Cisco Systems' CEO Discusses Q4 2011 Results - Earnings Call Transcript

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Cisco Systems (NASDAQ:CSCO) Q4 2011 Earnings Call August 10, 2011 4:30 PM ET


Gary Moore - Chief Operating Officer, Head of the Services Organization and Executive Vice President

Terry Anderson -

Frank Calderoni - Chief Financial Officer and Executive Vice President

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


Brian Marshall - Gleacher & Company, Inc.

Mark Sue - RBC Capital Markets, LLC

Tal Liani - BofA Merrill Lynch

Nikos Theodosopoulos - UBS Investment Bank

John Slack - Citigroup Inc

Rod Hall - JP Morgan Chase & Co

Brian Modoff - Deutsche Bank AG

Ehud Gelblum - Morgan Stanley

Simon Leopold - Morgan Keegan & Company, Inc.

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

Simona Jankowski - Goldman Sachs Group Inc.


Welcome to Cisco Systems Fourth Quarter and Fiscal Year 2011 Financial Results Conference Call. At the request of Cisco Systems, today's conference is being recorded. If you have any objections, you may disconnect. Now I would like to introduce Terry Anderson, Vice President, Corporate Communications and Investor Relations. Thank you. You may begin.

Terry Anderson

Thank you. Good afternoon, everyone, and welcome to our 86th quarterly conference call. This is Terry Anderson and I'm joined today by John Chambers, our Chairman and CEO; Gary Moore, Executive Vice President and Chief Operating Officer; and Frank Calderoni, Executive Vice President and Chief Financial Officer.

The Q4 fiscal year 2011 press release is on U.S. high tech market wire and on the Cisco website at I'd like to remind you that we have a corresponding webcast with slides. In those slides, you will find financial information we cover during this conference call as well as additional financial metrics and analysis that you may find helpful.

Additionally, downloadable Q4 and full fiscal year 2011 financial statements will be available following the call, including revenue by product and geography. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet and cash flow statements can be found on our website in the Investor Relations section. Click on the Financial Reporting section of the website to access the webcast slides and these documents.

A replay of this call will be available via telephone from August 10 through August 17 at (866) 357-4205 or (203) 369-0122 for international callers. A replay will also be available from August 10 through October 21 on Cisco's Investor Relations website at

Throughout this conference call, we'll be referencing both GAAP and non-GAAP financial results. Our commentary today will be providing information on both our Q4 and full fiscal 2011 financial results. The financial results in the press release are unaudited. The matters we'll be discussing today include forward-looking statements and, as such, are subject to the risks and uncertainties that we will discuss in detail in our documents filed with the SEC, specifically the most recent annual report on Form 10-K, quarterly report on Form 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

Unauthorized recording of this conference call is not permitted. I'll now turn the call over to John for his commentary on the quarter.

John Chambers

Terry, thank you very much. Since the last quarter's conference call, we've made solid progress on our comprehensive action plan to position ourselves for the next stage of growth and profitability, what we will call the next Cisco, which I will review at a high level in just a moment.

In terms of Q4 FY '11 overall guidance, we accomplished what we outlined in our Q3 conference call, achieving a little bit more in revenue growth and earnings per share than consensus expectations. Revenue growth for the quarter was approximately 3% year-over-year versus our guidance of 0% to 2%, and non-GAAP earnings per share were $0.40, slightly above expectations.

Total non-GAAP gross margins were 62.7%, with non-GAAP product gross margins at 61.2% and non-GAAP service margins -- gross margins at 68.6%. Overall book-to-bill was comfortably above 1, with total product orders in Q4 growing year-over-year by 11%. We also saw book-to-bill comfortably above 1 in all of our major product areas.

In terms of Q4 orders, there was very good balance from a geography, customer segment and most key product families. From a geographic point of view in Q4, our 4 theaters achieved year-over-year order growth ranging from 9% to 19%. Our enterprise, service provider and customer orders grew year-over-year between 15% and 19%. However, public sector spending continues to be a challenge, decreasing on a global basis year-over-year by approximately 4%. From a key products perspective, routing orders grew 17% year-over-year, switching orders 6% and new products grew 11% year-over-year.

The results in Q4 echoed our comments in the Q3 conference call. We are a very strong company with a very strong balance sheet, solid customer relationships, leading in many healthy markets. However, we need to address a few areas with the entire focus of the company. As with any technology company, we'll have to continue to focus and address the ongoing technology shifts, market transitions and changing competitive environment.

Since the last call, we've moved very rapidly on our plan to simplify operations and focus on our operating model and align our investments. We have driven this process in order to reinforce our ability to execute on our strategy, which is to take advantage of the global opportunity using intelligent networks to transform our customers' business and enable them to achieve their goals. I will provide a high-level summary, and Gary will provide more specifics on this.

First, simplifying and focusing our organization and operating model. During Q4, we reorganized our sales, engineering, services and operations organization, providing clear line of sight, accountability, accelerating the speed of decisions, driving toward major improvements in productivity and driving innovation at a faster pace. The changes we have now made position us to continually evolve our business models for the continued success in leadership.

Second, aligning our cost structure given transitions in the marketplace. We are well into the implementation of reducing our operating expenses by $1 billion on an annualized basis using Q4 FY '11 as a base. We will leverage this shift in cost structure coupled with the effectiveness in evolving our organizations and operating model to fund our future innovation and achieve value for our shareholders. This new cost and organization structure positions us very well to succeed in uncertain economic environment.

Third, managing our portfolio and divesting cutting back or exiting underperforming operations. As we planned, we have moved swiftly to evaluate and take decisive action to realign our portfolio. We made changes across the engineering to create simplified organization structures that allow for faster innovation, integrated product roadmaps, reduced costs and simplicity in the decision process. We have also made the decision to either exit or materially lower our investments in several areas of our Product and Solutions portfolio. Where material, we have announced these decisions publicly.

With these decisions behind us, we are confident we will deliver a total OpEx reductions of approximately $1 billion on an annualized basis and can move forward with a more focused set of portfolio investments. We will continue to pursue our innovation strategy to build, buy and partner to ensure that we are the best positioned in our priority markets moving forward.

Fourth, delivering value to our shareholders. Our financial and operating models are evolving to deliver value to both our customers and our shareholders. For shareholders, we have initiated a quarterly cash dividend, continue to be aggressive on our stock repurchase program and are in the process of making changes designed to improve our operating model in order to realize consistent, profitable growth and assure the most appropriate use of cash.

You can expect a broader dialogue around our business model and capital structure at a financial analyst conference for shareholders in September.

Many of our peers are now experiencing the same challenging -- same challenges in network capital spending, the public sector and the macro environment. We believe the changes that we implemented, well ahead of our peers, will now be a competitive advantage for us as we go forward in this uncertain macro environment. During periods of uncertainty, customers value companies with a strong balance sheet, existing strong relationships with these customers and one that can continue to help them with their innovation. It would be very easy to rest upon the changes that we've already made and continue to gradually evolve our company for the future. That is clearly what we will not do. We will continue to accelerate and drive through the simplification process at an even faster pace.

While the changes we have made and plan to make have been dramatic, we believe that this is an ongoing process in terms of our simplification goals, not lasting several quarters but several years. Gary will continue to lead this effort for our company.

As a result of more targeted focus and execution, Q4 met our expectations, and we expect that Q1 FY '12 will continue to show gradual improvement, and we will reflect that in our Q1 guidance.

Now for more on the format of today's call. First, we will share our perspectives on our priorities, how we're moving forward aggressively to address both the opportunities and challenges we are seeing while staying focused on our long-term vision, strategy and areas that we're working well across Cisco.

Second, we will share with you the areas of the business that require additional focus, including what we believe to be market-driven versus areas that are in our control.

Third, we will discuss what is going well across Cisco, followed by our Q1 FY '12 financial guidance.

Fourth, Gary will provide an update on the specific plans and actions we have taken and will take going forward to strengthen Cisco.

Fifth, Frank will cover a financial discussion of Q4 and our financial results for the fiscal year 2011, as well as an additional discussion on Q1 FY '12 guidance. I will then wrap up with a quick summary comments and then we'll move on to Q&A.

