questions. [Operator Instructions] So Kim, please go ahead and open the call.

Question-and-Answer Session


Our first question comes from Tal Liani with Bank of America Merrill Lynch.

Tal Liani - BofA Merrill Lynch

I have a question on switching and routing. Switching is down 7.5% year-over-year and routing is up 5% which is materially below the competition. The question is number one, your guidance is for total revenues to grow 5% sequentially and another 10% sequentially. So do you expect these two segments to recover materially the next two quarters? And number two, more specifically to routing, why do we see such decline, sequential declines, and low year-over-year growth in routing given that you don't have many competitors and there shouldn't be any pricing pressure in this segment?

John Chambers

Tal, there's always pricing pressure in every segment from a number of competitors. But if you look at where we are, if you look at switching, and you look at what we did this quarter, bookings were clearly in both our total product area comfortably above the revenues. So we clearly increased our backlog in these categories. And in terms of the momentum in the switching business, I would expect those to be positive, and while I don't want to break into segments and individual areas, if we were to do that, I would expect switching to be in the mid-single digits if I were looking out over the next couple of quarters to higher. I think what you're seeing very frankly there is, and bear with me for the audience who may not be as familiar with our product capabilities, is that 7000 might have the functionality to a salesperson of two 6000 Catalysts. And so they have to sell almost 2x to 3x the volume, the 7000 to have the same revenue scenarios. If you put a Catalyst in a wearing closet and it was a 6000 and now you can do it with the new 4000 line, while you don't lose share on that in terms of how the fuel fuse it, you do have a revenue drop on it, and you have to pick that back up. The new 2000 has the functionality of our old 3000 products. And so it's very easy to compete with the 2000 from an architectural point of view in terms of product, price performance. But we've got to learn, Rob, to sell up market in terms of the approach. So I think our challenge is to work through each of these product area and we are not going to give up market share in terms of revenues or ports. We're going to be very aggressive and control the evolution of this transition ourselves. So out over the next year, I feel really good how we're going to do on switching. And again as I said in the last quarter conference call, you'll see it bounce up and down by quarter, I don't think that will be any different this time. And I think if you look at the top 15 product areas, I said my goal, give or take one or two is to have decrease and five to decrease each quarter. And then to fix those, by the next quarter as it occurs. In terms of routing, we're doing very well and we do have good competitors. But you are right, our product portfolio is the strongest it’s ever been in core, Edge, and access. I think what you're seeing in the quarter is you have good CRS-1 growth but the CRS-3 hasn't kicked in, in large volumes yet because what's going to occur there is you've got to get to the testing cycles with the large accounts. So I would expect you to see that over the next several quarters as that picks up. In terms of the Edge, I really like our product capabilities and we did very well this quarter in terms of Edge orders. Now we've got to keep the pressure on in terms of converting those to revenue and then expanding off the initial capabilities and the direction. So if you look at it, I think in both these categories you look back a year from I think we'll hold our own very well and we'll see if that means slightly upwards with market share or slightly down. But I feel good about our overall products, Tal, in the direction.


Our next question comes from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank AG

You had this long-term kind of growth target of 12% to 17%. The question is, are you considering revisiting what you think your real growth rate is and perhaps managing the company's expense line and profitability more for perhaps a company that's a little larger and maybe a little slower growing than perhaps you previously thought.

John Chambers

Well Brian, we listened to your constructive criticisms and we agree upon the points. We're going to go each quarter couple of quarters at a time and Frank and I with the team will model out what we think our growth will be over the next year, and provide expenses in line with what we think that growth will be. Then we'll let the quarter speak for themselves in terms of what the long-term growth will be in the balance. But in terms of your direct question, I would expect our expenses to be in line with orders or slightly below orders in the intermediate time period in terms of direction. So we're just going to focus on getting the results, tell you what they are, not getting our momentum ahead of our headlights, and we'll focus more in a year cycle, and then we'll see what the results take us in terms of direction. That's a nice way of saying absolutely keep expenses in line with our order growth levels as we look out over the next 12 months.


Our next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank

My question is on the next couple of quarters of guidance, if you look at the sequential numbers, it's about 5% sequentially and then 9% for the fourth quarter. And I think you also mentioned, John, you thought that could be done while also improving backlog. If I look at those sequential numbers, those are at the very high end of the historical trend, especially the fourth quarter. My question is, what gives you the confidence that you'll be able to hit the high end of the historical range in the sequential revenue growth and at the same time continue to grow backlog? It seems to be a little bit of a stretch given the last couple of quarters performance.

