Cisco Systems, Inc. (CSCO) Management Presents at 39th Nasdaq Investor Conference (Transcript)

Cisco Systems, Inc. (NASDAQ:CSCO) 39th Nasdaq Investor Conference December 5, 2018 3:45 AM ET

Executives

Emily Hunt - IR

Kelly Kramer - CFO

Analysts

Meta Marshall - Morgan Stanley

Question-and-Answer Session

Q - Unidentified Analyst

All right, we'll go ahead and get started here with Cisco. I'm very pleased to have Kelly Kramer, CFO of Cisco here with us today; also joined with Meta Marshall. Meta Marshall and I make up at least half the networking team, networking coverage team at Morgan Stanley, so very pleased to be here and thankful that all of you could join us. We also have Emily Hunt some place in the room from Cisco IR, in case we mess this up, Kelly, all right.

So maybe I'll kick-off just with quick question. I think the thing that we get asked about most from investors is, you've had a great year, but now people starting to worry particularly on products cycle strength and cost getting tougher. What are you thinking kind of the key drivers that continue to be able to have year-over-year growth going forward?

Kelly Kramer

Sure. So first thanks everybody for being here and let me just start out with my usual disclaimer that I maybe making forward-looking statements and of course they are subject to the typical risk and those risk outlined in our financial statements of the SEC the 10-Q and 10-K. Now that that's done in terms of where the growth is going to come from, I would say the growth that we have return to now has been very much driven by the refresh portfolio we have in our campus switching driven by the Cat 9K.

Like we have said on our earnings call, we are still in the very, very early stages of that refresh. It's the fact that's ramp of a new product we've ever had and it continues to ramp and that its early days. On top of that, we're continuing to innovate and launch new products. A couple of weeks ago, we launched on the Catalyst 9200, which is almost as big of addressable market that current Cat 9K than 9300 and 9400 addressing. This is more for the midmarket. We just launched that that will be ordering and going to shift by December and January timeframe.

So that hasn’t started yet that will continue to go as well as we had a new product announcement and in our SD-WAN space with security integrating that as well as we had a new wireless controller. Again, all part of what we are driving with this intent base networking, we've standardize the operating systems where we can we can drive simplification, automation and management with the DNA center that allows, IT departments to manage not just their switches, but their switches, their enterprise routers, and their wireless exit points through a software to dashboard. So, we're in the early stages, there is still a ton of growth around, and we get the continuous innovation going on in the portfolio.

Unidentified Analyst

So one of the key aspects or things that people have clearly focused on with the introduction of the Cat 9K last year was the subscription services that you're putting on top of that, can you talk a little bit about like probably one of the other questions we get most frequently is what are the incremental services that are being delivered? And then can you expand that same model to other new hardware introductions?

Kelly Kramer

Yes, sure let me go ahead and put that in context. So we've always been switching business let's just say that the prior generation switch cost to 100 just making up a number. We launched the Cat 9K, the 9300 a year-ago, and we decided with our new products that we are going to offering -- we have a ton of we've always had a kind of software in our business, we've always have that embedded in our systems, we wanted to monetize it differently because we are adding additional services to it. So when we launched the Cat 9K that same 100 say that, Cat 9K 75 of it was the hardware plus the operating system all recognized up front. And then, 25 of it was based on its inspection, okay.

And that subscription allows things like DNA center has advanced features like embedded security to identify threats in encrypted traffic that you don’t have to decrypt. So things along those lines and that's like I said, you can 3 or 5 years subscription depending on how you want to do that. And so, we're monetizing that overtime and then as we have more and more innovation that will could evolve as well as the software subscription overtime. So for everything in our enterprise network portfolio now will be offered in that subscription model like I said the 9200 which will go out will also be subscription as well as the controller of the wireless -- the Catalyst 9800 or wireless control will also be a subscription.

