Cisco Systems Inc (CSCO) — Q1 2015 Earnings Call Transcript

Thank you. Good afternoon, everyone. And welcome to our 99th quarterly conference call. This is Melissa Selcher, and I’m joined by John Chambers, our Chairman and Chief Executive Officer; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, President of Development and Sales; Gary Moore, President and Chief Operating Officer; and Kelly Kramer, Senior Vice President of Finance. I would like to remind you that we have a corresponding webcast with slides, including supplemental information that 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 Investor Relations website. As it’s customary in Q1, we have made certain reclassifications to prior period amounts to conform to the current period's presentation; the reclassified amounts have been posted on our website. Click on the Financial Reporting section of the website to access these documents. Throughout this conference call, we will be referencing both non-GAAP and GAAP financial results. The matters we will be discussing today include forward-looking statements and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent reports on Form 10-K and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. Unauthorized recording of this conference call is not permitted. All comparisons through this call will be on a year-over-year basis unless otherwise stated. As we have in the past, we will discuss product results in terms of revenue and geographic and customer segment results in terms of product orders unless specifically stated otherwise. I’ll now turn the call over to John for his commentary on the quarter.

Thank you very much, Mel. I’m pleased to report another solid quarter, our strongest Q1 ever in terms of revenues, non-GAAP operating income and non-GAAP earnings per share. We grew revenues this quarter to $12.2 billion, up from $0.01 year-over-year, returning to growth as we said we would. We generated $2.5 billion in operating cash flow and returned close to $2 billion to our shareholders through share repurchase and dividends. With strong total non-GAAP gross margins at 63.3% and non-GAAP operating margins of 29.2%, we delivered non-GAAP earnings per share of $0.54. When I think about the quarter, there are three key takeaways that I would like to highlight. First, we are managing the business very well in a tough environment. Second, we are seeing the results of our three-year transformational work, moving from selling boxes to selling solutions and leading with innovation, speed, and efficiency as we disrupt the market. Third, we are leading the technology and business transitions in the market. Our strategy is playing out as we deliver innovative solutions based on intelligent networks to enable the next generation of IP and the Internet of Everything. We continue to focus on what has made us successful in the past: leading through market transitions. I give us very high marks on our execution. For example, in the data center, we are winning the SDN battle with application-centric infrastructure. This quarter, we now have over 900 Nexus 9000 customers, up from 580 last quarter, with strong continued momentum. In this first full quarter of shipments, we more than doubled paying customer adoption of APIC and our ACI controller, which enables automation and programmability of the network at a scale that has never been done before. The Nexus 9000 and ACI continue to see strong demand from customers, who recognize the significant advantages of ACI in their application deployment and management. As I said last quarter, we had two principal objectives when we rolled out our transformational plan in 2011. So how are we doing against these objectives? The first one is about driving innovation, speed, agility, and effectiveness in our business. As you are all aware, we are navigating the same macro environment as everyone else. At the same time, we are also executing on several transitions within our portfolio. Despite this, our results are at or near record levels and show momentum on both the top and bottom line. I'm optimistic regarding the future, as Cisco is well-positioned. The second objective is about moving our business from a model of selling boxes and standalone services to selling architectures and solutions that drive business outcomes. As every company, every city, and every country becomes digitized, we are seeing this through the results of our customer visits worldwide. We are engaging with entirely new business models, leading with software and services, and delivering integrated solutions. Recently, we described an enterprise license agreement for our software portfolio that we signed with General Motors, a model we are replicating across our enterprise accounts at this time. Last month, we discussed our successes in Barcelona and Chicago as they digitized their cities and evolved into smart cities. We are tying together the breadth of our product portfolio to deliver solutions that drive growth and economic opportunity, with security and scale. These large strategic deals are becoming a blueprint for how we will move forward. In the last few quarters, we have talked about three headwinds: emerging markets, service providers, and product transitions in our switching and routing. The good news is that the third area, high-end switching and routing, has turned into a tailwind based on momentum from our new product introductions, which we will share shortly. We are executing and progressing as expected, and I’m very comfortable with our growth trajectory. We are pleased that despite the headwinds, we are growing again and positioned well for a positive turn in service provider or emerging markets, ideally in both. For Q2, we expect to see mid-single-digit revenue growth in the range of 4% to 7% and non-GAAP earnings per share in the range of $0.50 to $0.52, which would be an increase of 6% to 11% in terms of earnings per share given the range covered. Our Q2 guidance reflects an added nature of conservatism, primarily related to reduced spending at several large U.S. service providers. I will now provide more detail on the business momentum in our geographies and customer segments within our portfolio. As a reminder, geographies are the primary way we run the business. In these areas, I will speak in terms of product orders year over year unless otherwise noted. We finished the quarter with product orders up 1%, and the product book-to-bill below one, which is in line with