Now moving on to our priorities, including Q4 accomplishments and areas that require additional focus across our company. As we discussed in Q3's conference call, we will stay very focused on 5 company priorities, which we will believe will be the key in both the growth and the future of the Internet but also our differentiation, as well as our advantages we think we can achieve in terms of margins versus our peers in the industry. As a reminder, these 5 priorities are the following: leadership in core, which includes routing, switching and services; comprehensive security and mobility solutions. Number 2, collaboration; number 3, data center going to virtualization going to cloud; number 4 video; number 5, architectures for business transformation. These 5 company priorities are the key drivers of the future of the network and are core to the Internet. They are, in our opinion, not only the most important but also the most difficult elements in intelligent networking, but at the same time, the hardest to provide an integrated solution from a leadership point of view.

Our customers know Cisco is uniquely able to deliver in these areas to support their business success and protect them as much as possible to the flexibility and future innovation capabilities both from a technology and business model perspective. We strongly believe that these strategic priorities are the constants that will guide us. They offer the most significant and certain opportunities to increase value for our customers and for our shareholders.

At the same time, we've acknowledged our challenges and need for speed with progress already underway. We are intensifying our focus and accelerating our pace of innovation and change I know that we're capable of and have demonstrated in the past. This is exactly what we addressed in Q4 and we'll continue to address throughout the fiscal year 2012. As we discussed during FY '11, we had several areas of our business come under pressure. Today, we will focus first on those areas, and that is the public sector and switching.

First, the public sector. We continue to see reductions to public sector spending in almost every developed market around the world. We shared our initial concerns about public sector spending in U.S. state and local governments several quarters ago. As a reminder, Cisco serves almost every section of government, every category of public sector and with the vast majority of our business being new every quarter, we tend to experience the shift in spending earlier than our peers, often 2 to 4 quarters before it becomes obvious.

Public sector order growth on a global basis decreased 4% in Q4. In the U.S., the public sector order growth decreased by 7%, with our federal government orders year-over-year decreasing by 18% and state and local governments decreasing by 2%. This should no longer be a surprise as we are now seeing similar concerns around the customer, public sector customer segments for many of our technology peers.

As we said before, we anticipate global public sector spending to continue to be in a challenge for the next several quarters. Therefore, as you would expect, we are realigning our resources to focus on growth opportunities in the public sector, such as data center evolution, especially as it relates to cloud, collaboration and video. After our restructuring, we also realigned some of our resources from public sector in the enterprise and commercial markets.

Now on to switching. We continue to see several dynamics in the switching market that impact our financial performance: declines in average selling price per port speed, increased competition and the impact of lower public sector spending on Cisco switching.

Macro public sector impact on switching. First, lower spending from the public sector does add pressure to Cisco switching portfolio performance, particularly in the U.S. federal space. Approximately 1/4 of Cisco's Switching business is derived from the public sector, where Cisco has a very strong market share presence. To put this in perspective, as several of you have asked us to do, we saw orders for Switching portfolio grew 6% year-over-year while orders for switching the public sector declined 7% year-over-year.

During Q4, if we'd exclude the Switching business related to the public sector customer segments, total switching orders would have increased 13% year-over-year. In regards to the average decline in selling price, ASP, if you will, per port, as we discussed last quarter, the switching market is in the midst of a transition as the average selling price by port speed is decreasing due to an accelerated Moore's Law. The rapid introduction by Cisco of new products almost across-the-board that contained greater price performance and also increased in terms of our competition.

While gross margins for the entire switching portfolio decreased by approximately 1.4% in FY '11 versus FY '10, Cisco now is maintaining both its market share quarter-over-quarter in ports and in revenue. For example, we shipped 36 million switch ports during Q4, our highest quarter in history.

Second, let me provide you an update on our Q4 switching results. We saw our total switching orders increase by 6%, as I said earlier. Our set switching revenues decreased by 4%. Further detail on our Q4 switching portfolio performance includes: fixed switching increased by 13% year-over-year from an orders perspective and by 5% from a revenue perspective, while modular switching was down 2% from an order perspective and down 14% from a revenue perspective.

We have taken several steps to react to the switching market dynamics we are seeing. Due to the largest switching portfolio refresh in our history, Cisco has driven down price performance to benefit our customers. This has caused the average ASP per port to decline. As we have in the past, we will drive our gross margins on these products higher through cost efficiencies and volumes as the products get further into their life cycle. This is more evident today as compared to the past due to our simultaneous refresh of nearly the entire switching portfolio.

Delivering market-leading innovation in switching. Paralleling our efforts for greater cost synergies, Cisco continues to deliver market-leading innovation within our world-class switching portfolio. According to our preliminary estimates, we believe that it will hold switching port share leadership at approximately 50% and with revenue share in the high, very high 60s. In the data center, our Nexus portfolio continues to be the market leader in delivering data center fabric as compute storage and networking come together, and is benefiting from the transmission from 1 gig to 10 gig where we are at the forefront of this innovation.

The Nexus 3000 has received immediate customer acceptance with key wins in large financial services and massively scalable data center segments. At Cisco Live, we launched the next generation Catalyst 6500 sup 2T. This 2-terabit supervisor reinforces Cisco's innovation by tripling the performance, quadrupling the scalability and adding 200-plus new features to a platform that has already deployed approximately 700,000 chassis to more than 25,000 customers worldwide.

Switching growth drivers, let me talk about them for a moment. As we see customers upgrading their data center from 1 gig to 10 gig, the ability to drive seamless convergence between wired and wireless networks and the demand to drive security and video performance within the core of every network. We believe that as this occurs, it is a good opportunity for growth and plenty of innovation that our customers expect us to deliver.

In summary, we're doing a pretty good job of holding switching market share numbers in terms of revenue and port share with continued focus on gross margins to offset pricing pressure. We are adjusting quickly to our public sector and switching challenges.

Now let's discuss what is going well. There are many areas that are going very well for us, including solid order growth across our key geographies, most of our key products and customer segments. Cisco is leading the way in intelligent network provider for our customers, and the network has truly become one of the most important, if not the most important asset, in IT according to many of our customers.

Starting with the top 5 company priorities, I will cover the following sections both in terms of revenues and bookings growth year-over-year. First, leadership in core. Routing revenues declined 2% year-over-year in Q4 and orders grew at 17%. While services grew revenues 12% and annualized orders grew 13%. Gary, good job by the team.

Second, collaboration. Our collaboration suite of new products grew revenue and orders 11% year-over-year. TelePresence continued to lead the way, with year-over-year revenue growth of 24% and order growth of 35%. We have also been very focused on gross margins for our new products with TelePresence products as an example approaching our traditional core product's gross margin.

Third, our data center/cloud momentum continues to be strong with Q4 revenues growing 32% year-over-year and Q4 orders growing at 35%. Our UCS product exceeded the $1.1 billion order run rate, with year-over-year growth of 129% in Q4. We also added approximately 2,000 new customers in Q4, bringing our total to 7,400 customers. We also achieved solid order growth of 80% with the Nexus 2000 and 77% with our Nexus 5000 line. Our Catalyst 6000 line declined by 21% while the Nexus 7000 had order growth of 43%.

Fourth, video continues to rise in its relevancy to our customers and importance to Cisco as a key driver for growth. Cisco's video strategy based on Medianet and Videoscape as key architecture tenants is receiving very positive reception from our customers, partners and industry analysts. Video had strong results in Q4 across all customer segments, with approximately $1.3 billion in revenue and 13% year-over-year growth. SP video grew 9%. As we said earlier, TelePresence for the year grew 24% and emerging technology video grew 34%.

On a full year basis, video revenues were approximately $4.9 billion, up 29% year-over-year including the effective TANDBERG acquisition. TANDBERG is now fully integrated into all aspects of Cisco.

With the recent launch of the new Catalyst 6000 products, all of Cisco's enterprise routing and switching products are now Medianet-enabled, allowing customers to deploy video in a pervasive and scalable manner enabling them to realize the benefits they seek. This is the type of technical and business architecture advantage that differentiates Cisco from our peers.

And our fifth corporate priority, architecture, as it's gaining strong momentum, as well as driving value to our customers, especially in the U.S. enterprise and commercial environment. Our customers recognize the value of integrated network architectures, and for example, a survey, a part of our over 16,000 customers who attended our recent major customer conference Cisco Live, which was the most highly rated and attended in our history. Respondents expressed their views of most important factors of an architectural approach. 99% of respondents said the most important aspect was increased reliability and security. 95% ranked product design and the ability for their products to work together. 85% that as an integrated architecture occurred, it approached -- it allowed them to approach easily to address new business demands, and finally 76% ranked the ability to adopt new technology trends faster such as cloud, video, mobility, et cetera.

