Cisco Systems (CSCO) Charles Robbins on Q3 2016 Results - Earnings Call Transcript

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Cisco Systems, Inc. (NASDAQ:CSCO) Q3 2016 Earnings Conference Call May 18, 2016 4:30 PM ET


Marilyn Mora - Director, Global IR

Charles Robbins - Director & CEO

Kelly Kramer - EVP & CFO


Simona Jankowski - Goldman Sachs

Ittai Kidron - Oppenheimer & Company

Vijay Bhagavath - Deutsche Bank

Steve Milunovich - UBS

James Suva - Citigroup

Pierre Ferragu - Sanford Bernstein

Brent Bracelin - Pacific Crest Securities

Mark Moskowitz - Barclays

James Faucette - Morgan Stanley

Paul Silverstein - Cowen & Company

Tal Liani - Bank of America

Simon Leopold - Raymond James

Brian White - Drexel Hamilton


Welcome to Cisco Systems' Third Quarter and Fiscal Year 2016 Financial Results Conference Call. At the request of Cisco Systems, today's call is being recorded. If you have any objections, you may disconnect.

Now I would like to introduce Marilyn Mora, Head of Investor Relations. Ma'am, you may begin.

Marilyn Mora

Thanks, Kim. Welcome, everyone, to Cisco's third quarter fiscal 2016 quarterly conference call. This is Marilyn Mora, Head of Investor Relations. And I am joined by Chuck Robbins, our CEO, and Kelly Kramer, our CFO.

By now, you should have seen our earnings press release. A corresponding webcast with slides, including supplemental information, will be available on our website in the Investor Relations section following the call. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements, and other financial information can also be found on the Financial Information section of our Investor Relations website.

Throughout this call, we will be referencing both GAAP and non-GAAP financial results, and we'll discuss product results in terms of revenue and geographic and customer results in terms of product orders unless stated otherwise. All comparisons throughout this call will be on a year-over-year basis unless stated otherwise.

The matters we will be discussing today include forward-looking statements, including the guidance we will be providing for the third quarter. They are subject to the risks and uncertainties that we will discuss in detail in our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. With respect to guidance, please also see the slides and press release that accompany this call for further details.

As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

As a reminder in Q2, on November 20 we completed the sale of the Customer Premises Equipment portion of our SP Video Connected Devices business and accordingly had no revenue or expense from that business in Q3 fiscal 2016. As such, all of the revenue, non-GAAP, and product orders information we will be discussing is normalized to exclude the SP Video CPE business from our historical results. We have provided historical financial information for the SP Video CPE business in the slides that accompany this call and on our website to help to understand these impacts. As a reminder, the guidance we provided during our Q2 earnings call and today's call has been normalized in the same way.

With that, I'd like to go ahead and turn it over to Chuck.

Charles Robbins

Thank you Marilyn, we delivered strong Q3 results against the backdrop of the Macro environment that continues to be uncertain. Despite this uncertainty we executed very well, with revenue growth of 3% and non-GAAP EPS growth of 6%. We continued to generate strong operating cash flow of over $3 billion in the quarter returning nearly $2 billion to shareholders through dividends and share repurchases.

Our commitment to operating discipline continues to yield solid results in spite of the challenging environment. The operational changes we continued to make will further enable our customers to leverage strategic role to network as they transform their businesses to become digital. As I did last quarter I would like to highlight our momentum in four key areas.

First in Security, we saw continued acceleration in the third quarter with revenue growth of 17% while deferred revenue grew 31% driven by our ongoing shift from hardware to more software and subscription services. Our security business is tracking as we indicated it would earlier in the year.

As one of the largest IT security vendors, we believe our portfolio is the most comprehensive and effective and enabling our customers to protect their businesses. Security is and will remain one of our absolute highest priorities.

Second, collaboration. Revenue accelerated by 10% and deferred revenue here grew 16%. This is yet another example of a successful transition to a cloud based platform increasing our market leadership which we expect will give us sustainable long term differentiation.

Third, our next generation data center portfolio is extremely well positioned to meet our customers need regardless of where they place their workloads enabling public, private or hybrid cloud deployments. At our partner summit, we received a very strong response to innovations as customers adopt our next generation data center solution.

Our strong position is evident in our installed base of 52,000 UCS customers and the continued success of our ACI portfolio. In March, we announced a dramatic improvement in price performance and by this I mean 100 gig performances for 40 gig pricing driven by new A6 which provide us a time to market advantage of 18 to 24 months while maintaining the same margin profile.