usual Q1s. EMEA was a highlight with growth of 6%. We saw very strong performance in the U.K., up 20%, and strength in Germany, up 6%. Southern Europe grew approximately 20%. We saw some stabilization in emerging countries within EMEA, with growth of 2% in the emerging segment of Chris Dedicoat’s business. Based on the role we play in the digitization of countries and companies, including our ability to bring innovation in job creation, we’re more positive on the future business in Europe than perhaps some of our peers. Our Americas business grew 2%. We saw growth in the U.S. of 3%, and when you exclude U.S. service providers, growth in the U.S. was 12%. The U.S. public sector had a very strong quarter with growth of 22%, U.S. federal grew an impressive 34%, while state and local declined by 2%. U.S. commercial grew 7%. U.S. enterprise declined 1%. Last quarter, we shared that the U.S. enterprise grew at a very strong 16% growth year-over-year. As I mentioned at the time, that performance was higher than normal, and we expected it to balance out this quarter. Looking at the pipeline for next quarter, we feel good that this business will again deliver double-digit growth. The U.S. service provider, however, declined by 18%. Within the Americas, Latin America grew 5%. Asia-Pacific, Japan, and China declined by 12%, led by China, which was down by 33%, while India grew 6%. The remaining emerging countries in Asia declined by 15%. Overall, emerging countries within the three geographies declined this quarter by 6%. The BRICS plus Mexico were down 12% while the other emerging countries actually grew by 1%. Our position in the emerging markets remains strong, and we believe we are positioned well for the inevitable upturn. However, as we told you last quarter, that is not factored into our plans. Moving onto the view from customer segments, in this quarter, global public sector grew 13%, global commercial grew 5%, global enterprise grew 2%, and service providers declined on a global basis by 10%. Emerging markets remain challenged and we saw dramatically reduced spend at several large U.S. service providers. As you think about our service provider position, I would focus on the following details, all of which are in our control. We recently reorganized to align with what our service provider customers want from Cisco. This was true of engineering, sales, services, and how we go to market. Secondly, we have the capacity to partner with customers as they transform during their own challenging times in terms of growth and profitability. Third, our market share and share spend are strong. Finally, our traditional box competitors have never been weaker. At this point, I don't think many of them have the flexibility to reposition to remain relevant to these service providers, putting us in a favorable position for any rebound in NSP when it happens. I now will move on to the discussion of our momentum in terms of products and services. I will discuss our momentum in terms of year-over-year product and services in terms of revenue but where appropriate we’ll share order information where it adds important color. As we move on, I want to draw attention to the convergence we are driving across almost all of our portfolios. As a first example, one that you are very familiar with, in the data center, we have converged networking with compute and storage and moved into what I believe is the number 1 data center position. Now we're converting networking with applications, security, and scale, and that's our ACI implementation. In routing, our NCS platform converges IP and optical networking with virtualization. We successfully converged wireless into most of our products, and convergence will also be very key for us in collaboration, which we’ll discuss later. In the industry, we are the only player with the assets to drive convergence for our customers, and this is a driver of both revenue and margins across our portfolio. Now let me move on to routing. Routing declined by 4%, reflecting both the lower CapEx spending by major service providers and challenges in emerging markets. We did see growth in several of our high-end routing platforms this quarter. For example, the ASR 9K saw solid double-digit order growth and our new products, the NCS 6000 and CRS-X, continue to ramp well with new customer wins. Given the tough environment, we believe we are gaining market share in these routing areas. Moving to switching, it was nice to see overall switching move back into positive territory, growing by 3%. We returned to growth after three quarters of decline, driven by our strength in the data center switching portfolio. In addition to the 60% increase in Nexus 9000 and ACI customers, we saw double-digit order growth from the Nexus 3K, 7K, 9K, and ACI combined. We signed a record 600 new customers for the Nexus 3000 this quarter, including several major Web 2.0 providers. Looking at our performance relative to one of our merchant-based competitors that has been making a lot of noise in this market, in Q3 FY '14, we saw orders for the Nexus 3K and 9K, which are our comparable portfolio, surpass their total revenue for the first time. In Q1, orders for the Nexus 3K and 9K were approximately 50% larger than their reported total revenues, growing in excess of four times their reported growth rates. Yet again, in just one year, we have grown back to where they had gotten to in the whole history of their company. A year ago, we were fighting an SDN perception battle, with competitors using PowerPoint instead of products. Today with ACI, we are bringing programmability and automation to networking on a scale well beyond what competitors define as SDN. Now we are in the market with products and solutions, and don't see, either traditional box competitors or the PowerPoint newcomers able to keep up. And for those who were concerned about SDN’s effect on our switching margins, our switching gross margins have been incredibly consistent over the last five to six quarters, and as we project forward, we see no change. In this quarter's example, our switching gross margins were above the mean level of this consistency. Data center and cloud, where we first converged networking with compute and storage, continue to hold the number one position in revenue share for x86 blade in the U.S. according to IDC. The data center grew 15% year-over-year. Five years ago, we invested in the market for converged infrastructures and brought it to life with