Cisco Systems Inc (CSCO) — Q3 2017 Earnings Call Transcript

Thanks, Shaun. Welcome, everyone, to Cisco's Third Quarter Fiscal 2017 Quarterly Earnings Conference Call. This is Marilyn Mora, Head of Investor Relations and I'm 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 made 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 in the Financial Information section of our Investor Relations website. Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results and we will 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 made 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 fourth quarter of fiscal 2017. They 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 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. With that, I will now turn it over to Chuck.

Thank you, Marilyn and good afternoon, everyone. Our results this quarter demonstrated that we're delivering against our strategic priorities and realizing the benefits of our investments to transform our business and drive long-term shareholder value. We delivered a solid quarter, with total revenue of $11.9 billion and non-GAAP earnings per share of $0.60. We had strong margins yet again and great operating cash flow, up 10%. We're managing the business well through a multiyear transformation of the company while remaining focused on delivering customers unparalleled value through highly secure, software-defined automated and intelligent infrastructure. We're on a journey which, as we've consistently stated, will take a number of years, but we're pleased with the progress we're making. As our customers add billions of new connections in the years ahead, the network will become more critical than ever. They will be looking for intelligent networks that deliver automation, security, and analytics that help them derive meaningful business value from these connections. These will be delivered through a combination of new platforms as well as software and subscription-based services which we've been focused on accelerating over the last 18 months. My vision for this company is to be the most relevant and most important partner for our customers as they enable their digital businesses and we will deliver on that vision. I look forward to discussing this in a lot more detail at our Investor Day on June 28. We continue to innovate across our networking portfolio with analytics being a key element of this innovation. This quarter, we completed the acquisition of AppDynamics, enabling us to provide customers with unprecedented visibility across networking, data center, security, and applications. As I talk to our customers and partners, I'm getting great feedback about the value of the insights AppDynamics provides to help them make informed business decisions. We're in the early stages of scaling out the AppDynamics solutions through the Cisco Salesforce and partner ecosystem and I'm excited about the future of this space. We were also pleased to announce our intent to acquire some new additions to our software and analytics portfolio. Software-defined WAN is a critical market transition and addresses the evolving customer demands and branch routing as a foundational block of executing in cloud networking. Viptela, combined with Cisco's IWAN technology, will provide an industry-leading cloud-first SD WAN platform that addresses the Edge networking needs of our most demanding customers. MindMeld provides an AI platform to build intelligent and humanlike conversational interfaces for any application or device and will complement our already strong collaboration portfolio. These acquisitions support our goal of offering customers extraordinary value through a combination of organic and inorganic innovation and they are aligned to our strategy of investing to drive longer-term growth and helping us transition to more recurring software and subscription revenue. We will continue to deploy our capital resources to give us first-mover advantage as we extend our technology portfolio. In addition to our inorganic growth, we're seeing strong organic growth of our next-generation products and solutions in both networking and security. Now let me share some business highlights, starting with our security business which has never been more relevant, as we've seen in recent days. Last week's WannaCry ransomware attack was another example of the devastating impact cybercrime can inflict on individuals, companies and countries around the world. Since Friday's attack, our Talos cyber threat intelligence team has been working around-the-clock to dissect the WannaCry ransomware, understand its attack patterns and keep our customers protected. It's important that the tech industry and customers work together to defend against these attacks from cyber criminals. We will continue to do everything we can to help our customers anticipate, prevent and protect themselves from any future attack by harnessing the intelligence of the network and the power of our security portfolio. Our security business delivered another solid quarter with 9% revenue growth and 39% deferred revenue growth, reflecting our combination of best-of-breed solutions, together with the industry's broadest security portfolio and a highly effective end-to-end security architecture. We continue to lead in network security. Our next-generation firewall portfolio grew 49% with 6,000 new customers in the quarter, bringing our total customer base to over 73,000. We expanded our portfolio with the announcement of our Firepower 2100 Series which offers both performance and protection for mission-critical applications. Our Advanced threat portfolio continues to deliver strong revenue growth of over 30% and we added 6,600 new customers, bringing the total number of AMP customers to over 35,000. Now let's turn to collaboration. In January, we introduced Cisco's Spark Board, the first all-in-one cloud-based collaboration and meeting room solution. We've seen good early traction with this SaaS-based service, with nearly 700 customers adopting this solution in the quarter. This is a great example of the transition I mentioned earlier focused on moving from standalone systems to best-of-breed products combined with software subscriptions. Our intended acquisition of MindMeld will help us simplify and enhance the collaboration experience even further through the power of artificial intelligence and machine learning. As chat and voice quickly become the interfaces of choice, MindMeld's AI technology will enable Cisco to deliver unique experiences throughout its portfolio. This acquisition will power new conversational interfaces for Cisco's collaboration products, revolutionizing how users will interact with our technology while increasing ease-of-use and enabling new capabilities. For example, users will be able to interact with Cisco Spark via Natural Language Commands, providing an experience that is highly customized to the user and their work. In our data center switching business, we now have a combined install base of over 20,000 customers who are using our portfolio to help them build, run, and manage their private and hybrid cloud environments. Our ACI portfolio grew 42%, as customers moved to 100-gig and look to automate the network and increase network performance, visibility, and security. We added almost 1,200 new Nexus 9K customers in the quarter, bringing the total installed base to 12,000. Our APIC adoption continues to increase rapidly with over 380 new ACI customers in Q3, bringing our total to nearly 3,500. Before I turn it over to Kelly, let me reiterate a few key points. I'm pleased with the progress we're making. As I've consistently stated, this transition will take time, but we're remaking this company to succeed in a dramatically changing marketplace. We're laser-focused on delivering innovation as well as aggressively managing the business to optimize profitability, cash flows and value for our shareholders.