In Q3 our ACI platform grew revenue approximately 100% while it exceeded a $2 billion annualized run-rate far outpacing our next closest competitor in both size of business and growth rate. Our entry into the hyper converged market with HyperFlex, as well as our acquisition of CliQr, an innovation in multi-cloud orchestration extends our leadership position in the data center.

Finally, we continue to make great progress in transitioning more of our revenue to recurring with increased emphasis on software and subscription offers. Our software subscription deferred revenue balance continues to exhibit accelerated growth this quarter up 36%. We have a number of strong proof points of how we have executed successfully against our objective and the potential to apply the same model to the rest of our portfolio.

In addition to the success I have highlighted in our security and collaboration businesses, we had double-digit revenue growth again this quarter in Meraki which stands out as an excellent example of how we begun to scale our enterprise networking into a subscription mode. As I look to the future, you will see us expand the approach we have taken with the success of Meraki, collaboration and security and apply it to our data center and core networking for both enterprise and service providers.

Our $180 billion of installed base with by far the most widely adopted operating systems for networking, makes us uniquely positioned to lead this migration. While the overall macro environment remains uncertain, we are nicely positioned to benefit from any rebound in the global economy. At the same time, we will continue to manage our business to capitalize on the key growth areas in front of us.

I am very pleased with our demonstrated ability to execute operationally and strategically in virtually any environment. Now I will turn it over to Kelly to walk through more details on our financials.

Kelly Kramer

Thanks, Chuck. I am pleased with our continued execution on our financial strategy of delivering profitable growth, managing our portfolio and strategic investments and delivering shareholder value. Starting with delivering profitable growth. Total revenue was $12 billion up 3% with growth in product revenue of 1% and services of 11%.

We did have an extra week in Q3 consistent with our guidance of the quarter the benefit to revenue was approximately $265 million, $200 million of which was from our services, subscription businesses and $65 million from our SaaS businesses like WebEx as well as from our product distribution. In switching as Chuck mentioned, we continued to see good momentum with ACI and the next generation data center.

The 3% decline in switching was mostly driven by macro related weakness in our campus business offset by positive growth in our data center switching. Routing experience 5% decline mostly driven by the high-end. We are seeing continued strength with our web scale customers where our core development continued and our sales to the top 10 web scale customers was up 31%.

Collaboration grew 10% by strength across the entire portfolio and deferred revenue grew 16%. WebEx continued its double digit growth with solid performance in Telepresence and Unified Communications driven by our new offerings in those areas. Data center grew 1% with the slower growth largely driven by continued macro challenges impacting customer spend. We expect that our HyperFlex offering will further expand our growth opportunities in the data center.

Wireless grew 1% led by strong double digit growth in our cloud based Meraki platform partially offset by declines in our controller and access point businesses. Security grew 17% along with continued strong deferred revenue growth of 31%. We had great performance in our advanced threat security and web security solution which grew over a 100% and 50% respectively.

SP Video grew 18% with ongoing strength in China. Services revenue grew a very solid 11% which includes the $200 million for the extra week I mentioned. Normalized for the extra week the growth was 4%. We again saw very good progress against our goals of driving more recurring revenue. Deferred revenue had solid growth of 8% with product deferred revenue of 9% and service of 7%.

The portion of our product deferred revenue relating to our recurring software and subscription business grew 36%. From an orders perspective, product order grew 3% with a book-to-bill comfortably above 1. Looking at our geographies which is the primary we run our business, Americas grew 4%, EMEA was up 2% and APJC grew 1%.

Total emerging markets grew 4% with the BRICs plus Mexico showing strength at up 4%, with China up 22% and India up 18%. Brazil and Russia continue to be challenging now combine representing less than 2% of our total product booking. In terms of customer segment enterprise declined 2% and commercial grew 8%. Public sector grew 6% and service provider was 4% flat. Similar to Q2 we are seeing pressure in the enterprise segment driven by the macro uncertainty.

We drove strong profitability this quarter especially with gross margins. From a non-GAAP perspective, gross margins was 65.2% with product gross margins of 64.5% and service gross margin of 67.1%. Operating expenses were 35.2% of revenue and operating margin was 30%. The total impact of the extra week on our non-GAAP cost of sales and operating expenses was $150 million.

We are being very disciplined in this tough macro and pricing environment focused on making the right investments while driving operational efficiencies and productivity. From a bottom line perspective we delivered non-GAAP EPS of $0.57 up 6% while GAAP EPS was $0.46. Q3 non-GAAP income was $2.9 billion up 4% while GAAP net income was $2.3 billion.

We have been very active from and M&A perspective closing five acquisition in Q3. Jasper Technologies making Cisco the largest cloud based IOT service platform helping enterprises and service providers launch, manage and monetize IOT services on a global scale. Acano which provides on premise and cloud based video infrastructure and collaboration software.