our ecosystem partners. Today, FlexPod, with NetApp, and Vblock with EMC, are the leading converged infrastructure architectures with two common elements: Cisco’s UCS and Cisco’s networking. Also, in the quarter, we announced innovation across our UCS portfolio, broadening the product line to meet demands of large cloud environments while also scaling down to environments with just a handful of servers. We continue to demonstrate that innovation is alive in markets where standalone products have become largely commoditized. I will also touch on InterCloud, where we announced this quarter 30 new InterCloud partners, which is a really nice job, Rob, including Deutsche Telekom, British Telecom, NTT DATA, and Equinix. This brings our world's largest interoperable network of clouds to 250 data centers worldwide across 50 countries, all of which are working with us to integrate ACI with InterCloud fabric, plus OpenStack roadmap. This is truly unique to Cisco, and it showcases our ability to pull everything together. We are frequently asked what Cisco is doing differently in the crowded cloud markets. Simply put, we see the same problem in the cloud that we observed 20 years ago in networking, wherein numerous networks operated on different technologies that didn't communicate with one another. As we broke down the silos with Ethernet, we made the Internet pervasive. We are running the same play in the cloud as only we can, unifying private, public, and hybrid clouds. Customers want to seamlessly move their workloads between clouds, with a common goal of policy and security. They need scale, speed, and reliability, and they care about data sovereignty and openness. We will position this market as a solutions play, meeting the network requirements of enterprise-class applications and providing the platform to deliver Cisco's growing portfolio of software-as-a-service offers. This will drive our strategic role with customers and, over time, our recurring revenue. I said earlier that security is the number one issue facing many of our customers. Security revenues grew this quarter by 25%. In this quarter, we combined our security products even more closely with Sourcefire products and delivered a highly anticipated Cisco ASA with Firepower services, which combines Cisco’s ASA firewall with Sourcefire into one platform. Customer receptivity has been very positive. Our innovation in security is very strong, with security continuing to be our customers’ number one business priority at the CIO level, but perhaps even more importantly at the CEO level. We are performing very well in this market. Nearly every initiative we have at Cisco has security as a key component, and we are committed to becoming the number one security company. Compared with even a year ago, we are receiving positive feedback from our customers, as now more than ever, customers need a strong and trusted company like Cisco to lead. They see Cisco as the only partner capable of delivering an integrated security architecture and security services and solutions across their business. I am very pleased that our leadership transition is going smoothly in this area, and we are moving aggressively to capture the opportunities ahead of us. Last quarter, wireless grew only 1%; this quarter, wireless grew 11%, with strong momentum in our 802.11ac portfolio, which now represents over 50% of our access point revenue. Cisco Meraki continued with outstanding growth at 86%. In collaboration, we are committed to transforming our collaboration portfolio and moving towards more enterprise license agreements in subscriptions. In Q1, our collaboration business was down 10%, as our new video products ramped up well, but at dramatically lower price points, resulting in declines in telepresence and unified communications. WebEx continued to grow well and remains one of the largest FAS businesses in the industry. As I mentioned before, collaboration should be the greatest productivity driver for our organizations. In the next week, you will see some bold moves that will secure our leadership position in cloud-based, simple, secure, and converged collaboration. I think we have great potential to grow this business over time. I really like our position and our pipeline, and I’m very optimistic about returning to positive growth levels relatively quickly in the collaboration arena. Service provider video declined by 12%, with the set-top box business down approximately 20%. Revenue for service provider video software and solutions grew by 13%. The bet we are making is on the video transition to the cloud, and we are seeing our video software business continue to grow as we help our customers transition to cloud-based video solutions. Now moving onto services, pulling everything together is our services strategy, which grew by 5%. Services now represent over 23% of Cisco’s revenue on a 12-month trailing basis. We’ve added approximately $2.3 billion in revenue over the last three years with strong margins. Today, at $11.1 billion in trailing 12-month revenue, it is our second largest business after switching, and that doesn't count the literally billions of dollars being delivered by approximately 70,000 strong partner channels around the world, where partners deliver solutions on behalf of Cisco, not just boxes. In many ways, it's a bit unfair to refer to our services business by that name, since it draws the comparison to what investors typically see at other companies, while our large component is driven by maintenance and support. Unlike our peers, nearly 90% of the issues we handle for our clients are solved with automation. We have many large customers around the world who depend on us and Cisco to run their networks. We have also rolled out a unique set of consulting, cloud analytics, and security services. As the network continues to increase in importance, our services become increasingly more important to our customers. To summarize my commentary, we have undergone a successful reorganization across the company and are seeing the results. Our employee sentiment data shows that employees both understand the challenges we face and are optimistic about our future and the changes we've made to tackle these challenges. Thanks to a lot of hard work which will continue, I believe we have positioned Cisco to lead the market transitions in front of us to the benefit of our shareholders, our customers, our partners, and our employees. Frank, let me now turn it over to you.