Thanks, Chuck. I'll start with a summary of our financial results for the quarter followed by the Q4 outlook. Q3 was a solid quarter with financial results consistent with our expectations. We executed well, driving solid profitability, strong cash flow and we continued to deliver on our strategic growth priorities. Total revenue was $11.9 billion, down 1%. Non-GAAP EPS was $0.60, up 5% and operating cash flow grew 10% to $3.4 billion. We generated 31% of our total revenue from recurring offers, up from 29% a year ago. We continue to be extremely focused on driving margins and profitability, increasing our non-GAAP operating margin to 32.3%, up 2.3 points. Before I go through Q3 in more detail, I want to remind you that Q3 last year included an extra week. It resulted in higher revenue in that quarter of $265 million, $200 million of which was in Services and $65 million from our SaaS businesses like WebEx and some from product distributions. We also had higher non-GAAP cost of sales and operating expenses of $150 million. This netted to $115 million of higher non-GAAP operating income last year. So onto this quarter. Total product revenue was flat year-over-year. I'll walk through each of the product areas. Switching grew 2%, with solid growth in data center switching driven by ongoing strength in the ACI portfolio which was up 42%. We also saw a slight positive growth in our campus business. Routing was down 2%, driven primarily by weakness in mobile packet core. Collaboration was down 4%, but adjusting for the extra week last year, it was down 2%. The drivers are primarily a decline in Unified Communications' endpoints, partially offset by continued growth in WebEx. Deferred revenue grew 10%. Data center declined 5% with the continued market shift from blade to rack. However, we're seeing solid traction with our hyperconverged offering, HyperFlex. This quarter, we also further extended our innovations in UCS with new converged solutions for IBM versus stack and with our strategic alliance with Docker to deliver containerized applications. Wireless grew 13% with strong Meraki performance as well as the ramp of our 11 AC Wave 2 portfolio. We continue to innovate with the launch in the quarter of new wireless networking solutions, including a new Wave 2 access point and a wireless controller. Security was up 9% with strong performance in unified threat management, with growth of approximately 50% as well as growth of over 30% in both advanced threat and web security. Deferred revenue grew 39%, demonstrating the value of our solutions and ongoing delivery of innovation. Services was down 2%. Normalized for the extra week, it grew 4%. We're continuing to focus on renewals and attach rates. We drove good growth in deferred revenue which was 13% in total, with product up 26% and services up 7%. Deferred products revenue from our recurring software and subscription businesses was up 57% to $4.4 billion which includes the acquisition of AppDynamics during the Quarter. Excluding AppDynamics, the increase was 51%. In terms of orders, total product orders declined 4%. Looking at our geographies which is a primary way we run the business, Americas was down 4%, EMEA was down 6% and APJC grew 2%. Total emerging markets declined 12%, with the BRICS plus Mexico down 10%. In our customer segments, Enterprise declined 2%, Commercial grew 1%, Public Sector was down 4% and Service Provider declined 10%. From a non-GAAP profitability perspective, total gross margin was 64.4%, down by 0.8 points. In Q3 '16, the extra week resulted in a 0.5 point benefit in that quarter. So adjusting for that, total gross margin decreased 0.3 points. In Q3 '17, our Product gross margin was 63.2%, down 1.3 points and Service gross margin was 67.8%, growing 0.7 points. We increased our operating margin by 2.3 points to 32.3% from a year ago. In terms of the bottom line, we grew non-GAAP EPS 5% to $0.60, while GAAP EPS was $0.50. We ended Q3 with total cash, cash equivalents and investments of $68.0 billion, with $2.9 billion available in the U.S. From a capital allocation perspective, we returned approximately $2 billion to our shareholders during the quarter that included $0.5 billion of share repurchases and $1.5 billion for our quarterly dividend, reflecting the 12% increase we announced last quarter. To summarize, Q3 was a solid quarter and we executed well. We're focused on driving operational efficiencies and profitability, enabling us to make the strategic investments to drive long-term shareholder value. Let me reiterate our guidance for the fourth quarter. This guidance includes the type of forward-looking information that Marilyn referred to earlier. We expect revenue in the range of minus 4% to minus 6% year-over-year. 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 29.5% to 30.5% and the non-GAAP tax provision rate is expected to be 22%. Non-GAAP earnings per share is expected to range from $0.60 to $0.62.