Synata which enables us to deliver search capabilities for collaboration cloud applications, Leaba a fabless semiconductor company and CliQr which defines an application defined cloud orchestration platform which is expected to help Cisco customers simplify and accelerate their private, public and hybrid cloud deployment.

These acquisitions are clearly focused on our key growth areas including IOT, software cloud and collaboration as well as continuing to strengthen our core. We have also seen solid momentum with our Ericsson partnership closing 17 deals this quarter. Moving on to shareholder value, in Q3 we delivered operating cash flow of $3.1 billion. Total cash, cash equivalent and investment at the end of Q3 were $63.5 billion with $6.3 billion available in the US.

We returned $2 billion to shareholders during the quarter that included $649 million of share repurchases and $1.3 billion for our quarterly dividend which we increased by 24% in Q3. Overall Q3 was a very solid quarter and a difficult macro environment. We focused on strong operational executions resulting in top line growth, stronger gross margins and continued operating leverage consistent with our expectations.

We are making the right investments in the growth areas of the business, balancing our decisions with sound portfolio management. Let me now reiterate the guidance we provided in the press release of fourth quarter of fiscal year 2016. This guidance includes the type of forward looking information that Marilyn referred to earlier.

The guidance for Q4 is as follows. We expect revenue growth to be in the range of 0% to 3% year-over-year normalized to exclude the SP Video CPE business from Q4 2015. We anticipate the non-GAAP gross margin rate to be in the range of 63% to 64%. The non-GAAP operating margin rate is expected to be in the range of 29% to 30% and the non-GAAP tax provision rate is expected to be 22%.

Non-GAAP earnings per share is expected to range from $0.59 to $0.61. We anticipate our GAAP EPS to be lower than the non-GAAP EPS by $0.08 to $0.11. Further details to this range are included in the slide and the press release that accompany this call.

I will now turn it back over to Chuck.

Charles Robbins

Thanks, Kelly. So let me quickly summarize before we move to question. First I think the number one key takeaway is that we continue to execute well even in an obviously very tough environment. Secondly, we have proven our ability to transition certain elements of our portfolio like we have done with Meraki security in collaboration and we believe we can accelerate long-term growth by bringing the same approach to our core and this process has begun.

And finally, everything we do will be done through the lens enabling our customer's success while driving value for our shareholders. Marilyn I will turn it over to you for questions.

Marilyn Mora

Thanks, Chuck. Kim, let's go ahead and open the line for questions. And while Kim is doing that I would like to remind the audience that we ask you to please ask one question.

Question-and-Answer Session


Thank you. Your first question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski

Hi, thank you very much. I just wanted to clarify your guidance for the July quarter. How much of the revenue comes embedded from acquisitions that closed in the last year just so we can get a sense for the organic sense in the business? And then when we think about the 3% growth in bookings in the quarter how much of that was benefit by the extra week in the quarter?

Kelly Kramer

Yes, I will answer the second part first Simona. In terms of how much benefit we got from the extra week, we don't think there's much. What we saw this quarter was the forecast was pretty straight forward. The team saw deal closure and conversion rates drag on because of the especially in enterprise segment and quite frankly the deal that we closed were more in line.

So we don't think we had any upside from the extra week in bookings sitting there. In terms of your first questions on your acquisitions, we will start to see; in the current run-rate we have the bulk of open DNS and everything else. For the new acquisitions you don't have the full quarter in a run-rate, we will get a bit of benefit from Jasper and Acano but it's not terribly material in the overall growth rate.

Marilyn Mora

Thanks, Simona. Kim we will go ahead and take the next question.


Thank you, next question comes from Ittai Kidron with Oppenheimer & Co.

Ittai Kidron

Thanks and congrats on great execution. First question is regards to the data center. I hear your comments with regards to the macro impact on it but it's five quarters in a row now we are dead business is stuck in between the $800 million to $850 million revenue and this business has the account for about a third of your growth in the past few years so if you give us a little bit more color as to why isn't this moving that will be great and the second question is regards to the gross margins.

I had to go back all the way to 2010 to find product gross margins that are equal to those you just reported. Can you just give us a little bit more maybe of a framework to think about? What is really changing in the portfolio whether it be the mix or changing the competitive environment, anything that can justify the increase in gross margins and how sustainable do you think that is?