Unidentified Analyst

And just as a reminder, what are you hoping to get you in terms of total recurring revenue contribution versus where are you roughly today?

Kelly Kramer

So, it's interesting we adopted, there is new revenue standard recognition getting from the U.S. ASC 606, which we had to adopt in our last quarter Q1 of '19. And we have been talking about recurring revenue all along, and we've been showing the transition. We now are talking because of the new accounting rules, which changes how revenues are recognized, we are really focusing on how much of our software is subscription base. So in Q1 of our total software, we had 57% of that with subscription base up 5 points year-over-year, and again it's driven by this intentional shift were going with our enterprise networking portfolio.

The reason we are not talking about recurring revenue anymore using that same example of 100 of the Catalyst 9K, 75 is being the hardware and operating system at being the actual subscription that's still is the same but with the accounting rules some of that 25 now is revenue recognized accounting wise front. And then only about half of that is differed even though to the customer nothing's change that 25 is what they are going to renew in 3 years or 5 years or whatever it is. So that's why we are really focusing on a subscription because that's what we like to drive the customers stickiness the subscription to software will be where the additional value comes t the lifetime of the customers.

Unidentified Analyst

And before I go on to my next question, I just want to make that everybody is aware of that we do have the conference app where you can submit anonymous questions and that we can read here or if you just have question raise your hand, we'll get you a microphone. So my next question is just in terms of looking more near term as we get to the end of the calendar year. How do you factor in a potential digestion period from any pull forward from tariffs at the beginning of the New Year? I think some people have expressed concerns that maybe there's a little bit of demand pull forward as people are trying to avoid depending tariff implementation.

Kelly Kramer

Yes, so the tariff, so just to remind everybody here, the U.S. List 3 of imports coming from China had a big impact on the network and had a impact first Cisco's networking equipment and that went into effect September 24th with the 10% tariff on the imported value coming in. There was -- when that went into effect in September, they said that was going go up to 25% in January, which would have significant impact over the weekend as many of you saw the Chinese administration and U.S. administration agreed to a 90 day say, which is a great news. So it won't be going up to 15% in January though it's not consecutively done yet.

So, I would say for the 10% tariff which cut the end at the September 24th on, we did not see any impacts from the tariff of people pulling in orders. And I can tell that by looking at and by total orders that I booked by month, the percentage by month didn’t change Q1 '19 versus Q1 '18. Now part of that is, the 10% is on the cost right so from the list perspective, it is not necessarily a full necessarily, it won't be a full 10%. So I think also there was enough demand that it just digested that. 25% would be a much bigger hit and that would obviously have some impact. So we're working through that and we are working with our supply chain and our suppliers to mitigate as much as possible regardless and we’ve made progress on that.

Where we can’t with, we’re taking commercial actions and pricing through. And just we’re in process of doing something their own supply chain moving lines and whatnot to try to minimize as much as possible. And for that, we’re very specific aware, we’re pricing it through, we’re not doing a broad based right from others are, we are just focused on the products that were impacted. So hopefully we just this 10% tariff stays what it is and they work through the 90 days and get a better deal.

Meta Marshall

So Kelly, you mentioned the Catalyst 9K is obviously driving a lot of growth and then 9200 will kind of drive growth as we go into next year. Are there any other major categories that are being refreshed, that we should think of as driving growth? I know the service provider portfolio or…

Kelly Kramer

Yes, I know, I think across the board. I mean, that’s -- I would say from the, for the time I’ve been at Cisco. This is, it’s a really great kind of innovation for our portfolio. So certainly enterprise portfolio not just 9200, but what we’re doing with the Catalyst 9800 or wireless controller. We also in the process of the whole wireless industry, is going to the 11ax, which will be a whole new product refresh. I would say on the service provider side it’s early days for 5G, though we’re seeing, we had a very large deal with one of the service providers for our virtual packet core, a big software deal as they get ready for 5G. The, we’ll see impact and benefit from the build of 5G, not necessarily this year, but in the core routing space that will come and we have some innovation coming out and routing as well.