In our view, the benefits to our customers of both technology and business architecture approach is becoming dramatic and more obvious. At the same time, the benefits to Cisco both in terms of total product growth as well as protecting gross margins are just 2 of the desired results. No other player in the industry has the product breadth, depth and experience in advisory services to effectively lead these architectural transitions.

Let me put this in terms that relate to revenue growth, profit growth and margin growth. Using the U.S. Commercial segment as example, in our U.S. Commercial segment, orders grew 19% in Q4. The vast majority of our commercial account sales reps are now selling the technology architecture starting with newer products, such as video, collaboration and data center, and then pulling through our core products as part of their solution. Just to provide some data, 87% of our commercial sales reps sold our UCS products, and 85% sold our business video this year. These new product areas have an attach rate and pull-through of our traditional routing and switching products in more than 50% of these new product sales. That is with our core routing and switching products being ordered to support these new technologies.

Typically, the pull-through addition core products is more than 2x the value of the new product orders. We believe the breadth of Cisco's product line and how products are integrated together is unique differentiator and a major competitive advantage.

We saw similar results in bringing together our technology architectures to our business architectures in achieving our customers' business goals. This is what we refer to as the whole offer from Cisco, and it is continuing to gain major traction in the market. For example, our U.S. enterprise area, using this business technology architecture approach to sales, achieved order growth of over 25% year-over-year in Q4.

We are not only seeing solid growth in terms of year-over-year orders but we are seeing the size of deals substantially increase. For example, the number of $1 million dollar-plus deals around this architecture approach approximately doubled from 2 years ago from $198 million to $382 million in the enterprise area.

Summarizing these commercial and enterprise successes in terms of impact to gross margins because of the technology and business architecture value from Cisco, our customers achieved their goals of productivity, innovation, lower cost of support, increasing reliability, products designed to work together.

Within Cisco, it achieves our goals of both sales growth and better gross margins because of the integrated approach. Our recent actions have created significant efficiencies within the company on how we do business with customers. When we meet in September, we look forward to sharing more specifics. I am very pleased with what I'm seeing, which is less complex, more value creative for Cisco.

Moving on to emerging countries. Our goal is to see emerging countries, which represents approximately 20% of our product business, achieve 40% of our product growth over the next 3 to 5 years. In Q4 and in most quarters, emerging countries achieved year-to-year growth in the mid-teens. In Q4, our emerging countries growth was led by the BRICs countries and Mexico. We continue to see very solid growth in the BRICs, with China ordering -- orders growing in Q4 year-over-year approximately 26%, India growing 7%; Brazil growing 35% Russia growing over 50% and Mexico growing 16%.

From a geographic perspective, we are now organized in 3 major regions, starting in FY '12 with the Americas representing approximately 55% of our business, the second geographic region being the Middle East -- Europe, Middle East and Africa representing approximately 29% of our business. And the third Pacific: Asia Pacific, Japan and China, representing approximately 16% of our business. Therefore, this will be the last quarter that we report in terms of the following 4 theaters: U.S. and Canada, Europe, emerging markets and Asia Pacific.

From an orders perspective, there is very good balance across the 4 theaters with year-over-year growth of 11% in total in Q4. The U.S. had year-over-year growth of 9% with the U.S. public sector down 7%, service provider up 15%, U.S. enterprise up 25% and commercial up 19% year-over-year.

Our European operations also had order growth of 9%, with all the major operations achieving double-digit growth, with one exception of the Mediterranean countries. Order growth was down over 10% year-over-year. Our emerging market theater achieved order growth of 12% year-over-year in Q4. And finally, our Asia Pacific operations achieved 19% year-over-year growth in terms of orders. We achieved solid performance across all of our largest countries in terms of year-over-year orders. 9 of the top 10 countries achieved year-over-year order growth in double digits in Q4. The U.S. was the one exception growing at 9%.

The U.K., China, Brazil grew in excess of 20%. Japan, Australia, France and the Netherlands grew in the teens with Canada and Germany growing about 10%. All of our global customer segments, with exception of public sector, had solid order growth in Q4.

Enterprise grew orders by 15% year-over-year, commercial grew by 16%, service provider grew by 19% and public sector, as I said earlier, was a negative 4% year-over-year.

Now moving on to Q1 FY '12 revenue guidance. Before I get to the numbers, let me remind you again that all of our comments, including forward-looking statements and actual results, could materially differ. As a reminder, Cisco will always be affected by major economic changes, capital spending patterns and new and existing competitors, potential issues affecting our suppliers, our ability to execute or not on our strategy and other risk factors discussed in our SEC filings. The guidance is based upon current pipeline in our view of the business trends based upon the information we have today and could be above or below our guidance.

As a reminder, FY '11 Q1 had revenue year-over-year growth of 19% last year, while FY '11 Q2, Q3 and Q4 averaged year-over-year revenue growth in the mid-single-digits. Therefore, Q1 FY '12 from a year-over-year revenue growth perspective has a tough comparison. As many of you know, Q4 is our strongest quarter of the year in terms of orders, but Q1, as you start the new year, is normally down sequentially from Q4 from an orders perspective of almost by 10%.

Also we see -- we all see the uncertainty in the global markets, and the last several weeks have obviously been extremely challenging from the stock market perspective. It is obviously too early to determine the effect on capital spending. Therefore, as you would expect, we will be conservative on our expectations for Q1 and for the fiscal year 2012, again with all the appropriate caveats discussed during the conference call.

Also with the major changes we have made to sales, engineering, service operations and the reduction in workforce that has been implemented in Q1, we would expect to lose some order momentum above our normal sequential decrease in Q1. However, our goal once again, is to grow orders year-over-year faster than revenues growth just as we did in Q4.

With that in mind, for Q1 FY '12, we expect revenue growth to be in the range of 1% to 4% on a year-over-year basis.

I'd like to now move our plan going forward and actions we will take. I've asked Gary to become Cisco's Chief Operating Officer with the specific mission to drive strategic prioritization and accountability within Cisco with a laser focus on simplifying operations. I would like to turn the call over to Gary to discuss how we are addressing our action plans. Gary?

Gary Moore

Thank you, John. Good afternoon, everyone. During our Q3 earnings call, we talked through our plans to address 3 key areas of work, and I'm pleased with our progress to date. We have met the milestones we have set for ourselves while executing effectively against an aggressive schedule.

So we agreed to: one, establish a simplified focus and more efficient organization and operating model; two, reduce and align our cost structure; and three, optimize our portfolio. Our guiding principles behind this work are to consolidate and align our portfolio in support of the company's top 5 priorities, enable faster innovation cycles to match customer and market demand, establish clear lines of leadership and accountability, empower the business to better serve the customer and improve the ease of doing business with us.

I would like to share our initial progress in each of these areas and address the work we still have ahead. First, we have taken swift actions designed to simplify the operating models of the company within each organization. Sales, Services, Engineering, Operations, Marketing and Finance. These moves will allow us to better align our people, processes and investments around our top priorities, increase our speed of innovation and focus more of our field and services sales force directly on our customers and partners.

As we highlighted last time, we have sharply reduced our boards and councils and appointed clear and accountable leadership to steer those. This includes our engineering organization where we went from 7 individual engineering leads to 2 coleaders that are now accountable and empowered to make decisions on the portfolio holistically. With this aligned structure, we are now able to readily adjust and execute on the evolving needs of our customers, and we believe quickly capture opportunities in the market.

Our organizational changes have resulted in the realignment of approximately 23,000 people across Cisco to bring accelerated decision-making, cost efficiency, scale and improved quality. Within sales -- within the sales organizations, we aligned approximately 4,400 employees. For scaling, approximately 90% of our sales teams are now directly managed by our 3 regional leaders. By moving resource, budget and decision-making closer to our customers and partners, we have empowered the geographic regions.

Before the realignment, just 70% of the sales force were directly managed by geographic field teams. To ensure a consistent and cohesive view of our customer needs as well as a single view across geographies, we have established service provider in the Enterprise segment teams to enable and maintain a global customer perspective. This select group of top talent works across architectures and regions to help deliver segment-based offers that bring unique value to our customers in the way they want to buy.