Charles Robbins

Hey, this is Chuck and I will answer the first one and I will give Kelly the gross margin question. So as we look at the data center business, we see a few things going on. First of all we think that there is an impact coming from the overall macro environment that is relatively undeniable. We also saw as our peers, some caution in the CapEx spend and the SP space and that was one of the segments we saw weakness this quarter even with our data center portfolio. We take data center in this context; we are talking about UCS in particular. The other thing that is going on is there is a transition going on in the data center relative to workloads. I talked a little bit about it on the last call. We see workload specific used cases being deployed on high performance blade. Systems like our classic UCS then we see also this move to hyper converged systems which led us to the launch of the HyperFlex platform last quarter.

We also see a transition to rack based systems which also results in stacks that are driven by container based architectures and so in the last quarter 30% of our business was from the rack portfolio which we do have for the appropriate used cases. And you will see us continue to expand our offering so we have UCS as a blade system, we have a rack conversion of UCS, we have HyperFlex in the market and you will see us continue to expand in our portfolio to meet the evolving used cases in the data center. I think that's what's going on right now. Kelly, on the gross margin question?

Kelly Kramer

Yes, on the gross margins, I will say Ittai a couple things. You are absolutely right when you go back and look historically. If you go back and normalize the biggest thing we did was obviously when we got out of the set top box business, that helped us quite a bit and normalized if you go back to just Q1 of this year we were at a $64.9 million and we had even last year, we had a $65.1 million.

So I would say it's kind of but the new normal in that $63 million to $64 million range, I would say the only other thing when you go back and you update your models for the extra week because a lot of the top one that I talked about comes of the balance sheet and there's not incremental cost. I did get a half point benefit just from the extra week in my gross margins. So I'd say a normalized view on the gross margins would have been closer to $64.5 million.

Marilyn Mora

Thanks, Kelly. Kim we will go ahead and take the next question.


Thank you. Next question comes from Vijay Bhagavath with Deutsche Bank.

Vijay Bhagavath

Yes, thanks. Clearly better than results, congratulations to you and your team. My question is as follows which is Chuck, heading into the back half what gets you most excited in terms of new product refreshed opportunities and then now that your security business is starting to turn the corner, especially versus the pure place would you double down on security investments both organically and M&A? Thanks.

Charles Robbins

Yes, Vijay I think the number one thing I am feeling very positive about right now again we have shown that we can drive the transition in our collaboration portfolio which is as you see that business of last two years the team's done a great job of transitioning it to a portfolio is available to our customers as cloud based services in seeing it growing double digits and also growing our deferred revenue balance of 16%.

I think that's one example and security 46% of our business now comes from software and subscription services which is clearly the direction that we had indicated we were going to take it at the same time growing 17%. Our Meraki business which really shows the evolution of networking to cloud based management and policy is over a billion dollars now and growing double digits and I think the thing I am most excited about longer term is we see a path to deploy that model across the rest of our portfolio and again that work has begun.

I think in the near term we see obviously a mix of pretty cautious environment still because we do see customers spending where they need to spend but don't misunderstand there's still a fair amount of caution in the market but I think we have executed well this quarter we had five of our seven product categories that were in positive growth with three of them in double digits.

We had all the GOs in positive growth from order perspective and we saw pretty good strength across our segments. So that's the first question. The second one relative to security the answer is yes, yes and yes. We will continue investing both organically and any other way we see appropriate to drive that architecture. The team's done a phenomenal job.

Marilyn Mora

Kim, we will go ahead and take the next question.


Thank you. Next question comes from Steve Milunovich with UBS.

Steve Milunovich

Thank you. Your switching and routing business, so businesses were both down. I guess how concerned are you about that? Do you think your product portfolio is yet to impact that? Do you believe your share or it's the market finally? What's the impact on your services business in other words how much of that is maintenance that could be impacted by declining hardware?

Charles Robbins

So let me take the first one and then Kelly you can maybe make the connection to the hardware. So on the switching business I will point out a couple of things. Last quarter we indicated that our campus switching business, the growth there is largely driven by refresh which in an uncertain time enterprises that have infrastructure that's functioning for them, they are not going to make the move to upgrade.

So we see a pause in that refresh cycle which we talked about last quarter and nothing really changed there. What we did see is we saw our data center switching revenue growth increase and the other thing I will point out is we had indicated that we believe our data center switching growth would, the new product portfolio would surpass the declines of the traditional products that we had and our order growth rate which we haven't put any of the documentation but our order growth rate this past quarter on that $4 billion portfolio was double digits.

So we are pleased with the progress that we have made in the data center switching space and again that's $4 billion and it grew double digit in order so we will okay about that. On the routing front its combination of things. I think there are certainly $1 billion in the quarter; $4 billion annualized run-rate on the annualized data center switching. Kelly's making sure we are clear.