Thank you, John. We executed Q1 with financial performance slightly above our guidance. From a top and bottom line perspective, total revenue was $12.2 billion, growing 1% on a year-over-year basis. The non-GAAP net income was $2.8 billion and non-GAAP EPS was $0.54. Our GAAP net income was $1.8 billion and GAAP earnings per share on a fully diluted basis was $0.35. Product revenue was flat, and service revenue increased by 5% on a year-over-year basis, with product book-to-bill less than one. Overall, non-GAAP operating margin was 29.2%. In Q1, our total non-GAAP gross margin was 63.3%, above our guidance of 61% to 62%. As we have said in the past, non-GAAP gross margin may vary quarter-over-quarter by a point in either direction of our guidance range. This quarter, we were above the range. Non-GAAP product gross margin was 62.5%. As compared to Q4, product gross margin was positively impacted by productivity improvements and by product mix, partially offset by pricing. Non-GAAP service gross margin was 66%, consistent with historical levels. Our non-GAAP operating expenses were $4.2 billion or 34.1% as a percentage of revenue, compared to 33.8% in Q4 of FY14. Non-GAAP operating expenses were flat quarter-over-quarter and up 3% year-over-year, reflecting investments in key growth areas. Our GAAP net income and GAAP earnings per share for the first quarter of fiscal 2015 included a pre-tax charge of $188 million, or $0.03 per share, related to a patent litigation matter described in our most recently filed 10-K involving the Rockstar consortium. A term sheet has been signed and we are hopeful to achieve a resolution of the associated litigation in a manner that is constructive for the entire industry. Now, moving on to the non-GAAP tax provision rate, it was 22%, consistent with our expectations. We ended the quarter with our headcount at 72,247, a decrease of approximately 1,800 from Q4 of FY14. This reflects reductions from our restructuring activity, partially offset by key sales, service, and engineering investments, as well as acquisitions. As a reminder, as we outlined in our Q4 call, in Q1 we began taking restructuring actions focused on continuing to invest in growth, innovation, and talent while managing costs and driving efficiencies, which would impact our global workforce during fiscal 2015. We announced and completed two acquisitions during the quarter, Metacloud and Memoir Systems, to enhance our innovation and long-term growth opportunities in key growth areas, such as cloud and software-defined networking. Both were executed consistent with our portfolio approach to acquisitions to drive long-term returns. Also, along with EMC and VCE, we announced during Q1 the next phase of VCE. Cisco will continue as a strategic partner and will have an approximately 10% equity interest in VCE. We expect the transition to close in Q2 of FY15. Looking at our geographic segment results, in terms of total revenue on a year-over-year basis, our Americas segment was up 3%, EMEA was up 2%, and APJC was down 5%. Total gross margin for the Americas was 64.1%, EMEA was 63.8% while Asia Pacific, Japan, and China stood at 58.8%. From a balance sheet and cash flow perspective, total cash, cash equivalents, and investments were $52.1 billion, including $3.8 billion, which is available in the U.S. at the end of the quarter. We generated operating cash flow of $2.5 billion during the quarter. In Q1, we returned $2 billion to shareholders, which included $1 billion for share repurchases and approximately $973 million through our quarterly dividend. Our balance sheet at the end of Q1 remains strong with DSO at 33 days and non-GAAP inventory turns at 11. Deferred revenue was $13.7 billion, up 4% year-over-year. Product deferred revenue grew by 9%, driven largely by subscription-based offerings while services deferred revenue grew by 1%. Each quarter, we are consistently driving a greater software mix and higher recurring revenue. Let me now provide a few comments on our outlook or guidance for the second quarter. I would remind you again that our comments include forward-looking statements. You should review our recent SEC filing that identifies important risk factors and understand that actual results could materially differ from those contained in the forward-looking statements, and actual results could also be above or below this guidance. The guidance we are providing is on a non-GAAP basis with a reconciliation to GAAP. As John mentioned, we expect total revenue to be in the range of 4% to 7% growth on a year-over-year basis. For the second quarter, we anticipate non-GAAP gross margin to be in the range of 61% to 62%. As we have said in the past, forecasting non-GAAP gross margin has always been very challenging due to various factors such as volume, product mix, cost savings, as well as pricing. As I said earlier, non-GAAP gross margins may vary quarter-over-quarter by a point in either direction of our guidance range. Our non-GAAP operating margin in Q2 is expected to be in the range of 27.5% to 28.5%. Our non-GAAP tax provision rate is expected to be approximately 22% in the second quarter. Our Q2 FY15 non-GAAP earnings per share is expected to range from $0.50 to $0.52 per share. We anticipate our GAAP earnings to be lower than our non-GAAP EPS by $0.10 to $0.13 per share in Q2 FY15. The range includes a pre-tax benefit of approximately $125 million from the reduced VCE equity investment to 10%, which is offset by a pre-tax charge of approximately $100 million in Q2 FY15 due to the restructuring actions that we announced in the first quarter. During Q1, we recognized pre-tax charges in our GAAP financial statements of $318 million related to that announcement; and we now expect total charges to not exceed $600 million during the fiscal year of 2015. Please see the slides that accompany this webcast for more details. Other than those identified and quantified items noted previously, there were no other significant differences between GAAP and non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring, and tax or other events which may or may not be significant. Our guidance does not assume a significant improvement in the emerging markets nor in the service provider segment in the near future. Although we believe we are executing well in a rapidly transforming market, given the types of uncertainties in mind, we will continue to provide our guidance with all the appropriate caveats one quarter at a time. We encourage our shareholders to have similar considerations. As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through explicit public disclosure. John, I'll now turn it back to you for some summary comments.