John Chambers

Let's go in the order you arranged them. When you talk to executives around the world and the enterprising commercial business, well, they feel good about the market. Their optimism is starting to increase and you're seeing that in terms of our order rates in many of the areas. And while there's sometimes that lag of a quarter or two before that hits full gear, most of the enterprise customer executives, and we talk to most all of them, are more optimistic by a fair amount in terms of GDP growth in this country and around the world than they were just three or four months ago. And you did see our enterprise business as you saw hit very, very strong run rates in terms of the U.S. as an example, stripping up high end financials in the high 20s. And that's sometimes as good as we've ever done in terms of this marketplace. And they're buying our architectural approach. They're buying our ability to combine technologies across our product lines and to help them solve their business goals at a faster pace than ever before. That's a nice way of saying, probably gaining market share in those over time and definitely gaining share of wallet spend and allowing us to move into areas like collaboration data center, where we were not major areas in terms of consideration before. If you look in terms of the momentum, it feels pretty good around the world. Rob, I'm going to ask you just to comment on what you're seeing that I think we've identified the caveats pretty articulately. And I think we've been a little bit conservative in some of those. The only area that I'm major worried at the present time about is public sector spending and whatever it is, we will get more than our fair share. I mean, I've called on the government leaders and most large governments around the world know we're positioned very well there. It's more a matter of as they squeeze their budgets down in the short run, can we pivot and take up areas in terms of moving into areas where we weren't much a leader in or gain share. Third quarter is very simple. This quarter every month, we did better than the prior month. And if you look at what we were doing in the three months, the first quarter was a little bit light like as we expected and signaled to you last quarter, that's how, Rob, your forecast came in. I'm sorry, the first month. The second month of the quarter, it pick up little bit above normal run rate. And the third month of the quarter was very solid and a couple of points ahead of what we had normally would achieved in the third month. We have scrubbed the numbers backwards, forwards, and sideways for the field sales forecast. And I expect Rob to hit. But then you look of the momentum for Q3 and Q4, we're now looking in two and three and four quarters out at a time. We also applied 600 sales reps at the beginning of this last year and Rob's putting 400 more in out of those 300 people we added, 200 of them were in sales and we're converting people into the sales reps from other areas that are important but we wanted to be a direct touch and direct involvement. So that's why we see the numbers in terms of direction, and you are right, if you add 3% to 5% on the Q3 number, that's a good growth in terms of year-over-year in terms of revenue and you can just do it conservatively at 7% to 9%, or you can do it aggressively at 9% to 11%. But that's the kind of momentum we think we're on in terms of direction Rob, any other comments on that way?

Rob Lloyd

Yes, John, I would just add, consistently around the world, enterprise and commercial appear to be markets we're gaining share and certainly gaining the relevance. The architectures of collaboration and data center are global markets for us and we're beginning to see those uptick even outside the United States as our momentum growth there in non-English speaking countries, which has been a focus for us. And then finally, I think the area of really driving our foundational technology is pretty critical. So emerging markets will be a growth engine for us as we capture the opportunities in Asia Pacific and emerging. I think those are the summary growth messages that we're going to continue to invest in.

John Chambers

Nikos, one last comment, and Blair I'll try to get the answers tighter. If you watched what we've done, if we were just a routing and switching company, that now in total is -- I'd have to look at the numbers. I think like 46% of our business is all that it is. And if you watch these new market areas that we are moving into, they are ramping at tremendous speed in terms of our video strategy, our TelePresence strategy, our media net, our collaboration and data center. We would've told you a year ago that our UCS would be growing at 700% year-over-year. That would be in many, companies that are leading edge, the preferred server technology they're using and switch technology and storage partner with our MDS growing you'd have said not a chance, John. So momentum feels very good in the data center. It feels extremely good in collaboration, we're winning in Video. Now our key is to balance all these portfolios and that's where I'm going to ask Ned to get closer and closer to me. I need help on balancing the portfolios from a strategy perspective and we need to be tougher on our focus on execution on holding people accountable for measurements. But it is these multiple growth areas that when one flows, another picks up. Now my goal is to get them all going at a faster pace in terms of their momentum and that's why I feel pretty comfortable about Q3 and Q4. It's all the appropriate caveats, because it does feel good on that.