On the routing business we have seen a few things. Clearly there is a macro issue that we are dealing with. We also saw again as you heard from some of our peers we saw some increased caution in the service provider space. We saw slow movement in the core of those networks. Kind of flat-ish activity at the edge. And we do have a number of new platforms that are in certification with several of the key players that at some point in the coming quarters we would expect those two to begin to show up favorably but that's what we see right now.

Kelly Kramer

And in terms of Steve, your question on impact of the services business, typically for new sockets there would be a little lag for that but I would say that our service business has been laser focused on driving renewals. So even if enterprises are holding on to their switches and routers longer, our services team and sales team have been very focused on getting the contracts renewed. And we have seen that pay dividends with the acceleration of growth and if you normalize our service revenue for this quarter for the extra week, they still grew 4% which is up from 3% year-over-year growth in Q2 and it was 1% in Q1 so we are really starting to get traction there.

Charles Robbins

Yes, and Steve, if I can just pile on to what Kelly just said that the team has been building out. Trying to strengthen our capability around the entire software and subscription model which requires a lot of focus on adoption and renewals and we have also taken the same approach to just sharpen our focus on our services renewal business and we did see improvement in that in the last quarter so I am happy that the team is making progress there as well.

Marilyn Mora

Thanks Steve, Kim let's go ahead and take the next question.


Thank you. Next question comes from James Suva from Citigroup.

James Suva

Thank you and congratulations Chuck and Kelly to your team here at Cisco. One thing that stood out was the very impressive gross margins this quarter if I calculated correctly looks like there is around $65.2 million and that was meaningfully above I think your guidance was $62.5 million to $63.5 million. Can you help us understand what were the factors to drive it higher because I know the driving's all included in the extra week and for the outlook are there any types of swing factors we should be aware of and the causes of why would be lower than reported gross margins from this quarter? And again congratulations to your team.

Kelly Kramer

Yes, sure. Thanks for the question Jim. Thing to keep in mind, true we did guide with the extra week which came in line but just again couple of things. When we guide we tend to have a little conservatism in the gross margin rate but take off that half point and we are still parked at the $64.5 million range. We do have normal seasonality quarter in and quarter out. So always, Q1 and Q3 are our strongest quarters and Q2 and Q4 are weaker and its typically driven by our mix, especially our mix of drivers in those two quarter so that's also a driver and I think operationally speaking again the teams are doing a very good job from the productivity perspective in terms of driving cost out of the product. We had lots of efficiencies out of this supply chain in terms of managing our freight and our inventory management.

So I would say we had a very strong quarter from an operational excellence. If I look at pricing this quarter we are being very disciplined on pricing. We are starting to see a tiny bit of a tick up and you will see that in our queue where the impact to our gross margin rate year-to-date 2.2% and Q3 was 2.4% so still strong but you know we are still seeing price arisen but the strength we are seeing this quarter mostly came from just improvements in productivity.

Marilyn Mora

Great, thanks Kelly. Next question please.


Thank you. Next question comes from Pierre Ferragu from Bernstein.

Pierre Ferragu

Hi, good evening. Thank you for taking my question. I just wanted to come back on what you said about your hyper scale and web scale clients so if I get that correctly, you had revenues of 31% there? Could you give us a sense of what made most of this revenue and most of this growth, was it mostly switching, routing, anything else and then if we experienced that very strong performance on that segment, what did the rest of the enterprise look like in terms of growth so you were down 2% overall I assume it's higher what scale is probably 31%, the rest of the enterprise was down quite significantly.

And lastly, could you help us quantify any kind of the macro impact you mentioned with enterprise in this quarter and in your guide for next quarter so right on the points of revenue or whatever, do you have a sense of how much you have lost because of the uncertain macro environment? Thanks for that.

Kelly Kramer

Okay. So I will start and make sure I don't forget the rest of the pieces here, Chuck you got me covered there? Okay. So of our massively scale of debts and our customers, of that amount more than half of it is certainly switching and the next biggest follower is routing so it's more than 50% significantly more than 50% is our switching products. To your point on what you inferred, what would mean if switching overall was down three, I just want to reiterate what doing?

Charles Robbins

Let me just clarify the question. He believes that we will roll the we scale into our enterprise business so he was saying we were negative two on enterprise so our service provider segment so now you can answer that question.

Kelly Kramer

Yes, sorry about that Pierre. These web scale customers are definitely in our service provider segment which was flat overall from the quarter of our bookings perspective. On the rest of the portfolio to your question of the service provider we are seeing the slowdown from just the overall there's a lot of CapEx spend and you are seeing it reflected certainly on our routing portfolio.