Thank you, Frank. And well done. I’d like to talk now about the leadership transition at the CFO level and summarize the call. The quality of our financial leadership team is something that we all take great pride in. Cisco has successfully transitioned through multiple leaders, often five to eight of them in every major functional area of the company over the years. Recently, Frank has been exploring the right time to step down as Cisco CFO. Frank joined Cisco over 10 years ago, serving as CFO for the last seven years. Among his many accomplishments is his very successful capital allocation strategy, including implementing Cisco’s first dividend, effectively managing some of our most challenging macro and industry environments, and he has been recognized time and again for his strong leadership. While I know that Frank has other ambitions, I'm very glad that he has agreed to stay on as an advisor to the financial leadership team and for me over not just hopefully the next several months but for longer than that—if you’ll have us, Frank. Effective January 1st, Frank will step down as CFO, at which point Kelly Kramer will assume the role as Cisco’s CFO. One of Frank’s best and most defining leadership characteristics is his focus on building incredible leadership teams. Almost three years ago, Frank hired Kelly. It is a credit to the work of Frank that the leadership team and the board have concurred in appointing Kelly to assume the role of CFO. Kelly brings a wealth of experience to this role, both from her three years at Cisco and 20 years at GE. In your last role at GE, you were with GE’s healthcare systems business as the CFO of that group. Kelly is known for her business judgment, no-nonsense approach, and strong strategic leadership style. At Cisco, she has led both Cisco's corporate finance and business finance groups, managing, among other things, all the controllers of Cisco's business units, with a focus on pricing and margins. She has learned Cisco's business inside and out and has proven herself to be a highly strategic, thoughtful, and influential leader. Kelly is not afraid to challenge all of us to think differently, and it has been impressive to see her do this while becoming a trusted partner to our entire leadership team. Kelly, I’m going to give you the same advice that I once got when I became CEO and then gave to Frank seven years ago: Do a great job, have fun, and don’t mess it up. We know you won’t, and I look forward to working with you closely. Frank, I truly want to express how proud I am of your many accomplishments. Your integrity and ethics define you, and you have always maintained the forefront of our employees, customers, shareholders in our long-term strategic business planning. You have been a great finance leader, but more importantly, you have been a great business leader. You have built a world-class financial organization that is driving Cisco’s transformation and ensuring we are positioned to execute on the opportunities ahead. I know the future will hold very exciting opportunities for you, and I look forward to our continued relationship. Thank you once again, Frank.