And then of course, we just have and our security portfolio that continues to just be growing and we a lot of internal R&D innovation going on, as well as we’re always looking acquisitively. We just closed the dual acquisition and identity management. And then in our application space, which is very software focused, they continue to grow double-digit. We close on BroadSoft and the Unified Communications space that’s really accelerating our move to cloud calling, which we’ll accelerate the growth in that phase. So I think there’s a ton of innovation going on and I feel pretty good about the growth prospects for the Company barring any kind of major economics.

Meta Marshall

And are there any kind of product cycles on the software side? You've obviously done the AppDynamics deal, you’ve done BroadSoft. Just how to think about software growth going forward?

Kelly Kramer

Well, I guess, I think it’s important to remember that we’ve always been in software, right? It’s how we monetize through a system. But we’ve always had 80% of our 25,000 engineers to 22,000 engineers or software engineers. And I’d say, if you look at the last 3 years of acquisitions it’s been heavily, it’s not exclusively in the software area, whether it’s acquisition in security or and cloud areas that enable ease in this hybrid world. So but even in our channel development, the teams are focused on software. And how do, we make it simpler for our customers, we’ll offer so we give to them to enable what they’re trying to work in this very complex IT environment.

Unidentified Analyst

So when you look at the, particularly, as you shift to subscriptions and software. What is the best metric for us as investors should be tracking to just follow how well that shifts is taking place?

Kelly Kramer

Yes, I think it is that of our -- and which we disclose and we have been disclosing for a couple years there. The percent of our software revenue that it is from subscription, you should see that continue to go up. We’re already at 57%, a couple years ago, at the end of ’14, I think we’re at 30%, right. So we’ve gone dramatically since the end of fiscal ’14 to where we are today. And that’s just going to continue to scale as we launched more, more of our products exclusively with the mandatory subscription, so that’s going to be the right metric to look at.

Unidentified Analyst

And then, I think a key thing that we’ve always focused on, in Cisco’s business that’s hard to track but clearly has an impact as a pace of replacement cycles and hardware. And so obviously if you go from replacements switches every five year to every ten that’s a big drag or it’s a big headwind. So, when we think about shifting to software I know that a lot of it will be subscriptions, but will there be some replacement cycle impact both on software and then more importantly perhaps on the impact of the pull-through of hardware? The software impact that the timing of hardware cycles.

Kelly Kramer

Yes, I think again the beauty of software is you're constantly innovating in that space and constantly developing new solutions that you can embed. Well like anything else whether it's your iPhone or your PC, there is a certain point when you keep adding the functionality to the software, you have to have the right hardware to support being able to optimizing it’s a full benefit of that. So it is a virtual cycle if you will of development on both side, again you also have to have great hardware to run this stuff and have the speed. So we’re innovating across the entire hardware systems software landscape.

Meta Marshall

So maybe a question for me on -- to sell kind combo products like you started to be much more successful and like security and networking rather, that requires almost the sales force transformation of somebody maybe taking a little bit longer to close a deal that they could have close before. And just what incentives have you put in place or just how have you guys been successful of making that transition of people selling more combo?

Kelly Kramer

Yes, that’s a great question. So, we have a fantastic sales force and then we have a great partner ecosystem as well. And we've been spending a ton of time over the year for last three, four year educating on software selling. And again selling software is much different than selling when we used to sell just switch to add of course software embedded and licensing is difficult. So, we have been inventing in the training of our sales force as well as the training of our partners. We've been investing our backend systems to its earlier because enterprise agreements are very complex, operating is complex, subscriptions are easier.