Charles Robbins

Yes, couple of comments. I don't think we have exposed over half that business is coming from switching so clearly there is value in our switching portfolio the web scale players are seeing. I also think that there is still a small percentage of the overall SP business as it relates which is why you will see flat when this segment goes up 31% given the size of that business but obviously you could have done the math. And -- but I do think that our teams have done a good job here. Kelly, the third portion of the question was that relative to any revenue impact in Q4 that we have built into the guidance, relative to the macro environment, just generically, we are not modelling any improvements I think is the safest way to say it. We do see a continued amount of uncertainty out there and we are not modelling any improvement into Q4.

Marilyn Mora

Great, thanks Chuck. Next question please, Kim.


Thank you. Next question comes from Brent Bracelin from Pacific Crest Securities.

Brent Bracelin

Thank you for taking the question. Chuck, I wanted a follow-up on services revenue. I get there was a clear benefit of an extra week but this down marks I think the second quarter in a row of upside coming from the services segment. I imagine most of the return is double digit growth was the extra week. I guess my question is are you seeing a broader increase in services driven by solution selling trends and if so do you expect the services kind of recovery to potentially be a leading indicator for a future product recovery?

Charles Robbins

Thanks for the question, Brent. Let me say that over the last few quarters Joe Cozzolino and his team have been incredibly focused on driving the operational excellence around the P&L element of that which is what you are seeing with the gross margins and I think some of the discussion I had earlier around the focus on the renewal capability. I think we are seeing general improvement in the execution there. We see advanced services obviously doing reasonably well. Security services doing reasonably well and as I mentioned earlier the renewal activity our teams did a better job this past quarter so I think a lot of what you are seeing is operational discipline and execution to be honest.

However, I think there is an opportunity and more of our customers are asking us to help them as they look at their strategies to take advantage of this digital transition that's occurring. I am not sure I am in a position where I will give you any sort of tangible connection between it and future part of the growth but we definitely see that as a required service we are going to provide to our customers because they are looking to us as one of the few large capable financially viable partners that really understand this transition.

Marilyn Mora

Great, thanks Chuck. Next question please, Kim.


Thank you. Next question comes from Mark Moskowitz from Barclays.

Mark Moskowitz

Yes, thanks good afternoon. Just want to see if we can talk a little bit more about the cloud, ACI momentum. How should we think about the mix of this cloud revenue for Cisco, in terms of how much is going into public cloud vs private cloud as the run-rate improves? And then is there any change in the public cloud versus private cloud related to a margin either from a gross margin or operating margin perspective, we should be aware of? Thank you.

Charles Robbins

Thanks Mark. So I will let Kelly tackle the second question. If you look at where we declared when we stated our strategy as around cloud, it really is focused on enabling what we believe to be the long term desire of customers to operate in a hybrid cloud model and we said that we were going to do three primary things. We were going to make sure that we provide the infrastructure to the cloud providers and we have done that SPs and we have done that obviously with the top ten web scale providers given the business was up 31%. We also said that we were going to transition our portfolio to be cloud delivered and as a service delivered we are going to make sense over time across the entire portfolio and you have seen us do that with our continued growth in Meraki in collaboration and security and now the plans are actually underway on the project to deploy that across the rest of our portfolio although its early days but I think when you look at that deferred revenue of 36% on the balance sheet, that says we are being successful in the second pillar.

And then the third pillar was to help our customers with the infrastructure needed to actually take advantage of both private and public clouds or enabling hybrid and when you look at the data center switching portfolio on annualized $4 billion business with new orders growing in double digits I think that customers are driving both and the three pillars of that strategy are working. As far as gross margins when we sell to private cloud versus public cloud providers, Kelly any comment there?

Kelly Kramer

Yes, I would say we obviously have different margin profiles within both but I will say whether its campus versus data center or whether it's to the service providers versus enterprises both margin profiles are well above the Cisco average gross margin rate and between campus and data center side. We are within 5 to 6 points of gross margin so the differentiations not much there. We can have variations within that. We can have some public cloud customers on some deals that might have better or worse margins but overall the portfolio is within those ranges and again way accretive to the overall system of the margin.

Marilyn Mora

Kim, next question please.


Thank you. Our next question comes from James Faucette with Morgan Stanley.

James Faucette

Great, thank you very much. I just had a clarification, you talked about ACI hitting about $2 billion annualized run-rate and I think our notes have suggested it was at a similar level last couple of quarters at least you gave us similar level. I just wanted to make sure our notes were right there. And then really my question is around acquisitions. You guys have clearly been quite active doing acquisitions and doing a lot of what looked to be pretty promising technology relates acquisitions. Should we expect the current pace to persist or are we going through an accelerated period that you expect we will be going down from? Thanks.