Thank you, John.

And Kelly, congratulations.

Thank you.

Frank, I’m just looking at you. You’ve weathered these last seven years better than I have. I’ve lost a lot of hair; you’ve got a little bit of grey in it.

We have to see how it continues, right?

Yes. All right. Now to summarize our call today. I've discussed the accelerating pace of change in the industry, recognizing that in many cases, Cisco and our technology are driving that change. I am more convinced than ever that the pace of change is providing an advantage for Cisco for several reasons. First, the role of the network is at the center of every major technology and business transition, which is becoming clear to our customers and the industry as a whole. Many customers are no longer interested in piecing together disparate infrastructure from different vendors or in purchasing standalone technology. They are digitizing their businesses, cities, and nations and want Cisco to be a strategic partner delivering solutions and business outcomes. They recognize that to move with agility and security, their solutions must be based on integrated architectures, combined with intelligent networks. You are seeing this reflected in increased enterprise license agreements, enterprise services agreements, subscriptions, consulting contracts, and other advanced services, including cloud analytics and security. Second, we have proven our ability to move quickly and aggressively to transform Cisco into a leaner and more effective company. Since FY ‘11, we have added around $4.1 billion in revenue at around $61 million in incremental non-GAAP OpEx. Remarkably, for every dollar of revenue we’ve added over this transitional period, we've only added about $0.01 of non-GAAP OpEx. No peer can come close to this by a factor of ten in terms of performance represented for Cisco and our shareholders. And what’s exciting is we're just getting started; our transformational evolution comes as our peers are just beginning their transitions, which we commenced 3.5 years ago. We have successfully redeployed this operating leverage in many ways. We’ve invested in innovation, built entirely new skill sets within Cisco, disrupted our largest businesses to keep pace with this market's demands, and created flexibility in our operating model as we managed through these transitions. Throughout, we’ve driven record annual non-GAAP earnings per share for our shareholders. Third, we are continuing to evolve the leadership team and the talent needed to propel us forward. As we focus on leveraging the potential of our people with Cisco's support, we are unleashing incredible innovation and energy. Fourth, the power of our brand and our global channels and strategic relationships with customers is only strengthening. We continue to earn the trust of our customers, translating into greater opportunities for Cisco. The environment feels a lot like the mid-90s, when companies turned to Cisco to learn about the Internet. Today, they’re coming to Cisco to help with their transitions into digitizing their operations, cities, and countries, preparing to take advantage of the opportunities presented by the Internet of Everything. To reiterate where we began, we believe we are managing very well in a challenging environment. We are witnessing the fruits of a transformative program lasting over three years, transitioning from selling boxes to selling solutions and leading with innovation, speed, and efficiency as we disrupt the market. We are leading technology and business transitions in the market. We have been very transparent about the challenges we’ve faced in our business. We're in an evolving environment, and we will continue to face those challenges. We also have managed the business effectively in light of those challenges. We have made difficult decisions when necessary and are now seeing the benefits of those decisions. In summary, I am highly optimistic about Cisco's future and excited about the path ahead. Mel, let’s move to my favorite part of the session, the Q&A, and turn it over to you.

Great. Thanks. Operator, let’s move to questions.

Hi. Thank you. I just wanted to ask you first about your product order growth. I think you said, up 1% year-over-year. That comes on the back of relatively easy comps relative to the year-ago number. Our method implies that sequentially, bookings declined something like the mid-teens, which I think would be well below normal seasonality for this quarter. So just curious if you can give us a little more color on the puts and takes in there; if you can touch on FX, China seemed to decline at a little faster rate, and how much of that was due to some of the weakness in the U.S. carrier space that you referenced?

Okay. So, Simona, I’m going to go through the most positive updates first. Unlike last quarter, where we had about fives up and fives down, this time most of the positives are in the right direction, with the exception of service provider and emerging markets. Starting with our high-end switching and high-end routing puts and takes, high-end switching grew by 10% as I mentioned earlier, showcasing how well we've executed on our transition and our success in taking market share while pulling away from a few smaller competitors. Routing is likely gaining share too; we have our best routing portfolio at the high-end, with both Nick Adamo and Kelly Ahuja heading that up. I think we are very well positioned in routing. Security saw 25% growth. Data center was at 15% growth this quarter, which was slightly lower than expected. In Q1, our server technologies were slower than anticipated, but I would expect that to rebound in Q2 to more aligned with the usual 20% growth. UCS was at 16%, and I predict it will also see growth into the 20s. Services had a very promising return to mid-single digits; we had hoped for what will be a bottom at 3%, feeling confident our services revenue will shift towards mid-single digits. Wireless had a strong return to double-digit growth at 11% on revenues and mid-teens on bookings. I expect continued solid growth next quarter as well. Collaboration was the only area I felt did not perform as well; bookings were down by about 2%. The collaboration portfolio had 10% on revenues. We saw better growth in Europe than expected, especially in southern Europe, and solid performance in the U.S. managed service providers. The two main issues for Simona remain service providers and emerging markets. Emerging markets were down by slightly less than last quarter; they went down by 6%, and the BRICS were down 12%, with China being the hardest hit at down 33%, yet the remaining emerging markets had slight positive growth around 6%. The service provider segment presents the largest challenges due to a few large U.S. companies that significantly slowed their order rates. We think net neutrality and Title II discussions could be impacting these providers, predicting a slowdown in order rates if regulation changes—the slowing began to show in our results this last quarter. Our strategy is effective, and even if that segment struggles, we’re positioning ourselves to be strong against the competition over time, especially when the market rebounds.