From an operations perspective, we are establishing a global -- a globally consistent approach and bringing together most operations teams into one aligned team. We are changing our processes to reduce duplication and increase our execution speed, with focus on -- with focus placed on the needs of our customer, this alignment has already reduced the deal approval process time for large quotes by 65% to 70%, resulting in a better experience for our customers and faster conversion rates for our sales teams.

John Chambers

And we had higher win rate as well.

Gary Moore

That's correct. We have also done considerable work to improve our ordering process to speed booking times. Because of the improved process for reconciling the quote to order, we eliminate unnecessary delays in our booking process.

Secondly, as we said last quarter, we have a goal to reduce our annual expenses by $1 billion using Q4 as our baseline. To achieve this, we looked across the business for areas where we could lower costs and improve operating margins. As it relates to our workforce, we are reducing our regular full-time workforce by approximately 6,500 employees. As part of this process, we have now reduced our VP and above population by approximately 17%.

Consistent with our manufacturing strategy, we are also -- we also announced the planned sale of our set-top box manufacturing facility in Juarez, Mexico. With this reduced -- with this -- we will reduce the workforce by approximately 5,000 people. We saw solid growth in the set-top box business, and to be clear, we remain committed to this segment of the portfolio. We will also be reducing our contract workforce by approximately 1,200 people in Q1.

As we complete this process, we are focused on retaining and attracting talent. Our people, along with our technology, remains core tenants of our success. Through this period, we have continued to attract industry-leading talent in engineering and sales.

Moving forward, we plan to reinvest in our people. As such, we have begun to increase our focus on employee retention and development. This includes total compensation and enhanced professional development programs that we'll be starting this quarter.

From a gross margin perspective, we're continuing to drive improvements through product simplification, aggressive value engineering, maximizing commodity pricing opportunities and enhancing our supply chains. We expect to see ongoing value improvement in component as volume of our new products continues to grow.

Finally, the third area, optimizing our portfolio. As part of our efforts, we have evaluated and taken decisive action on our portfolio. Looking at the portfolio from the perspective of current and future market potential, it is now better aligned to our company priorities and structured to continue to meet and capture market and customer needs. Through this process, we have begun to rightsize our investments across all of our businesses through exiting businesses, reduced investment and reinvestment in our priorities.

From a reinvestment perspective, we have increased our financial commitment in several key areas, including but not limited to our collaboration, data center virtualization, mobile Internet technologies, TelePresence, security, cloud, systems management and video. Reductions in investments were in businesses where we were overinvested in certain non-core aspects of that business. In these situations, we remain committed to the long-term potential but need our investment to better match the market demand in the near and medium term.

As an example, we communicated this week the decision to adjust our investments in our energy business to match the needs of the market by focusing on energy management through standards-based solutions and will no longer be investing in premise energy management devices. As part of these efforts, we're exploring options for our network building mediator and mediator manager product line.

We have already made the decision to either exit or significantly lower our investment in several areas of our product and solutions portfolio that do not support our company priorities. Where material, we have already announced these decisions publicly.

Establishing the right operating model is also critical to managing our portfolio. We have now simplified our organization structure to achieve faster innovation, integrate product roadmaps, reduce costs and streamline the decision-making process. For example, we have made some changes to consolidate disparate engineering groups across the company with the purpose of increasing our focus on strategy and roadmap synergies. Specifically, we have consolidated separate switching, routing and optical groups into one Core Technology Group. We have moved our 4 software groups into one integrated operating system group.

Previously separate, the voice, social networking and WebEx organizations are now consolidated into one communications and collaboration group. And as we announced internally last week, our cable and set-top box video teams, along with the business video groups, are now moving to one aligned video group under a single leader.

The strength and alignment between sales, services and engineering will allow us to collaboratively gather and address customer feedback with the goal of quickly capturing market transitions and regularly assessing and improving our portfolio. The positive impact of this new engineering structure is being amplified across Cisco by reducing complexity for our product sales and services teams and saving valuable time for issue resolution in our technical assistance centers.

Finally, we will continue to pursue our technology strategy to build, partner or buy to ensure we are best positioned to meet customer and market requirements. So what's next? Although we remain well positioned to capture market and technology transitions, we acknowledge that they are accelerating at a faster pace than we have seen historically. This increased pace requires us to move even faster.

As a result, we are continuing on a multiyear journey, with the goal of becoming more nimble and aggressive with sustainable and profitable growth. The changes we have made thus far have put us on the right track but significant opportunity remains. We will continue to assess our portfolio and our business processes, aiming to make it easier for our sales force to focus on the customer and for our customers to deploy our market-leading products and solutions. You can expect us to drive further actions that allow us to address market transitions with greater speed, agility and consistency.

With a focus on operational excellence, we will continuously evolve policy, process and system enhancements for clear decision-making, productivity, accountability and cost savings. Cost savings identified during this journey will be used partially to fund the innovation and development of new capabilities within and across organizations to drive increased shareholder value. We are committed to making the changes necessary to remain the leader in this industry.

At this time, I'd like to turn it over to Frank Calderoni.

Frank Calderoni

Thanks, Gary, and good afternoon, everyone. For today's call, I will first comment on our Q4 fiscal year 2011 financial results, and then I'll provide some additional detail on our full year fiscal 2011 results.

During the quarter, we increased total revenues to $11.2 billion, which is up approximately 3% from the prior year. Total product revenue in the fourth quarter was $8.9 billion, and that grew 1% year-over-year and 3% quarter-over-quarter. Our switching revenue was $3.4 billion, representing a decline of 4% year-over-year and a 4% growth from last quarter.

Routing revenue is down 2% year-over-year to $1.7 billion and down 7% quarter-over-quarter. High-end routing experienced a revenue decline of 3% year-over-year. Orders for both switching and routing were very strong toward the end of the quarter, contributing to our strong book-to-bill for Q4. New products revenue totaled $3.5 billion, an increase of 7% year-over-year and 6% quarter-over-quarter.

Total service revenue was up -- was $2.3 billion, and that was up approximately 12% from the prior year. We experienced strong year-over-year growth of 11% in technical support services and approximately 17% in advanced services.

Looking at our results by geographic segment, total revenue increased across all geographic segments on a year-over-year basis, ranging from up 1% in both the U.S. and Canada and European markets to up 17% in our Asia-Pacific markets, with emerging markets up 3%. Beginning in the first quarter of fiscal 2012, we will report based on the 3 new geographic segments as announced in our press release on May 5. That's namely the Americas, EMEA, Asia Pacific, Japan and China. Geography will continue to be the primary way we run the business.

Our total product book-to-bill for Q4 was comfortably above 1. Our Q4 FY '11 non-GAAP total gross margin was 62.7%, and that's consistent with our expectations and down 1.2 percentage points quarter-over-quarter and down 1.4 percentage points year-over-year.

Non-GAAP product gross margins for the fourth quarter was 61.2%, that was down 1.9 percentage from last quarter. As we discussed last quarter, non-GAAP product gross margins in the third quarter included an approximate 1% benefit from certain nonrecurring items which are not included in this quarter. The remaining decrease as compared to the third quarter was driven by mix, higher manufacturing-related costs, offset by component cost savings. Discounts and pricing were flat as compared to the third quarter.

Excluding the benefit of nonrecurring items in the third quarter, non-GAAP product gross margins has ranged from approximately 61% to 62% over the last 3 quarters. On a year-over-year basis, non-GAAP product gross margin was down 2.4 percentage points, driven by discounts in pricing, mix and offset by cost savings. We saw strength in our non-GAAP service margin of 68.6% attributable to strong margins from both technical support, as well as our Advanced Services business.

As a reminder, we typically experience improved service performance in the fourth quarter due to seasonality driven by support initiations and renewals. Non-GAAP service margins also included some nonrecurring benefit which we do not expect to reoccur in future periods. For total gross margin by geographic segment, please refer to the accompanying slides.

Turning to the expense side. Our fourth quarter non-GAAP operating expense was approximately $4.2 billion, which represented 37.5% of revenue, consistent with our expectations. As we indicated in our July announcement, as a part of our plan to reduce our FY '12 annualized operating expense by $1 billion using Q4 FY '11 as a base, we are expecting to reduce our global workforce by approximately 6,500 employees, which includes approximately 2,100 employees who elected to participate in a voluntary early retirement program.