Our next question comes from Jason Ader from William Blair.

Jason Ader - William Blair & Company L.L.C.

I just had a quick question on the gross margins maybe for Frank. Frank, why would the gross margins be flat sequentially at the consumer mix which would normally be down a lot in the April quarter?

Frank Calderoni

Jason, the mix from a consumer standpoint does help us quarter on quarter going from Q2 to Q3. But the overall margins we saw this quarter for consumer are still lower than we had expected last year. So due to some of the things that we experienced in the quarter, primarily on the pricing and then also some of the inventories. So that's continuing. We also have the mix on the data center products with the UCS from a continuation standpoint. And then also, we're making an assumption here and of course factors can change from quarter-to-quarter. But if you look at the point that we mentioned in the script on the switching, and the transition that we're going through on multiple products within the switching that, that would also play into the back half of the year. So I'm trying to be somewhat balanced and conservative based on what we experienced in the quarter. And being also somewhat realistic over the next two quarters, so looking at a 62% to 63% range.


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

Mark Sue - RBC Capital Markets, LLC

Historically, network complexity drove the adoption of end to end in an architectural approach. But these days, standardization is driving a faster adoption of best-of-breed, which is resulting in something of an unbundling effect for Cisco. And if you're pricing actions and extend payment terms are a direct response to increased competition, and you don't want to give up market share, why would 62%, 63% gross margins be the floor? And likewise, if you're trying to compete with new products, which require new investments, are 23%, 24% operating margins sort of the new peak for Cisco longer-term?

John Chambers

A bunch of questions. Let me kind of summarize it. And then Mark, maybe follow up with you from our team on more details on it. In terms of looking at it, in a respectful way, I know you're throwing a fastball and a curve ball that you want me to address both issues. The network's role is increasing in this. It is at the center of everything from security to how you combine any device to any content, intelligent networks, virtualization of where your processes are, et cetera. And the best-of-breed is actually going the other way. Our team, Rob, and I'm going to ask you to comment specifically on this are learning to sell architectures and learning to sell the cost efficiencies of a technology architecture tying together. In terms of the floor, I wouldn't view it as necessary cash in contrary to 62% or 63%. I think we can improve it over time, or we may just even be a hair below it. But this is a basis that we're pretty good on transitions. In fairness, you're saying, "All right, John. You guys are really good at market transitions. How did you get surprised on this?" Well the two things that were surprising to me was the ramp up of the switching product line. We've never introduce all of our products in such a short time period from the core routing, edge routing, access routing, to high-end switching, data center switching, the fixed and modular component parts and we did all of them at once. Normally you have a balance going on. Now, that speaks to the innovation engine being on fair. That's why candidly, I'm pretty comfortable with our innovation engine and our vision and strategy. Now as they come out, they always start at lower gross margins and they go up. And you saw in the example, just using the Nexus 7000 as an example, seven points in five quarters that we improved on it and I think we need to do better in terms of the direction. And then as you get these in place, we'll get better and better at selling them Rob and we'll move some of the people at overlay sales and the direct sales and drive it through as well. So I actually think in the approach in terms of the model is right we are seeing growth faster in the UCS and some of the products at the low end. A good problem to have, but it does put downward pressure on the consumer units is a couple of quarter phenomenal year. And then I think we've got to strike our balance in terms of obviously expenses and cost efficiencies in the group, although this is important to us in terms of feeding our future direction and we'll spring our groups together on it. That will be the way I'll answer it. Rob, what would you add?

Rob Lloyd

John, I think an example for Mark that you mentioned earlier is in the data center, we have an architecture that's selling. And when I ask our sales teams and I asked our partners, that architecture is clearly winning. The foundation of that new architecture has lower margins than the products that it's replacing. And it will be an ongoing improvement for us which is currently underway to improve the gross margins at the Nexus 7000 and equate to the gross margins of the Catalyst 6000 that it's replacing. So that's an example, where to Mark's question, we will be seeing margin improvement at that architectural approach to data center replies. And I think that's applying to several of our product transitions.

John Chambers

It might take as a year and a half to win the first $1 million orders in a large enterprise customer regardless of industry for the date center and those are servers, and the network, and our storage approach. Then, you ramp it after that. So you do have front end -- what I'd call getting the field ready type of activity that then ramp up on the back side. So that would be the way I'd answer it, Mark. Give us a feedback on what you agree with and what you perhaps are challenges further on.