Great. Thanks, Simona.

Hey, Frank, first sorry to see you go, but I wish you all the best. John, I just wanted to clarify on the guidance, and maybe start on the previous question. Your guidance implies about a 4% decline in revenues. Should we assume that most of that—and in fact all of that—pressure comes from service providers and emerging markets? Are you seeing a potential slowdown in your switching side as well or should we expect that to remain robust? I just want to clarify what's embedded in the guidance?

Yes. My three years of law school would have me say it is entirely due to something my team would have me spare solely on this; almost all pressure is coming from those two major factors. If you look at simply the U.S. growth without service providers, it was 12%. Major strength came through that area, and that was in spite of a slow start from our enterprise business in making some organizational changes to set up for this next year. Brian Marlier and his team produced strong performance to build their pipeline, and I am confident they will return to double-digit growth this quarter. The pipeline is solid. Even within our service provider business, our pipeline is increasing. Our new leadership team is improving our relationships with these service providers, and we are gaining market share. Therefore, it is essential to emphasize that the two biggest challenges remain emerging markets and service providers, but we see positive trends in many other areas.

Thanks, Amitabh. Next question, operator?

Yeah, John, how are you doing? And Frank, congratulations on your retirement, and good luck dealing with us, Kelly. So, a question on the gross margin reaching 63%. Your guidance looks decent as well. How do you see your gross margin progressing? You mentioned that there might be some pressures—how do you expect to manage them into the next quarter?

Got you. Frank, why don’t you take the first part?

So Brian, I tend to repeat my thoughts on this. From a gross margin standpoint, as we look at it, we’re projecting gross margins of 61% to 62%. The first quarter always tends to show higher gross margins. We saw benefits from a stronger mix as well as UCS, which tends to be lower in comparison. However, Q2 will likely bring a negative mix due to the end of the calendar year, as it’s typically a strong quarter for UCS. We need to manage that balance as we look ahead.

Regarding the enterprise license agreement with General Motors that John mentioned again this quarter, it’s a robust deal for them—and for us. There has been significant interest from other companies, and we are working with several. Overall, the structure of the deal is beneficial for both GM and Cisco. With a company like GM, which is invested in our strategy, it facilitates their ability to grow and implement innovative solutions that enhance business outcomes.

What’s exciting about these enterprise licenses is their capacity to integrate hardware and software across multiple solutions, including security and collaboration. This allows us to improve efficiencies and create greater value driving Cisco’s services and products sales. Kelly, do you want to add anything?

Great points, John. I would emphasize that strengthening our relationship with customers through these agreements leads to integrated solutions with better margins and creates long-term value.

Let’s be clear: driving security, collaboration, and consulting services together creates a more cohesive solution set for our customers. They appreciate this holistic approach far more than piecemeal products from competitors. We are positioned in the market to take advantage of many of these emerging trends.

Thank you for those insights and sharing your thoughts. Operator, next question?

Hey guys, I appreciate the chance to ask some questions. First, Frank, great working with you and good luck. Can you provide some insight into your thoughts on retiring? What your plans might be next? I also wanted to understand the enterprise business better; orders were down compared to being up last quarter. Were there issues related to your agreements with VCE? What are your expectations for UCS coming into the next quarter? What can you expect as you change your equity stake in VCE? What gives you confidence that enterprise orders, UCS, and the data center overall will rebound next quarter?

Got it. First addressing the enterprise question directly: our Global Enterprise Theater run by Woody Sessoms produced strong growth of 15% this last quarter across varied architectures, along with VCE and FlexPod driving superb results. I’m confident that this trend will persist. The U.S. enterprise, as I said, still experienced a slight decline due to some organizational changes. However, we expect these adjustments to stimulate double-digit growth as the quarter proceeds. We closely monitored their pipeline, and despite some unexpected fluctuations, we are optimistic.

That's correct. VCE surpassed a billion in annualized run rate, boasting more than 2,000 configurations and thousands of customers—all of which have not slowed down because of our restructuring.

I want to emphasize that the government as a sector is similar to public sectors globally; we achieved 13% growth in both with strong performance. They are progressively digitizing operations, and we are closely partnered in this transition. We're positioned for upcoming growth, even in various challenging elements from each region.

Thanks, Ehud. Operator, please take the next question.