But having the right systems internally, so we know where our licenses are, where they are in the live, we know where to go making sure that our customer are using the features and driving adoption, driving ability to renew. And then from an incentive standpoint, over last three years we've been shifting, we uses to incent our sales force certainly on a dollar quote. We enhanced that to include not only certain of the typical business, but a certain amount of their quota has to be for these recurring offer to make subscription. And again, it's blow out across the entire sales force that’s really getting traction. I think we come a long way from where we were when we started this journey few years ago.

Meta Marshall

And then maybe just a question on gross margin. You DRAM have obviously been a headwind for much of the last call it 12 to 18 months. Some of the other componentry is been a headwind as well. As DRAM pricing come back from start historic levels over the next year, what should we expect our gross margin?

Kelly Kramer

I would say just to ground everybody, memory prices has been headwind for us and the whole industry for 18 months and it still is and Q1 still had a big pretty big impact on our gross margin and it will also in Q2, have an impact though less of an impact in Q2. But when we look out, of course we’re working with the vendors now and looking at the price list now, we think that will return in the second half of our fiscal year to be a less of a headwind and then turn to a tailwind at the end of that, which is good, because what’s happening right now is that’s a massive headwind, it’s offset by the goodness and the favorability we’re seeing from all the shift to software.

So that is truly helping our margins, been offset by that and then the only real other dynamic that you’ll see on our gross margin is again as we shift product to be this is special case that weren’t before the five that we’re replacing that will have a negative impact, a little bit of a negative impact as you ramp because again you’re recognizing all the cost upfront but then you get that revenue over subscription, so as we ramp there’ll be a little bit of a headwind from that but again the good news coming from the software is helping a lot.

Unidentified Analyst

So, I want to ask kind of go back to the tariff issues and kind of the political environment perhaps that you’re operating in is that. First, on tariffs and the like, how does that impact and basically what’s happening from a larger political landscape prospective? How does that impact the way that you’re thinking about your supply chains? And what do you have to do with supply chains? Is there a long term change or a philosophy change that you need to embrace? Or is this -- are you looking as this now is like quick adjustment and then?

Kelly Kramer

Yes I mean I’d say we’re very global company and we’ve a very global supply chain and a very global value chain that our suppliers supply into that, I would say we’ve been regardless of tariffs we’ve been -- we’ve a -- our team has been looking at how do we optimize to have the manufacturing and the component in the right place at the right cost to get to our customers as quickly as possible. So with these tariffs, it accelerate at some of the things that we’ve roadmaps to do whereas we can move lines fairly -- take some time, but we can move it fairly quickly from China to say other parts of the world that has very little impact has no impact really from a cost impact to the customers are very small.

So, we’re in process of doing that, a lot of the tariff also impact us from component that come into. So we’ve got a great supply chain and partnership with our suppliers where they’ve been very agile and moving to other countries as well. So I’d say the supply chain and the whole overall ecosystem with our supply chain partners is moving very quickly and is very agile and again it’s a global world that allows us to move these things, over time.

Unidentified Analyst

So, and speaking about it being global market, et cetera. Is that -- it seems like specifically in your business that purchase decisions are becoming increasingly politicized, and how you think about navigating that and allocating resources and you just talked through about at a high level?

Kelly Kramer

Yes, I mean it is in some -- obviously the U.S. and China, there’s been issues overtime not just the tariff. I think certainly Chinese competitors aren't allowed to sell in the U.S and a lot of the U.S. tech companies don’t get a lot of traction in China. There’s very big China networking company obviously that is very successful. I would say we try all kinds of things. We’ve great relationships with the government of China. We’ve smart city partnerships with the Guangzhou in China where we’re building a smart city there. We’ve a JV in China that we’re growing that is way for growth. And so, I think there’s way to navigate through that and I think at the end of the day our goal is to have the right product, to take the political step whether we’ve that or not, they’ve the right product at the right price for whatever country you're selling them to have that drive that demand.

Meta Marshall

So maybe you guys continue to be a quite acquisitive over time. There has been maybe pullback in some of these high growth valuations in some of the companies that you…

Kelly Kramer

That's one positive.