Our next question comes from Jeff Evenson with Sansford Bernstein.

Jeffrey Evenson - Bernstein Research

Are you doing Sean. Could you give us an update on the dividend and especially what I think are the related issues of the commercial paper that you're issuing and your expectations around repatriation?

John Chambers

In sequence, the dividend very much on track, we will pay it by the end of this fiscal year. We will now start paying it by the end of fiscal year, Frank will determine when payments starts, obviously. The only question is, is it 1% or 2%. In terms of our country's understanding of the importance of bringing back foreign earnings into our own countries investment for jobs, for plant and equipment, even for acquisitions, I think you're now seeing political leaders at all levels understand that. And at the risk of repeating the theme, every major developed country in the world, doesn't matter if it's Japan, it doesn't matter if it's Germany, France, you go right down through the list, all of them bring back those foreign earnings of 0% to 2%. So we have a tax policy that is just broken. It's at an unreasonable high rate, and then it's the worst of all worlds. The majority of our growth, almost 70% of our market, and probably 90% of long-term growth is outside of the country and we have a policy that makes us non-competitive outside the country and then not only doesn't encourage us to bring it back, but penalizes it with double taxation. That's a nice way of saying, I think this one has well over a 60% profitability of being resolved in a positive way and I do believe that Republicans, Democrats in the administration are much more receptive to this that they were just six or 12 months ago for combinations of reasons. So that would be how I'd answer it Frank anything you'd add?

Frank Calderoni

On the question about the commercial paper, as I mentioned earlier. We did announce within the last 12 weeks to 10 days about a $3 billion commercial paper offering. That clearly is focused on short term debt. Right now a very attractive rate to provide us with flexibility and liquidity, especially in the United States. I also mentioned that if you look at our balance in the United States at the end of the last fiscal year from a cash perspective, it's $3.1 billion. So this gives us a little bit more flexibility in the short-term based on kind of what John was saying before, to be able to deal with some corporate needs. The other thing that we have from a debt perspective that comes into play as well, as we stated before with some of the debt that we have in the $15 billion amount that we currently have, we have a little over $3 billion that's coming due later this month, which is at a higher rate. So to be able to manage that, in the short time frame is the reason why we're going forward with this offering.


Our next question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc.

Frank, on your growth and operating margin targets long term, are you still thinking of the same range as you talked about at the analyst day? 64% to 66% in 28 to 31. And if so what would it take to get back to that? Is that a level of a revenue level or is it just a number of quarters during which you expect some of these product transitions to play out? And then John, I just wanted to clarify your comment that you're seeing significant strength in your U.S. Large Enterprise business and you think that the data center architecture bet is working. But at the same time you also talked about pricing pressure and a mix shift to the low end. So I just wanted to understand how those two reconcile?

John Chambers

Sure. Which one of the two do you want Simona?

Simona Jankowski - Goldman Sachs Group Inc.

I'll go with the second.

John Chambers

So in terms of the architecture and the data center type of approach, we've got new products that have tremendous price performance. We're going to control the switching transition. The great news is we've got this in a breadth and depth we've never had before we usually would have one product and then a year later a different product area. And a year later it will be over five or six years, we would have brought out this range of products. They're all moving very well. The good news and the challenge is they have price-performance, our own price-performance competition that is dramatically better than the products that they're evolving from. So it's very easy to take a product that you use to do a given function and take a product class with this next generation one or two levels down. We've got to learn to architecturally sell that. In terms of the data center, it is playing out identical to what we expected. In terms of the market, our ability to really comment on architectural approach both in the traditional Brownfields and the Greenfields. I wouldn't cut us out of the bare meadow opportunities just for server architecture in terms of the direction. So you are seeing companies realize that they are an advantage to a major architectural play. We have advantages versus the incumbency big time in terms of we don't have an installed base to protect and we're moving very aggressively on that, and we're also doing that from an operating cost perspective. Our strategy is now being copied from an architectural perspective and people are following along I think you look back a few years from now and it will be the example of it. So it's a nice way of saying very simply, that if you look at the products what we're doing, we are providing more and more function. It will take a while for the network growth to occur to really pick that up in terms of the volume, but in terms of versus competition, we are really in good shape. Rob, just a quick comment on your sales force. I have worked everyone of them. With the exception of pressure and emerging markets, they would tell you that in terms of when they go head-to-head, their win rate is as good or better than it's ever been. General comments on that?