We indicated that we expected to take pretax charges, aggregating approximately $1.3 billion over several quarters as part of our expense reduction actions. During Q4, we recognized pretax restructuring charges

to our GAAP financial statement of $772 million, of which $728 million was related to our July 2011 announcement. This included $453 million related to the voluntary early retirement program and $204 million related to the employee severance for approximately 2,600 employees in the U.S. and Canada, most of whom will exit in early FY '12.

The remaining Q4 FY '11 restructuring charges are primarily related to a $61 million non-cash charge related to the planned sale of our Juarez, Mexico manufacturing facility. The remaining $44 million of the charges was related to the completion of restructuring actions we've previously announced related to our consumer business. In a moment, when we get to the detail on the guidance for Q1, I will provide additional information on the expected timing with regard to the remaining restructuring charges we expect to incur, which are primarily related to our international operations, which is part of our overall plan.

At the end of Q4, our headcount totaled 71,825, and this was down approximately 1,600 from last quarter as we start to see our baseline cost structure come in line with our goal of reducing our annualized expense run rate by the $1 billion. Our Q4 headcount reflects most of the headcount reductions from our voluntary early retirement program and the consumer restructuring that we announced in Q3.

As I indicated, the remainder of the headcount reductions we announced in July that are related to the reduction of force and the disposition of the Juarez manufacturing facility are not reflected in the Q4 headcount numbers as we expect a certain portion of these employees leaving in Q1.

Non-GAAP operating margin for the quarter was 25.2%, and our non-GAAP net income for the fourth quarter was $2.2 billion, representing a decrease of approximately 12% year-over-year. As a percentage of revenue, non-GAAP net income was 19.6%. GAAP net income for the fourth quarter was $1.2 billion as compared to $1.9 billion in the fourth quarter of fiscal year 2010.

Our non-GAAP tax rate was 22.3% in Q4. Non-GAAP earnings per share on a fully diluted basis was $0.40 per share, representing a decline of 7% on a year-over-year basis. GAAP earnings per share on a fully diluted basis for the quarter were $0.22 per share, reflecting previously discussed restructuring charges, which represent approximately $0.11 on an EPS basis. GAAP earnings per share on a fully diluted basis in the fourth quarter of last year was $0.33 per share.

Moving on to our full fiscal year performance. Total revenue for fiscal year 2011 was $43.2 billion, an increase of 8% over FY '10 revenue of $40 billion. Non-GAAP net income for fiscal year 2011 was $9 billion, down approximately 4% from fiscal 2010, non-GAAP net income of $9.4 billion.

Non-GAAP earnings per share on a fully diluted basis for fiscal year 2011 was $1.62 per share, up slightly from $1.61 in fiscal year 2010. GAAP net income for fiscal year 2011 was $6.5 billion or $1.17 per share on a fully diluted basis compared to $7.8 billion or $1.33 per share on a fully diluted basis in fiscal 2010. This represents year-over-year decreases of 16% and 12%, respectively.

Included in the slides, which are accompanying this call is a full year comparison of our 2011 to 2010 financial results.

Now moving on to the balance sheet. We closed the quarter with a total of cash, cash equivalents and investments of $44.6 billion. That's up $1.2 billion from last quarter, reflecting continued strong operating cash flow of $2.8 billion. Of this balance, $4.8 billion was held within the United States at the end of Q4.

Accounts receivable at the end of Q4 was $4.7 billion, with DSO of 38 days as compared to 37 in the third quarter. We ended the quarter with total inventory of $1.5 billion, with non-GAAP inventory turns of 11.4, which was up 1.1 compared to last quarter. We had inventory purchase commitments of $4.3 billion, which is up approximately 1% or $56 million quarter-over-quarter.

We ended the fourth quarter with total deferred revenue of $12.2 billion, an increase of 10% year-over-year. Of that total, $3.7 billion was deferred product revenue and $8.5 billion was deferred service revenue, representing increases of approximately 1% and 15% year-over-year, respectively.

Product backlog at the end of fiscal year 2011 was $4.3 billion, as compared to $4.1 billion at the end of fiscal 2010. Q4 included share repurchases totaling $1.5 billion or 95 million shares, a dividend payment of $329 million.

Given the strength of our balance sheet and the relative position in the market, if overall market conditions continue to be depressed, you could expect us to be more opportunistic in our repurchase program, especially at these levels.

Now let me provide a few comments on our outlook for the first quarter. 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 these forward-looking statements. The guidance is based on current pipeline and our view of the business trends based upon the information that we have available today, and actual results could be above or below our guidance.

As we mentioned earlier in this call, we will take approximately $1 billion out of our annual expense run rate in FY '12 using Q4 as the base. We have made meaningful progress towards this goal in Q4. We expect operating expenses in Q1 FY '12 to be approximately $150 million lower than Q4 or $600 million on an annual run rate basis. In connection with these actions, we have previously communicated that we will recognize total pretax restructuring charges to our GAAP financial results in an amount not to exceed $1.3 billion over several quarters. As I mentioned earlier, we recognize approximately $728 million during the fourth quarter of fiscal 2011, relating to the expense reduction actions as part of the July 2012 announcement.

In Q1 FY '12, we expect additional pretax charges to our GAAP financial results of up to $300 million. The remaining balance of the $1.3 billion in charges is expected to be recognized during the remainder of fiscal 2012.

As has been standing practice for sometime, we are continuing to provide detailed quarterly guidance one quarter at a time. In light of the uncertainty in the macro environment, we encourage you to continue to model conservatively. It is important that expectations do not get ahead of where the market is today.

The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP. For Q1 FY '12, we expect revenue growth to be in the range of 1% to 4% on a year-over-year basis. As we have said in the past, forecasting gross margin has always been challenging due to various factors such as volume, product mix, cost savings and competitive pricing pressures.

For the first quarter, we anticipate non-GAAP gross margin to be approximately in the range of 61% to 61.5%. Our gross margins in Q1 will be impacted by a few one-time items, including higher component costs related to the Japanese earthquake and several large transactions in Asia. We will be talking further about our longer-term gross margin profile at our Financial Analyst Conference. We do remain focused on maintaining strong gross margins, which of course, is very hard to forecast, due to the mix of our business.

However, currently, we do see a near-term significant -- we do not see a near-term significant shift in our overall gross margin profile from what we have guided for the Q1 gross margin. We believe our gross margin management efforts, including continued value engineering in our mature markets and new design process improvements will help balance some of the margin pressures.

Our non-GAAP operating margin in Q1 is expected to be in the range of 24% to 25%, and our non-GAAP tax provision rate will be approximately 22% in the quarter. Our Q1 FY '12 non-GAAP earnings per share is expected to range from $0.38 to $0.41 per share, and we anticipate our GAAP earnings in Q1 will be $0.10 to $0.14 per share lower than our non-GAAP EPS. This range, including our typical differences, as well as an impact of $0.03 to $0.05 as a result of our anticipated restructuring charges related to our expense reduction action. I'd ask you to please see the slides that accompany this website for some more detail.

Other than those quantified 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. As a reminder, Cisco will not comment on its financial guidance during the quarter, unless it is done through an explicit public disclosure. With that, let me turn the call back over to John.

John Chambers

Frank, thank you very much. Summary comments from my end and then to the Q&A session. Moving forward, we would like to give you some perspective on Q1 and our momentum going into fiscal year '12. We believe our broad portfolio positions us well for growth in fiscal year '12. Our networking peers have recently found themselves in similarly challenging transitions. We have always used these market conditions to make bold and tough decisions and then execute it in a way that further extended our lead versus our peers.

Our clear goal is to do this once again. We have already made and implemented many of the decisions to achieve our next phase of growth in the next 3 to 5 years, and the creation of value for our shareholders. You will now see us move aggressively to pull away from more competitors as they adjust to these market challenges. Having already made these changes well ahead of our competition, this is also a competitive advantage for us.

While it'd be easy to say that this is a broad industry challenge and, therefore, only make the changes we have outlined so far, that is clearly not what we will do. We will achieve a better balance of our entrepreneurial and operational capabilities. We'll also move aggressively to create value for our shareholders, customers, partners and employees.

In simple terms, you will find us to be a very focused, agile, lean and aggressive company this next year. We do not underestimate the transitions in front of us or the importance to rapidly simplify our organization to deal with the many challenges facing us, especially in switching public sector and now the global financial concerns.