Meta Marshall

All right, that you've been more aggressive and so, how do you kind of evaluate the fact you been a continuing appetite plus kind of where were evaluations are going out?

Kelly Kramer

Yes, I would say we are very acquisitive as you say and were always looking and were always we will always have a many deals that were evaluating in the spaces that are interesting to us. I will say though that we are always very disciplined. I'll use security as an example because we've been very acquisitive there. Those valuations still are very, very high, but we are constantly looking. If we see that obviously we do a example the one we just close in October, that deal is pretty high valuation, but we know that products and do obey to those identity management security multifactor of indication usually important for cloud security as security has delivered from the cloud.

We know our sales force can take that in scale like crazy, a lot of reasons company's want to be acquired by Cisco is, we do have the huge enterprise sales force and we can scale it globally very fast, we've talk about Meraki over the years that business and we bought Meraki for the 100 million orders and now that's a over 2 billion business this many years later. So, we know how to scale businesses. I think do what we know we can see our path very quickly to get the value out of that. Any deal we do, we have a very rigorous process of making sure that deal is going to have a return to our shareholders and has a good return.

And we have a rigorous process not only of integrating the Company in, but then quarterly we go through how is it progressing from what we expected and that will be a metric financially, but are we able to retain the employees, are we getting the commercial solutions to be thought out in time, are we getting the same development portfolio of directly in respect to the time. So I think we do a pretty good job of making sure to get that return. Now that being said, if it doesn't -- if there's a deal out there, the crazy price, we're not going to do a super deal, right, if we don’t see the financial return.

Unidentified Analyst

So one of the things on that I think is noteworthy is particularly in the security space, the retrenchment of leadership of the Company that you bought has been like frankly unbelievable to me at least. Can you talk about, how you've been able to manage that? And then secondly, it seems like inevitably there is a clamor for you to do bigger deals sometimes I feel like it's from investors that already own those names. So they're maybe taking their own book, but why haven't large deals made sense and then in what case could it adjust?

Kelly Kramer

Yes, I would say, so to your first part on that, in security specifically, the security industries are very fascinating and it is extremely fragmented, that's why we like it and certainly it is very important to every company, but it's fragmented. So it's a great for us you will go in there and consolidate. I would say what’s also interesting about the security is it's a very small world all these CSOs in the world and all these start-up CEO, they don’t know each other. And so what's work for us is back and when we did our over this next phase of security acquisitions when we bought was it 4 or 5 years ago, that founders are still with us five years ago.

And then as we keep adding to security companies, they want -- they have a great they love working together building out this portfolio again. We are the largest enterprise security portfolio out there and they love the roadmap they're going because our view is for security we need to have a integrated architecture. And we’re really the Company to do that. If you think about your company as our most enterprises, most enterprises have 50 plus different security point solutions and well they might be great for that point solutions but the challenges how do you when that one point solution find something how do you get it to the rest of the organization. We strongly believe that you have this integrated architecture where if we get a threat from somebody login on to some website they should be on or some accounts coming in, once its notified somewhere whether it's on the end point or DNS or open DNS we can blow it through the entire enterprise.

So we do really believe in that. So I think that’s why for security, the retention is so high to model the acquisition they like with road map and it's very close through of things. So your broader question on acquisition, we over the years we done over 200 acquisition and our spot into that 5 billion or so range or less, I would say we have often get asked about larger more deal which really we look at, we do look at there is nothing to say we would do a $20 billion or $50 billion deal but again it goes to we’re very disciplined, we were very disciplined about where do we see the adjacencies in the business, how can we accelerate and how can that drive for the Company and we try to be disciplined and where we’re growing and what kind of investments we're making.

Unidentified Analyst

So in the last, I want to make sure we extent the invitation of anybody has questions from the audience. You can find a microphone. We have a question on the front.