Rob Lloyd

Yes, John. I don't think we're losing market share in any of those spaces. I think we can do a better job at articulating the architectural advantages at the lower end of our fixed portfolio, and we have some actions underway right now to look after that.

John Chambers

Nice way of saying we've got to learn how to sell up market as well as beat the competitors. We're beating the competitors fine, but we've got to sell up in terms of additional functionality. And then we can load the networks with that functionality, Simona, as well.


Our next question comes from Ittai Kidron with Oppenheimer & Co.

Ittai Kidron - Oppenheimer & Co. Inc.

I wanted to follow up on Jason's earlier question on the gross margin. And John, specifically on the switching side, what is it about this transition that you didn't anticipate that is happening? And as we look forward for the next two or three quarters, what is it specifically, if you can provide us a little bit more detail on what changes over the next few quarters that would margin to improve in that segment?

John Chambers

Fair question, Ittai. It's probably one that a number of your peers have. And I know we can ask it in different ways. In terms of what has always occurred -- and bear with me, I'm going to take a step back. When we originally entered the switching market, with the team from [indiscernible], everyone was convinced that you cannot get gross margins higher in switching than high-40s, at best low-50s. And yet every generation products we brought out we’d bring out a product at a given gross margin level then would do what I call a Texas two-step which is price performance improvements with better margins, price performance improvements with better margins as you go through it. We know how to do that, I just think we have to do it at a faster pace in terms of the approach. And if you watch even the 7000 just as a proof point that's exactly what we did over the last five quarters. Now with the 2000, 3000, they're new. We've got to do the same things there in terms of the approach. And as you would expect, we have working groups in each category. Now the two things that challenge us here, that have never challenged us before, I have never been fortunate enough to have all new products across all of our product portfolios at the same time. Normally you have two or three new products per year and it takes you four or five years to have that generation of products evolved that we have today. This is tough to compete against. I mean, the innovation engine is doing really well. The speed of take up, I did not anticipate. How quickly the ramp occurs and the trade off, our ability Rob to fill the higher end versus the sale at a given point, part of that is competition. But part of it is we have to, with our own customer, show them the value of going up one level in terms of the direction. So I would say it's the speed of take up in these scenarios and secondly in terms of the product groups all at once plans. That's a fast ramp. We've never -- if you have, let's say just for purpose of discussion 10 major switching products moving at the same time as opposed to one and then six months later another and that plays out over four or five years. That gets balanced more. So that would be the two areas that I think that we have to work on and get more effectively. It's a good problem to have if you're going to have a problem here. It's not one with the competitiveness of your product. It's not one that the architecture isn't winning. It's not one that you haven't designed leading Edge products in each category, but it is. You've got to be careful that you don't create competition within yourself. And if you do, you show the ability to move up market more effectively than we are at the same time.


Your next question comes from Richard Gardner with Citigroup.

John Slack - Citigroup Inc

it's actually John Slack for Rich. My concern is on the consumer side. Clearly down 15% year-over-year, a gross margin drag. What's the ongoing strategy there, how important is the Consumer business to Cisco? Any sort of color you can give us on that, and what you can do to kind of turn the direction there?

John Chambers

When I asked Ned to lead it for me and we brought in Jonathan to be the lead of the Consumer specifically, we knew going in it was going to be tough. And we based our strategy on being able to sell added value on an architectural play in the home. As you saw in the most recent Christmas holiday season, value add higher end products got crushed and the ability to move was mainly on lower SKUs and lower balance within it. And so it turned out to be a tougher market than we anticipated and this last six months in particular, the things that are most important to Cisco than being able to sell are key, were not what the customers were buying within the category. Flip was up 15% year-over-year, but that wasn't the kind of growth that we wanted. We were looking more in the 30s in terms of the growth for the Flip architecture. So let me flip to you Ned a little bit of what you found. And then let me come back come around to talk about where we're going to go-forward and jump into it any way you want.