As we have shown by our tough and bold decisions last quarter, we are committed to a leadership team to make the required fundamental changes to our operating model. We clearly intend to use these market inflection points to position Cisco to lead. I have always believed that our strategy starts and stops with customers and our partners that serve them. As you would expect in the last quarter, I've talked to hundreds of customers and top partners in individual meetings. While I thought and hope that they would stay committed to Cisco during our transition, I found that, without exception, although I'm sure there are some out there, that not only are they remaining committed to Cisco, because of our unique value we bring them, but they also want and expect us to win. This is clearly what we are going to do now.

To summarize this simply, our entire company is ready to accelerate. Our employees are ready for this change, and they know what an energized Cisco is capable of achieving. Throughout our history, Cisco has adopted and evolved to meet both challenges and opportunities. This time is no different in terms of results, although we will clearly do it in a different, more simplified and accountable way that we have done before. Make no mistake about it, all the efforts we're putting in place are focused on driving shareholder value while continuing to stay focused on the success of our customers, employees and partners.

I want to thank our shareholders, employees, customers and partners as we transition to the reinvigorated Cisco, the aggressive, focused and simplified Cisco you've come to expect over the years.

Terry, I'll turn it over to you for the Q&A.

Terry Anderson

Thank you, John. So yes, we'll now open the floor to Q&A. As a reminder, we do request that sell-side analysts please ask only one question. With that, operator, please open the floor to questions.

Question-and-Answer Session


[Operator Instructions] Our first question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski - Goldman Sachs Group Inc.

John, I think you gave a number of statistics on the quarter including orders up 11% and backlog up 5% and deferred revenue up 10% year-on-year. You're obviously guiding a lot below that, at about 2.5% of the midpoint, which assumes a significant slowdown in your orders in the October quarter. So can you just be a bit more explicit about what you are assuming about the October quarter, both in terms of your own business such as the distractions you talked about with the reorganizations and also in terms of the macro focusing in particular on some of the new concerns from the last couple of weeks?

John Chambers

Okay, a couple of thoughts. First is Q1 is a real tough comparative quarter because in Q1 of last year, our product orders were already up 10%, and our product revenues were up 20% and total revenues up 19%. So when you look year-over-year on that, it's very tough, Simona, to balance the 2. So I would not infer at all that we're signaling a disproportionate change in order rates. We do think that you will see a slowdown due to the changes we made and we've put that into our model. Our sales team, and I want to congratulate Rob, has been remarkably accurate over the last 120 days on both as a team and in total on their projections. So we're modeling in a little bit of conservativeness on the macro issue but actually, I think many of the things that you actually said in your notes, you were remarkably accurate on in terms of our plans and thoughts. Nice way of saying -- No. I think we would expect orders to grow faster than revenues in Q1, just as we said in Q4.


Our next question comes from Nikos Theodosopoulos with UBS.

Nikos Theodosopoulos - UBS Investment Bank

I wanted to ask about orders as well. You mentioned -- well, given the backlog numbers you gave for the year end, it looked like orders grew about 7% to 8% for the entire fiscal year. Can you give some color on that? And what would have that been without public sector for the year if you have that? And if you can elaborate also, John, on orders. You mentioned in your commentary that orders picked up late in the quarter, and I'm trying to understand what led to that given the macro issues? Did you have some sales force incentives? Or was that just the sign the market is stronger than the stock market's reading?

John Chambers

Okay. In the sequence that you talked about, in terms of year-over-year product bookings, it was about 8% year-over-year in fiscal year '11, 11% in the fourth quarter. In terms of the quarter orders, it wasn't me but one of our team absolutely did say that we had a good July and we did. But the orders were pretty consistent throughout the 3 months following into our normal order pattern. May was a little bit strong. June was okay, and July was a little bit strong. So each of the quarters had good year-over-year growth but we finished with a very strong July. We always have sales in cities [ph] on Q4 because people making their goals are looking at how they come in to extra money by getting the orders in, et cetera, and this quarter was no different from that perspective. In terms of the public sector effect, I don't have that number. I might be able to kind of look at it as we work through this but I might have to, Nikos, answer that question another time.

Terry Anderson

We can follow up.


Our next question comes from John Slack with Citigroup.

John Slack - Citigroup Inc

I was wondering if you could talk about what's going on in routing, maybe down 3% on the high end, entire routing was down 2%. Maybe if you could kind of dive into your view on service provider CapEx, I know some of your competitors have commented that, "We're having a more linear CapEx environment this year." Any sort of color you can give us around that will be appreciated.

John Chambers

Sure. We saw our strongest quarter by far and away in service providers this last quarter. We saw the growth consistent in almost all major geographies, total growth 19% on new orders, growth in the U.S. to 15% in terms of the orders. Routing was, in terms of booking, very, very strong. Areas like our CRS had the strongest growth that we've seen in a long time, 65% year-over-year. Movement into areas such as the ASR 9000, and since we got some of the features that we needed for certain parts of the world, saw 156% increase in terms of orders. The 1000 saw a 40% increase in terms of the orders. And no, we saw service provider spending in this most recent quarter very, very solid. Now the second part of your question. Many of the service providers have different goals in terms of their revenue growth with the capital expense growth. If you're in areas where they're growing; i.e. mobile; i.e. video, especially entertainment; i.e. cloud where they're providing services and capabilities to the customers; and if you're a company that can help bring customers to their service providers, you're getting a lot of the opportunity that some of our peers may not be experiencing. So I think our win rate was up dramatically versus our peers, and you saw us take on some of our toughest Asia competitors right in their home countries. And as you expect, there's going to be a little bit of discounting to win those deals. But we're doing very well in every major geography. And service provider trends on CapEx, I think, like AT&T said this in the last month or so is they actually increased their expenditures for the second half of the year. So we did not see that nor did we see any major effect in service providers even in countries like Japan where we saw 13% growth year-over-year.


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

Tal Liani - BofA Merrill Lynch

First, congrats. Finally, we see some stabilization. I wanted to ask you about public spending and try to dig deeper into public spending. One angle is if you can discuss the components of public spending. You have federal and state and Europe, but there is also a bigger part or big part which is none of the above, and if you can discuss the components and maybe a little bit the trends. And second related to that is, this is still the end of the fiscal year. June was the end of the fiscal state year, and September is the end of the September year and these are still budgeted projects, which means the real weakness can only start next year so -- or the following year. How do you bake into your estimates or your expectations what could happen in public over the next few quarters?

John Chambers

Okay. First the good news is the year-over-year comparison start to get more favorable in a couple of quarters. Secondly, for whatever reason, Tal, as you know, we tend to see changes 2 to 4 quarters ahead of our peers. I used to say I'm not sure if that's good or bad, I don't like it. It's clearly a challenge for us, but it does allow you to change once you see it. We saw the -- to answer your question in a little bit more detail, the state and local government, as an example, in the U.S. We began to see the weaknesses as we've said during Q2, first in state and local government and connected the dots, and we thought it was going to increase in terms of the challenges in state and local government, which it did, and then it would logically flow on to the federal side of the house. If you look at how those orders have occurred in the last 2 quarters, as we said this quarter, federal was down 18% in Q3, a quarter ago, it was down 21%. In terms of state and local, it was down 2% this quarter, down 8% in terms of the quarter before that. The programs actually -- many of them are getting cut. And you're seeing people make very tough decisions in terms of the budget and direction. Even e-rates, you're seeing questions about do the schools, do you spend money on networking, which is clearly your capability to wire your schools differently and get almost a 4:1 assist from the federal government? Or do you put that 20% -- 28% into teacher salaries? And so there are trade-offs going. You're seeing this pressure on a global basis, every major country's going through it. Unfortunately, the minute, using the state and local as an example starts to come back a little bit, we see other aspects in federal or we see other aspects and other governments around the world. I think we're going to be in a couple more quarters in terms of the direction. We do not have the large projects that many of our peers have that are locked in and have to continue so they probably will feel the effects of it further out in future quarters in terms of the direction.


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

Mark Sue - RBC Capital Markets, LLC

John, when does all this restructuring end and what does the baseline financial model look like when you're finished? Can you also ensure us that kind of gross margins, for example, won't fall below 60%? And then maybe just separately, what else do you need to get comfortable with the before increasing the dividend, assuming what it looks like no tax relief from the government?

Terry Anderson

Mark, just a reminder, we're going to stick to one question each. Maybe perhaps try the first one, John?