Kelly Kramer

I will take the first one. So on the first one, yes, we are being rounding. It's actually closer to $2.2 billion run-rate and sequentially I am certainly up than what I was last quarter.

Charles Robbins

Yes, I think when we hit it last quarter it was probably roughly $2 billion, now it's closer to $2.2 billion or $2.5 billion on the ACI portfolio and then on the acquisition front what I would say is that given the valuations and the movement in the tech industry there will be continue to be opportunistic and we are in a good position as a strategic buyer with some of the challenges in the public market and some other valuations becoming a little more realistic. What I would suggest to you is over the next 12 months we will be quite as active as we have been in the, wouldn't expect it to be quite as fast paced as it has been but we will continue to be opportunistic around the areas of growth important to our future.

Marilyn Mora

Kim, next question please.


Thank you. Next question comes from Paul Silverstein from Cowen & Company.

Paul Silverstein

Thanks very much. Going back to the question about the top ten webs, I don't think you have ever broken it out or at least my memory. Routing's 15% of your total revenue and service providers if I typically remember the numbers correctly were 80% routing, that would suggest that the web guys were somewhere in the range of 15% total revenue if looking at the current numbers correctly. Is that the ball park?

Charles Robbins

15% of our overall total revenue or 15% of our service provider revenue?

Paul Silverstein

Basically routing is 15% of the total and service provider is 80% of routing and again that would suggest that traditional service providers bring the bulk of your routing revenue or somewhere in the order of 12% total revenue. I recognized it more than just routing. And if I saw this service provider category correctly in terms of 30% of total bookings, we may have misread the number. That would suggest what, I am trying to get back at, let me just ask the question directly. Can you give us any sense for how large the Web 2.0 category is?

Kelly Kramer

Yes, Paul we haven't been disclosing that so we just don't disclose that.

Paul Silverstein

Isn't that 15% range?

Kelly Kramer

Again Paul, it's not something we give out. I apologize but it's not…

Paul Silverstein

No worries, all right, let me ask you a simple question and I think you mentioned it before but, can you give us any insight of the linearity of the quarter?

Kelly Kramer

Yes, I'd say it wasn't that crazy, I mean obviously our extra week went actually feel in from a calendar perspective was in February. But again, because the way the teams were forecasting, I'd say the linearity in terms of the -- what we see usually coming through was in the normal ranges.

Marilyn Mora

Thanks, Paul. Hey Kim, we'll go ahead and take the next question.


Our next question comes from Tal Liani with Bank of America.

Tal Liani

Hi, hopefully you can hear me. I have just one clarification, it's the -- tone of the previous conference call was very different, it was about a very weak environment and we didn't speak about the growth trends, the tone of this conference call is so much more positive in a very similar business environment. So what happened in the last three months that makes you so much more positive about everything you've done, basically also before, very little is new now. What makes you so much more positive now versus three months ago in a similar environment or unless maybe the environment gotten better?

Charles Robbins

It's a good question Tal. I'm just having a better week this week. No, I'm kidding. I think the difference is, if you go back to when we ended our last quarter, it was towards the end of January and if you recall, the last few weeks of that quarter were the weeks when the stock markets were having those incredibly wild swings and our customers actually put the brakes on pretty significantly and so coming into that earnings call we had seen very tough close to the quarter from an orders perspective. We saw our enterprise customers in particular really put the brakes on because they were just completely unsure of what was going to transpire and I think that led us to a very cautious tone and so that would the number one reason why we were more cautious then. I'd just want to make sure that we are balanced here that while we're optimistic and we're pleased with our execution, we still are operating in a relatively uncertain environment. We've got the Brexit coming up, the vote coming up in June, we've got the news out of the Fed today, we've got all the election dynamics, we've got issues in Brazil, we've got geopolitical dynamics. So there is still a relatively broad set of unknown issues out there. So we're still operating in an uncertain environment but I think that would -- the stock market issue and the timing at the end of our last quarter would probably be the biggest difference.

Marilyn Mora

Thanks Chuck, I think that was really helpful. Operator, we'll take another question please.


Thank you. And our next question comes from Simon Leopold with Raymond James.

Simon Leopold

Great, thank you. I wanted to go back to the web-scale vertical a bit. I know that's beating the dead horse a little on this call but I wanted to see if you could talk about the bigger trend around the white box competitive threat because it seems apparent that there is not the dramatic shift to white box that many had feared but maybe it's yet to happen. So if you could talk how you're countering the threat or the substitution effect of those web-scale customers building or buying unbranded switches rather than your products? Thank you.