Ned Hooper

Sure, thanks John. And you know, John Slack, what we have focused on as a strategy is bringing together the convergence of video and networking to be able to deliver high-value products and to be able to deliver experiences for our customers both directly to consumers and through partners through service providers as they deliver consumer applications. A part of the strategy we've executed over the last year has actually been to exit some of the commodity products and commodities SKUs that we were selling in the U.S. and to exit low-volume global markets where we were sub-scale. So as we looked at what happened over the last quarter, the combination of the market’s overall focus on deeper discount and lower priced products and the exit of those SKUs and markets is what caused us to underperform our expectations on both revenue and gross margin. And as John said, we're focused now very much on making sure we're very efficient in our investment bringing our resources together and driving the operational improvement. So in the short term, we do expect the consumer market to stay focused on lower value products. But we believe the opportunity for Cisco is to create those premium experiences and premium products and we're going to stay focused on that and driving that both with our retail and service provider partners.

John Chambers

It's 2% of our business, John, to answer the question very directly, we get a lot of creative ideas and potential architectural plays here, and we have some plays coming in terms of Smart Grid and how that ties to every device in the home up and how you make the home architectures work better. We clearly will be very careful on spending this area and make sure we catch the market transitions if we ramp up expenses in the way. We will be combining resources in a constructive way to help on expenses as well.


Our next question comes from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley

First of all, John, you've given out some numbers since last quarter. I just want to see if you can update them on the size of the run rates of the Nexus family in total by revenue and the three different ASRs so to see how they're doing just on a comparable basis. I think you also gave the ISR G2. Just anything you can fill in there would be helpful in a comparable basis, the ones you gave out last quarter.

John Chambers

Go ahead, ask the question, because I'm looking for a little bit of data because I'm going across a number of these at the same time. Go ahead and get the second part and I'll combine the two.

Ehud Gelblum - Morgan Stanley

I hate to bring back gross margins, but taking a look at that in terms of what UCS is doing, so far UCS appears to be somewhat on track doing the run rate of $650 million of revenue. I believe in the past you said it would be $1 billion run rate by the end of this year. So it seems to be doing nicely and on track and yet it's detracting from gross margin this quarter half a point. Going forward, as UCS continues to get larger I'd imagine it will continue to detract from gross margin. First of all, can you give us a sense as to where the gross margin on UCS stands today, and so we can do our own calculations depending on how large UCS gets, what the impact is on gross margin and how low will it take gross margins down? Could it get into the 50s before we get this turnaround and it starts bouncing back up again. And then leave a comment on services as it keeps getting larger as a percent of revenue where that kind of tops out will be great as well.

John Chambers

A lot of questions and I might do the services as wild card at the end, because that's something I think many people do not realize how much a differentiator is for us. 67% gross margins. I mean, it's off the charts. And what is even more interesting, as you invest in services, your customer satisfaction goes up, your win rate goes up, your architectural plays goes up and the customers are able to implement their solutions to achieve their business goals at a faster pace. It's nice if saying well, Gary, Joe, you guys are getting a home run at this and it's becoming literally a think about it, it's 21% of our business today and growing at a rate probably five points faster than the rest of the business and yet it pulls all the rest of the business through in terms of direction. To answer your question both directly and indirectly including keying off with a question you asked last quarter, in terms of comparing apples to apples, the Nexus product lines respectively, the Nexus 2000 grew at about from a revenue perspective about 160% the 5000 close to 60% not quite there, the 7000 about 97%. To go back to the Nexus approach in the 5000, these are all pretty good shape, the ASR 1000 grew about 7% the ASR 5000 grew as I said well over 100% but to your point, if you're comparing the ASR 5000 and going back to [indiscernible] based on that and look forward about the stair in improvement you're seeing growth in this product category at about 30%. The ASR 9000 grew at about almost 500% in terms of the ramp. And the ASR 9000 as you all know is so important, Rob, to us at the edge of the networks. That's what the reasons that we're getting more optimistic about service providers is that Edge 9000 after being in pilots for a long time and after being in terms of the mode of ramping with ASR 5000 where there were primarily two or three customers that have been doing the majority of the volumes for us both those look good and it goes back to one of the questions earlier. It might have been Tal, about routing growth, why we feel pretty good about the routing growth within the category. In terms of the UCS, we'll break out over time. I'm not sure what the gross margin each category that gives our competitors an awful good idea of what they have to do and not do. But I think I would view that as a separate growth area and kind of break it out from our traditional growth. And we might begin to give you a growth in margins in categories over time, in terms of concepts of where we're going. But the UCS standalone is when you combine the standalone with the switch, with the storage. The switch and the storage clearly have very good margins and barring the surprise especially the switching should increase over time, the architectural play there is what we're after. So I would begin to look at those as a blended approach and I'd look at how do we get our gross margins back in line in some of the product areas and talking about, Ned, I'm asking you guys to play a huge role in making this happen from the engineering side and from the strategy side, and the UCS is a great problem to have. So I don't view that as a negative driving down our gross margins, I view it as incremental revenue, incremental profit and then how do we do on our traditional business, which as I said in my comments I think we need to do better.