Unidentified Analyst

So, it's just -- this is re-trading like something you address, but my initial impression is tariffs was China which made for rush of imports in your Q5. And then in Q4 people might be expecting this tariff to go up from $0.10 to 25% on that to be supposed to be.

Kelly Kramer

90 days that’s correct.

Unidentified Analyst

So, I think from December 1 or January 1 whatever the latest think was?

Kelly Kramer

It's supposed to be January 1st, this one is supposed to kick in and now they postponed it for 90 days.

Unidentified Analyst

Should I read through that Q3 was a bit flattered to Q4 might be quite a weak.

Kelly Kramer

So I would say no so, we’re on the fiscal calendar. So when we ended our Q1 which is like calendar Q3, that included one month of the tariff at 10% included October basically. So and we didn’t see any pull in and part of that for the 10% part of that was because I think a lot of people didn’t think the tariff would cut in for that big list of 200 billion and then the administration give us a weeks to get it to do it and they start week. So they didn’t have enough time to buy ahead and we certainly did see it. Now for this fiscal quarter Q2 which ends at the end of January, we expect it January 1dy so our last month of the quarter to go to 25%, we would have expected people to pull in December not they postponed, I don’t know if we will see that but I would have expected.

Unidentified Analyst

Did you see any of that in the order of pipeline change in December was December is like?

Kelly Kramer

I mean again we have a super healthy backlog. We have a super healthy funnel. We haven’t seen a swoosh coming in it -- and the hand strong in the IT environment.

Unidentified Analyst

So up until this week and you aren’t seeing a change in minority or request for deliver or anything like that.

Kelly Kramer

No.

Unidentified Analyst

Got it and then I want to go back to what you said on the 5G really quickly is that the 5G you had a big order, maybe you can elaborate that a little bit in. A lot of times on this technology transitions you see kind of a ranking of the size of deal for capability right like the price per port or software, like software displacing would have been hardware sale? Are you seeing that or how should we think about that as an impact?

Kelly Kramer

Well I would say for the shift I’d say in the backhaul for the virtual packet core that happened years ago, that’s a natural evolution and again that big large software purchase is that service provider builds out, makes sense we’ve really had a great relationship with those guys, I would say, for switching and routing in general you’re always going to have the natural price for port going down, I mean I’d say those two technologies naturally have a price erosion typically in that, but that’s just it’s like Moore Law.

But I think the more software you’ve going in there and again the constant innovation you’ve, that’s how you continue to keep that, you’ve to keep the margins up, in those businesses, so FID builds out, again it’s still early, early days I think that source provider are just getting to the point where they’re starting to build out their RAN networks and everything else, that will demand great amount of throughput and everything else, and we’re doing some internal innovation on our core routing portfolio to be ready for that as they start -- we think they’ll start building out there -- we’ll feel the impact in fiscal ’20 or so as we get there.

Unidentified Analyst

And then last question to kind of wrap up here as we think about like your earnings growth, EPS growth going forward, how you’re thinking about the relative contribution from -- of that -- to that EPS growth from revenue growth, margin expansion and impacts from buybacks?

Kelly Kramer

So all of those are good, I look at those as good things right now, again I think as I said earlier I feel great about the -- again barring any macro craziness I feel good about the IT environment and the revenue growth from our very strong innovation in the portfolio, I would say software is -- helps dramatically on the margin and again as we work through some of these other headwinds, that all start to flush through and of course we’re always managing driving earnings growth and cash flow growth so we’re always going to manage our R&D investment and our investments that continue to drive that and then we’re kind of sitting on the share we’ve been doing a massive share buyback once we had repatriation from the tax reform in the U.S.; we’re working through a massive 30 billion buyback right now that we’ve been doing, that’s also benefiting from an EPS perspective, so we’re but regardless of that we’re focused on driving cash flow up and earnings up.

Unidentified Analyst

Great, Kelly that’s all the time we’ve. Thanks for joining us.

Kelly Kramer

Thanks very much.