John Chambers

So in terms of the gross margins overall, as you would expect us, we've done a lot of heavy lifting on value engineering. We are paying both our engineering leads and our sales leads on total profit, including gross margin goals. Clear ownership of each gross margin in each product category, and we're coming at it in all aspects from supply chain, as Gary said earlier, to regular in-depth reviews with a great deal of focus in terms of the direction. In terms of the challenges, the better we do with UCS, it was about 1% decrease in gross margins this quarter. It does put pressure on the gross margins. What we're looking at and what Frank alluded to very directly is, we're using Q1 as kind of a baseline that we don't see dramatic changes on for the short-term future in terms of the direction. Our gross margins on our larger products might go up or down in any given quarter but they're often balanced in terms of our new products improving on their gross margins in terms of directions overall. So I know that didn't answer all 4 of your questions. I went to the one that you are probably most interested in which is the gross margins, our focus on that and our ability to -- if I would've told you a year ago, switching was only going to be down 1.4% over the year, you'd probably said unlikely. Yet we've made a great deal of progress in all of our switching products in terms of improving gross margins. We'll do the same thing in routing and we'll do the same thing in terms of our data center products as we move forward, Mark.

Frank Calderoni

And Mark, as I had mentioned earlier, we'll be talking more about our longer-term gross margin profile at the Financial Analyst Conference coming up in September and also address a little bit more about the question you had about the financial profile.


Our next question comes from Brian Modoff with Deutsche Bank.

Brian Modoff - Deutsche Bank AG

John, so do you see the gross margin starting to stabilize? I think it's been trending down for the last several quarters. And if not, where do you see that stabilization occurring? And do you -- have you seen any effect from as you sit [ph] the terabit upgrade to your 6k Switch platform in terms of helping maintain share in that installed base? And what are the effects of that recent upgrade?

John Chambers

Yes. If you think about it Brian, this is probably the hardest one to forecast transition. It makes forecasting revenues look easy because as you've got a bunch of mixes going on and pressure occurring. I'm going to piggyback a little bit on the answer that I gave, I think it was Mark earlier, that if you use switching as an example, when we were first hit by the competition in switching, we were playing defense and learning how to teach respond to a just good-enough-type of approach. As you've seen, we've done, what I would call, pretty good job over the last 2 quarters both on stabilizing margins in the switching group, focused on the group as a whole and done this without any meaningful loss the last couple of quarters in port share or revenue, in fact, actually might be gaining in port share in terms of the direction. It's a hard one to forecast out 1 to 2 years but to answer your indirect part of your question, we do not see a major falling off the cliff type scenario on margins. Most of our margins will go up and down on the quarter. For example, next quarter you will see a little bit of pressure on routing margins because we got some pretty big deals in China. But overall, if you look at our total contribution, we're very comfortable with the growth there and keeping the margins within a reasonable pace on direction. Do you have anything else to add, Frank?

Frank Calderoni

John, what I would -- I mention this earlier in the prepared remarks but if you look at excluding the benefits, some of the nonrecurring items that we had in the third quarter, the non-GAAP product gross margins have ranged in the last 3 quarters in that 61% to 62%. So although we've always had a lot of variations or mix dynamics within, they've been pretty much in that range, which I think is good as it relates to how we're carrying that forward.

John Chambers

Make no mistake about it. Everyone in the company is focused on margins and with specific responsibility for the areas of responsibility that they control.


Our next question comes from Rod Hall with JP Morgan.

Rod Hall - JP Morgan Chase & Co

I just wanted to know on the enterprise and commercial growth rates you gave in orders, they actually accelerated, for both of them, in this quarter over last quarter. I wonder if you could comment in a little bit more detail on what drove that? I mean, were there particular incentive programs you put in place? Are there particular products that are doing exceptionally well? Just give us some idea what's driving that growth. And then I just wanted to clarify your comments on public sector spending, and ask if there are any areas where the public sector's actually spending more on technology to save money? So those are my questions.

John Chambers

Okay, I'll combine them both and Terry won't let me do it again in terms of the growth. What we're learning to do in the enterprise and commercial is do a much better job of selling the whole solution. We start with the business fundamentals the customer is trying to solve on their -- it doesn't matter how they interface to their customers or how they bring their expertise to innovate faster or productivity. And then we often lead with the new products, i.e. video or collaboration or the data center, to achieve those goals. And it does pull along usually well in excess of 2x the core routing and switching with it. So that's one of the fundamental changes. When we've done this in scale, and I would say, Brian and Allison have done it in the U.S. enterprise and commercial market, there weren't any abnormal incentives on that but they did it very effectively with discipline across all of their sales reps, and you saw a ramp-up and a win rate that was very high. We clearly intend to take those type of processes globally in terms of the touch in direction and to feed the engine that's growing most rapidly. I would watch the enterprise and commercial growth. We think, it will grow, be the most predictable and grow very well in terms of during normal economic times. And if we were to see surprises there, moving from double digits as an example or midteens as an example, then that would be an indication in capital spending that would cause us alarm. But no, you were absolutely right that in enterprise and commercial, especially in the U.S., where we have a little bit more focused discipline on this and we're going to take it globally, the growth was very sustainable, and our value to the customers, they often view us as if they're #1 IT partner. In terms of growth in public sector, there is a lot of opportunity on cloud. We're seeing our cloud opportunities double almost every month in terms of opportunities within the government but especially here in the U.S. You're seeing a lot of emphasis in terms of how do you save on travel, so you see areas like the video playing a key role and we're clearly going to focus on that in terms of direction. And so we'll move where they'll be spending their money, but those will be 2 of the areas that come to mind, Rod.


Our next question comes from Ehud Gelblum with Morgan Stanley.

Ehud Gelblum - Morgan Stanley

The question has to do on gross margin on the products versus the services business, John. Your product revenues were up sequentially. Gross profit dollars, I think, were down and services was up but gross profit dollars were up higher because your gross margin there went up higher. So I just wanted to probe a little bit deeper into the dynamics going on between the gross margin on the product side. And is that based mostly on mix and should we see that come back up again? Or why was the discrepancy that you seem to be making much more profitability in the services right now than on the product? And related to that, last quarter, you gave some comments on whether the Nexus 7000 gross margins were relative to your 6500 and said it was about an 18% difference. Can you give us an update on, is that closing the gap? Is it getting up into the high 60s where your 6500 is or higher? And is that having to do with the gross margin product?

John Chambers

Why don't, Gary, you or Frank take the first part of the question, and then I'll weave the second part into one of the other questions. And let Frank...

Frank Calderoni

So let me -- just starting back, just give you a little bit of color on the gross margins for Q4. I assume you're asking Q3 to Q4. So I'll start with the product gross margins and then kind of go into talk about the services, which is part of your question. So from a product gross margin standpoint, we did see the margins come down about 2 points quarter-on-quarter. Now as you recall, and I mentioned this earlier, we did have some nonrecurring benefits that we had in Q3, specifically as it relates to some warranty and the legal settlements that benefited the margin last quarter that does not reoccur this quarter. So one of those points of decline related to that. The second part of the other point was a combination of some mix as far as looking at some of our lower-margin products like UCS and some of our set-top box that had strong quarters, that had a negative impact on the margin. And then we also had some manufacturing-related costs. One of the key things which I wanted to stress which I mentioned earlier, when you look at anything I said here or even the comparison to Q3 to Q4, is our pricing was pretty flat quarter-on-quarter when you start looking at pricing and rebates. So I think that was a major trend that we just kind of saw from one quarter. So that's kind of positioning where we are on the product side. On the services side, clearly, we had improvements. In margin, we went from 67% to 68.6% quarter-on-quarter or an improvement of 1.6%, which then had a positive impact overall for the company. As I mentioned, we have -- this is the end of the fiscal year, it's one of the quarters where we have a lot of services activity and renewals that go on, that does tend to help our margin profile in the quarter, some of which is recurring, some of which is not that we take into consideration when we set the guidance for next quarter. But overall, I would say very good profile within our services business. So when you look at both on the technical side, which is where we tend to have the best margins. But even on the advisory services, there was some good results there as well.

Gary Moore

A lot more volume, a lot more volume on the advisory.

John Chambers

Real quick answer on the side of the 7k, we're improving by about 1 point, 1.5 points per quarter. We need to do better in that.


Our next question comes from Simon Leopold with Morgan Keegan.

Simon Leopold - Morgan Keegan & Company, Inc.