Our last question comes from Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan & Company, Inc.

John, during the course of the call, you mentioned market share a number of times spread out for the call. I'm hoping you could kind of go back and simply address maybe the gap between perception and reality and just clarify one element I think I heard you saying, or at least suggesting was that in the Switching business you're going to fight back with pricing. I want to make sure that that's -- that I heard that correctly. And in general, what are you doing in terms of the real fundamental aspects around market share. If you could summarize that.

John Chambers

Sure. Well first let me start with a 10,000-foot view in reiterate, we are a portfolio play at Cisco. And if we have our top 15 product families, and we're gaining share in 10 and losing share in five, that's what I would consider, Ned, a reasonable balance. That doesn't mean there won't be quarters where we do 13 and quarters where we do eight, but it is that consistent balance overall, especially for the high-end segments of the product areas. According to our cuts on what the industry analysts are providing, if I look at year-over-year growth through the end of the calendar year, there are three categories that we lost share in. If you look at quarter-to-quarter and anticipating what's going on, there might be five within that group. If you look at where we are on LAN switching, I clearly am very comfortable with our product issue here. I think we've corrected the port scenario. And I think that we do our job right you see us pick up on revenue and approach. I want to say very specifically we are not fighting back with pricing. I wanted to say that very specific. This is not a price game. This is a price-performance game with our new products coming out at dramatically better price performance than our prior once. And as you'd expect, our customers will move to a product that has ramps twice the performance at half the price. That's just a logical evolution of where the markets going in terms of direction. On service provider routing, although we might lose something on the edge for a period of time this quarter. I really like where we are. And with ASR 9000, ASR 5000, we're going to be fine in terms of service providing the edge in terms of the direction and service provider routing in total. And [indiscernible] begin to kick up and not expect that throughout the remainder of this year in terms of direction. We still have some work to do in application switching, I think you all are aware of that. I'm actually pretty comfortable with wireless and I'm pretty comfortable with where we will go with security over time. Security we made the number one priority in engineering not because of its short-term opportunities but because of its long-term importance architecturally. There's no way you can do securities as pinpoint products, elements and a few routers, or element with a few switches. It has to be integrated with every basics, every software, every architecture within it. Padma, you and Bret own that for me. And I expect great things. But I'm realistic, that's over two to three years. Now I deliberately, Simon, commented on the areas where I felt we were exposed. I didn't focus on the other strong areas. The last one perhaps exposure wise will be set-top boxes. If you major in set-top boxes, obviously this is going to be a tough challenge for us the last couple of quarters. You'll see us balance that. You saw our IP set-top boxes begin to pick-up but for us it's no longer a set-top box game. It's a software architectural gain, next-generation of experience of next TVs, social media, working into that. Communications as a whole. This is where areas like you and me begin to play in as well on it. So if those are the weakest areas you've got, I think we're positioned pretty well in the weakest, and then you begin to go to our strength. You heard the strengths collaboration, data center. We're currently doing extremely, extremely well. Last comment, we're winning on architecture, price performance, plays and we got to sell up market in terms of it. In terms of specific pricing pressure putting the issue on us, that's not our problem that we feel that we're exposed on. We are with a whole bunch of new products at the same time. That candidly have really good price-performance and gross margins that will take a while to build up to a normal run rate. Blair, I don't know if you want to say anything else. Summarizing it, and I know I went long in a couple of questions. I apologize for that.

Blair Christie

That's okay, John. You are the CEO. Why don't we go ahead and just close the call at this stage. Cisco's next quarterly conference call, which will reflect our third quarter fiscal year 2011 results, will be on Wednesday, May 11, 2011, at 1:30 p.m. Pacific Time; 4:30 p.m. Eastern Time.

And additionally downloadable Q2 FY '11 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 in our website in the Investor Relations section. Click on the Financial Reporting section of the website to access the webcast live and these documents.

Again, I'd like to remind you that in light of regulation fair disclosures, 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 on this call. And thank you for your participation and continued support. This concludes our call.


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