Yeah, thanks a lot. John, could you talk a bit more about the service provider business? What would you need to see for it to turn? It’s quite intriguing that you cited net neutrality, which is currently a hot topic. We’re all trying to see when we might see that change. Several factors appear to play a role, and your leadership on this issue would be immensely valuable.

On our service provider business, let's assume for now it may not change in the next couple of quarters. We’ve established a new structure and built relationships with over 30 major service providers at the CEO and CTO levels, altering our approach to meet their unique needs, especially on mobility and video. The service provider space is commoditizing, which reflects our need to adapt to their economic landscapes. However, key challenges remain, particularly with revenue pressures. Companies like AT&T have forecast a CapEx decline for the coming year. If we fail to address Title II, we risk significant deceleration. I believe that our message must outline the potential repercussions of regulatory changes on service providers’ investment decisions, especially as they are challenged in certain regions. Additionally, positioning ourselves positively among competitors strengthens our chances for rebound when the market turns.

Thank you, John. Operator, next question?

Thank you. Good afternoon. The patterns we’re seeing today are somewhat similar; we have regions with positive and negative results, and thus we’ve seen a reversion to the mean. Are there considerations in place for substantial changes that could leverage efforts that Cisco's making to result in enhanced economic value and equity outperformance? What discussions are occurring to unlock value? Are we at a point where Cisco will consider new inputs to formulate a better outcome?

Well, Mark, a few thoughts here. We’re succeeding in most of our major market transition strategies. Our architectures are well received, and we’re excelling in convergence technologies across the board. We’re breaking ground with our application-centric infrastructure, pulling our products ahead of smaller competitors, as well as establishing our presence in the Internet of Everything space with superior product offerings. I think our collection of diverse solutions and focus on integration is what enables us to break away efficiently in the market. I feel quite optimistic about the advances we can make as we respond to these transformative pressures.

Thanks, Mark. Operator, next question?

Thank you very much. I wanted to go back to the question on margins. I am curious about the opportunity for profitability improvement. It seems we are on the backend of an extensive multiyear overhaul of corporate structure. Wondering if there exists an opportunity for margin expansion in a context of continued revenue growth? Conversely, what topline growth do you feel translates to improved profitability, as we move through the latter stages of this reorganization?

Yep. You echoed sentiments I share; it’s been a productive transition over the last three years, growing revenues by $4 billion with only a $61 million increase in operating expenses—a massive success by comparison to many of our competitors. The emphasis on metrics—productivity per employee—leads us to improve our revenues notably in segments where new innovations can boost profits further. I am optimistic about our strategy and execution which reinforce our market leadership moving forward.

Indeed, John. There are multiple strategies we are currently pursuing. As John noted, our services revenues have significantly increased, benefiting from automation and analytics and providing higher value at lower costs. We anticipate even further improvements here as we expand our offer portfolio. Such developments will directly correlate with gross margin improvements as we continue seeing larger enterprise contract flows and advanced services.

Okay. Thanks, James. Operator, let’s move to the next question.

Hi, guys. How are you doing?

Good!

I was hoping you could provide some more clarity around the service provider segment. The set-top box business is still in decline, and it’s been declining for some time, making it difficult to analyze. Could you provide some insight into how the service provider business would be performing excluding set-top box on an apples-to-apples basis?

Sure. My team will verify the numbers for you. We can clarify that the global service provider segment was down 10%. If you remove the set-top box impact, it would have only been down by 6% overall. We do see fluctuating performance, especially in Europe where service providers grew by 13% last quarter. Meanwhile, we’re observing promising signs of growth in terms of emerging markets with companies like Reliance in our partnership molds.

Thanks, Alex. Operator, next question?

Thanks. Frank, the best wishes to you, and thank you for your many years of good service. Good luck to you, Kelly. I wanted to revisit the gross margin metric if possible. I notice that we haven't reached this level of product gross margin in quite some time. Your guidance looks positive, but I can't help but wonder if there’s a pressing need to raise that outlook for gross margins given your historic outperformance.

Yes, we deliberated that at the operating committee recently. I can say that we are indeed monitoring gross margins closely and that Gary leads those efforts, focusing on everything from product cycle improvements to overall portfolio management. It doesn’t mean we’ve rewritten our entire strategy, as we are trying to consolidate upcoming expansions into areas where higher margins can manifest. Our goal is to ensure strong margins not only for today but moving forward as well. We are aiming to maintain significant growth by pursuing new solutions, which will subsequently improve our margins.

Correct, John. There are quite a few things we are putting into action currently. That being said, we anticipate continued strong demand for both our data center and infrastructure services as we expand cloud services and find innovative approaches to integrations. Overall, we’re working towards achieving substantial improving metrics, yielding operational efficiency as seen with our high services growth.

Okay. Thanks, Ittai. Operator, next question?