One quick clarification and then a question. Clarification, I think I missed if Frank had any commentary on the expected share count. And then in terms of question, I wanted to get a better understanding of operating expenses, particularly looking at this fourth quarter, we're using this as the baseline for cost cutting so it's an important number. And it was a bit higher and certainly up sequentially from the trend that you had in April and January and year-over-year. So I'd like to try to understand what were the elements increasing July operating expenses versus the April quarter? And how we should think about that in terms of as we build out the quarters in 2012?

Frank Calderoni

Of course, so let me take that on the OpEx side first. So you had the headcount actually increasing that we've been working throughout the year, and that has actually, when you look at the ramp of where the headcount had been coming on in Q3, we had some additions that came on in Q3 which then increased the overall cost or the expense in Q4, that was the driver. Of course, now that's changing. As we move into FY '12, I'll come back to that. We had several other unique items that tend to be more seasonal toward the end of the year. We had some engineering projects that we're closing in on Q4, and we had certain events on the marketing side with our Cisco Live and various efforts like that, that drove higher costs. We had some other value engineering projects that we worked through this quarter, I'm just giving you kind of some deltas quarter-on-quarter. Of course, that's going to provide some benefit as we look at margins. We talked about that already going forward with some of the efforts that we have underway. And then we also have some other currency that was a factor from a quarter-on-quarter standpoint, and we look at our expenses from a dollar standpoint, and as the dollar, if you look at it, actually weakened quarter-on-quarter that drove an item there. So all those variances were pretty well established in the quarter, driving that growth on a year-on-year basis. Yes, that is the baseline that we had talked about going forward. I mentioned in the guidance for Q1 that we expect to take that down $150 million as it relates to Q1, and then we'll continue to see a reduction on that expense going forward in Q2 and Q3 as we continue to see some of the other reductions from a resource standpoint taking place in our non-U.S. geographies. So we talked about $1 billion, we'll have $600 million on a run rate basis after Q1, and then we'll have further improvement in Q2 and Q3. We expect, right now, based on the modeling that we're doing, that we'll get to the run rate in that Q3, early Q4 timeframe and we'll continue to make that progress. But we feel fairly comfortable that we're well underway from that standpoint.

John Chambers

We're actually a little bit ahead of schedule. On the share count, we might handle that a little bit later.


Our next question comes from Jason Ader with William Blair.

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

I just wanted -- I wondered if I missed that you mentioned the wireless security and video connected home and the new products? That was just a quick clarification. And then John, a question for you. If we're entering a period of macro weakness and I'm not saying we are, but if we are, why are you more confident that you'll come out of this current period stronger than you did the last one?

John Chambers

Got you. So questions in terms of key product areas. I'm trying to see where wireless was. I know it had a good quarter. I'm trying to find out where it was in terms of the direction. I'm going to shoot from the hip if I don't see the number. It was up 26% in terms of bookings and about 33% in terms of revenue. In terms of the connected home, you are seeing us largely move out from that scenario. We'll continue to stay focused with Linksys in terms of key product area. We'll improve the gross margins on Linksys and the growth rates, and I think Martin will do a good job on that. Let me also answer your indirect question. A couple of areas that people had questions on about are we going to stay involved in? Let me say very explicitly. Areas like WebEx. Collaboration will be an architectural sale. It will combine Quad, WebEx, TelePresence, any device to any content over any combination of the networks, and that's why it was so important to have Medianet now go across all of our enterprise customers in terms of the direction. WebEx, we left it a part too long. We brought it in at the beginning of this last fiscal year, and you saw it move from negative growth to mid-20s in Q2 and Q3 and Q4 actually grew at 60%. In terms of set-top boxes, we are very much committed to this marketplace. You will see us move, however, from traditional set-top boxes to IP set-top boxes to Videoscape. Receptivity, so far, has been very, very good in terms of that direction, and you actually saw our Scientific Atlanta group grow about 10% in orders and 11% in terms of revenues this year. In terms of Smart Grid, it's a market that we think has tremendous opportunities. You're seeing growth year-over-year in the hundreds of percent, and we've won a large number of the jump balls around the world from Russia to Australia to Canada to here in the U.S. It's a market that we think plays right into our sweet spot, and we're doing it with open standards, have very good confidence in that direction. In terms of what gives me confidence on it, I might close with that question once we get 2 more questions, so I would do that in terms. Terry, if you could give me a couple more questions then I'll close with that last scenario.

Terry Anderson

Great, okay. Actually, we'll queue the last question here, and you can perhaps wrap with that, John. Last question please.


Brian Marshall with Gleacher & Company.

Brian Marshall - Gleacher & Company, Inc.

When I calculate the pro forma OpEx savings as well as the reduction in COGS from the fab transfer and when I do that, I get well over $1 billion. So I guess the question becomes, is that math accurate? And are we getting the benefits of that incremental number above $1 billion basically in the form of reinvestment in the 5 core focus areas? And if that's so, can you give us a little bit of details on that?

John Chambers

The answer is you have -- absolutely have that read right. We've clearly cut deeper. So we get back, reinvest. We reinvest in engineering by a couple of hundred million as an example. You also saw us cut deeper because we're watching currency issues, and we clearly have to cut deeper because, next year, assuming that we hit our plan and we are going to do that, we have to pay bonuses to our employees, which we didn't have as much of this year. So those had to be covered in terms of our cutting into the fabric. So let me answer the prior question. It's a good one to wrap it up with. What makes us confident? If you watch what is occurring, we position, I think, ourselves very well to lead as the role of the network and intelligent networks plays a much more strategic role in service providers, enterprise commercial customers and even in the public sector. In terms of why we're confident, the more we put focus on our customers, the faster we have grown. And candidly, we've taken it to our competitors pretty good this last quarter, even with all the media being brutal on us. We clearly won the majority of jump balls, and you can see us continue to do that, both with our traditional router competitors, which we will pick up a lot of share on this next quarter but also with some of the large data center players, who are into the switching segment, they clearly have not taken hardly any market share from us in the last year, if at all. And we're taking an awful lot of share in terms of the data centers. So we're going to be aggressive in terms of the competition and aggressive on recruiting the people. In terms of the role of the network, we had been the leader in these 5 key primary areas, and they are difficult to combine together. The architectural play is working. No one else is really approaching it that way in terms of the direction. We have the clear leadership position in almost every category starting with each customer segment at the enterprise, service provider, commercial and public sector. Each of the 3 regions we're leading in clearly. You begin to bring that down to the top 10 countries, all of them experienced growth in the double digits in orders except U.S., which was 9%. You bring it down to emerging markets, the top BRICs plus Mexico grew an average of 25% year-over-year both in terms of bookings and revenues this year. And as we realign our regions to give more resources to the other emerging countries, then we'll focus about how we take them up from what's a 5% or 6% growth, more to what we've been able to experience in our targeted emerging markets. In terms of the product families, we're leading in routing by a long way, and that lead is actually going to expand. In terms of switching, I think we've probably seen the toughest part of switching and you always want to be careful saying that with all the appropriate caveats but both in terms of gross margin pressure and price pressure and competitors, I think we've weathered that storm pretty well, and now we need to focus in some of the areas without losing momentum there. In terms of the areas of the future, the cloud, we're remarkably well positioned. TelePresence has just changed it to whole new video architecture. You look at creating value for our customers, very solid. We're #1 customer satisfaction in both services and overall. And we just reorganized Cisco really to focus on simplification, which means we're going to drive innovation, we're going to drive out cost and productivity better. So while I wish we had never had to go through this, it clearly was time for a fundamental change at Cisco, and even though our peers are now experiencing the challenges we saw 2 to 3 quarters ahead of time, we're not going to not only not slow down, we're actually going to accelerate and go after it. I feel very confident about Q1 in terms of what we can control and influence, and we have built some conservatism into it as you would fully expect us to do. So with that, Terry, let me turn it back over to you.

Terry Anderson

Great. Thank you. So in closing, Cisco's next quarterly conference call, which will reflect our full or excuse me, our first fiscal quarter 2012 results, will be on Wednesday, November 9, 2011, at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. Cisco will be hosting our annual Financial Analyst Conference on Tuesday, September 13, 2011, in San Jose, and we'll also be providing a live webcast. Additionally, downloadable Q4 and 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 at 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 FD, Cisco plans to retain its long-standing policy to not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. Please call the Investor Relations department with any follow-up questions from this call. Thank you for your participation and your continued support, and this concludes our call.


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