Charles Robbins

Yes, Simon, it's a good question and I think that there is a misconception about what's driving this belief that the -- all the customers want to buy white box switching and I think this is sort in the same vein of -- it's all about cloud, it's like -- or all about STN or all about white box. None of these customers are fundamentally chasing a technology trend; there are underlying business drivers that are leading them to the solutions. And so what we've been doing is focusing on attacking the business driver and not so much the technology trend that everybody writes about. So in the case of the web-scale players, what they are looking at is, they are looking for significant automation, they are looking for the ability to run massive datacenters at very -- at huge scale, very low cost with a ton of automation which overtime will become the norm I think for all customers. There is this massive focus on operational expense reduction which is all around automation program ability which is where we're headed with our core platforms and the enterprises as well. So what we do it is we've built some really aggressive products, our teams, again the A6 improvements that have been built that give us the advantage on the price performance and then enabling our portfolio to fit within the operational environments, so these customers I think has been the key. And that's what they're looking for, they are not singularly focused on white box, they are looking at how do they solve that problem and we're just spending more time with them to really understand what they need and how we can fit their requirements and you're going to see us continue to evolve our portfolio in whatever way we need to to make sure that we remain relevant there.

Marilyn Mora

Kim, next question please.


Thank you. It comes from Brian White with Drexel Hamilton.

Brian White

Chuck, I'm wondering if you could walk us through what you've seen so far with the Inspur relationship in China. I see China revenue decelerated but it still grew very strongly at 22%. And also the Erickson relationship, it sounds like you got some big deals from the quarter or few deals in the quarter, maybe just highlight if you feel like that relationship is still on-track for this $1 billion by 2018. The reason I ask, obviously Erickson had a very soft March quarter. Thank you.

Charles Robbins

Brian, it's a great question. I actually didn't expect anyone to highlight the fact that our China revenue was decelerating as our third quarter of really solid growth in China. Now we'll point out that that is across the board, it's across the portfolio, the team has done an amazing job there and I've spent a fair amount of time over there and I think that we're really pleased with where we are in China right now in the midst of the uncertainty that's been discussed in the marketplace. On the Inspur partnership, in September we signed the MOU which was basically a letter of intent to formulate the venture, and I was over three weeks ago where we formalized the term sheet basically and we're in the final stages of getting that one put together. I would expect it will be in market sometime in the fall with some of the early products and solutions with them. We're spending a lot of time with them right now. So I think sort of late this year is when we'll begin to see some early results from that.

I think on the Erickson front, anytime you do these really large partnerships, they always take a little longer probably than we would all hope but we're very optimistic, we just spend a ton of time together, I think on the last call we talked about the number of joint solutions within the first 100 days that we actually had on display together at MobileWorld Congress which was pretty amazing. And then this past quarter we saw 17 transactions close between our teams which in the midst of a time where HANS was doing a pretty significant organizational restructuring and our teams are getting to know each other. So we think that we'd all wanted to go faster but we're pretty pleased with where that partnership is right now.

Marilyn Mora

All right, Chuck, I think that was our last question. Now I want to go ahead and turn it over to you to close it up.

Kelly Kramer

All right, thanks Marilyn. First of all, I want to thank everybody for spending time with us today and I want to thank you for your questions. I would just go back to the three things that I stated earlier. I'm really proud of what we've done, I'm proud of the way the teams have executed. It is a challenging environment out there and I think that our teams have proven that we continue to execute regardless of the environment we face.

As I said last call, we're running the company on two fronts, we're focused on the execution and the operational excellence and at the same time we're focused on transitioning our business and investing in the future which I think was displayed by our progress in the different areas that I highlighted during the call today. I think that again, if you look at our success and security and collaboration, next-gen data center, the Meraki cloud networking platform and overall on our transition to software and subscription, I think we're on that journey. We've proven that we can transition elements of our portfolio and we're going to apply that same approach again to the rest of our business. We're in the early days in the front end of a long journey but I'm pleased with where we are.

So I want to thank all of you for spending time with us today. And I will look forward to talking about to you soon. Marilyn?

Marilyn Mora

Thanks, Chuck. Cisco's next quarterly call, which will reflect our fiscal 2016 fourth quarter and annual results, will be on Wednesday, August 17, 2016, at 1:30 PM Pacific Time, 4:30 PM Eastern Time. Again, I'd like to remind the audience that in light of Regulation FD, Cisco's policy is not to comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

We now plan to close to call. If you have any further questions, please feel free to contact the Cisco Investor Relations department. We thank you very much for joining the call today.


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