Thanks, Kelly and thanks again to all of you for joining us today. As I mentioned earlier, we delivered another solid quarter and we're executing well. We're confident in our strategy for long-term growth and profitability. We believe that the network will become increasingly important in solving our customers' most complex business problems and helping them get secure and stay secure. We also believe that we will continue to see strong momentum in our shift towards more software and subscription revenue. This reflects the success of the investments we're making in these areas, together with the flexible consumption and buying models we're offering our customers. Marilyn and I'll turn it back to you for questions.

Great. Thanks, Chuck. Shaun, let's go ahead and open the line for questions.

I wanted to gain a better understanding of the guidance, Kelly and Chuck. The revenues are slightly below our expectations. Is this due to macroeconomic factors, the transition to the subscription model, or might there be some disruptions impacting it? The growth in deferred revenue and product revenue is strong, but I was hoping you could clarify any factors influencing this. I would really appreciate it.

Kelly, why don't you take him through the bridge and then I'll just make some comments?

Certainly. When considering our guidance, it involves multiple factors. It begins with our backlog and the subsequent orders, along with the sales funnel. We are also factoring in our transition to more software and subscriptions and its impacts. Regarding the guidance we just provided, our orders were slightly weaker in Q3, which results in a lower backlog than we expected. I'm assuming that the order strength we observed in Q3 will carry into Q4. To provide some context, we've been facing headwinds throughout the quarter, especially with SP and the emerging markets, which worsened this quarter as reflected in the numbers. I anticipate this trend will persist. Additionally, we've encountered some new macro issues, particularly within the Public Sector and U.S. Fed space. Therefore, I expect that the order patterns from Q3 will continue into Q4. Lastly, we are seeing an impact from the transition we are currently accelerating, which is affecting our balance sheet by about 1.5 to 2 points. The combination of these three factors is leading to our guidance in the range of minus-4 to minus-6.

Yes, I want to add a couple of comments regarding what Kelly just described. The Public Sector business, especially in the United States, particularly at the federal level, is currently facing significant challenges due to a lack of budget visibility. Regarding our strategy, we’ve seen a 57% growth in the software and subscription segment. If we look back eight quarters, we had $2 billion in that area. Initially, we spent the first two or three quarters convincing our teams that this shift was necessary, and now we’ve more than doubled that figure to $4.4 billion, with accelerating growth. We are pleased with this transition. Despite the challenges we face, we remain committed to maintaining our earnings and our capital return strategy.

Chuck, I want to shift my focus this time from the data center business to gross margins. Your press release mentioned some pricing pressures, and I would appreciate more details on your guidance and the assumptions for gross margins. Specifically, how much of that is due to product mix versus pricing? Additionally, any insights you can provide on the nature of the pricing pressures—whether they are competitive or related to product changes—would be helpful.

Thanks, Ittai. So Kelly, let's have the same strategy. You want to go through the math on this and then...

So Ittai, when we look at the drivers of our growth margin, price in Q3 actually has been in the same range that it was pretty much last year as well as last quarter in terms of the price index that we're seeing. So that's in the same range. Again, it's high, but it's in the range. It's not increasing. I would say in terms of the guidance for Q4, we're assuming that. We're also making sure the teams are being very aggressive where they need to be aggressive in areas and then against competitors where we need to be. But overall, the pricing hasn't changed dramatically besides the normal erosion that we see in churned business lines. I'd say, in terms of mix, that hasn't dramatically changed as well, with switching being positive this quarter, that helped a lot. And again, while the mix isn't changing, there's mix changes with MBEs in the guidance going forward but it's nothing dramatic. So I'd say we feel good about being able to continue driving the margins that we have. The only other piece I'll comment on, because we mentioned it before, we're still seeing some cost pressure from the increase in DRAM pricing that got baked in both our Q3 as well as into Q4. But we've been doing a lot of work and our supply chain team has done working with our suppliers to make sure we can secure our forward supply at prices that we can plan on. So I think we've pretty much got that boxed in for the guidance.

Just a couple of quick follow-up questions to some of the comments that have already been made. Can you talk a little bit about the orders and you mentioned that fed was weak. But when you look at the other areas of weakness, can you talk about, like, what's driving those, etc.? And I guess, more long term, it continues to be a good deferred revenue growth and you mentioned the security. What are the priorities that your customers are showing in the security space generally? And what are you able to address now versus where are the things that they're asking for that you think you need to improve on?

Thank you, James. Let me discuss the order details first, and then Kelly can add her insights as needed. To provide an overview globally, I'll highlight the factors contributing to the challenges we faced in certain areas, while assuming the other parts of the business performed as expected. In the Americas, the primary issue was with the U.S. federal sector due to significant uncertainty surrounding budgets. Mexico also saw notable instability, resulting in a 49% decline year-over-year, reflecting concerns about the investment climate. Additionally, the Service Provider sector in the Americas faced challenges, which influenced orders in the U.S. In Europe, the currency situation in the U.K. had a considerable negative impact on the business. Meanwhile, the Middle East experienced ongoing pressure from fluctuating oil prices and geopolitical uncertainties, although some countries showed signs of strength. The U.K. remains a crucial market for us, and the Middle East continues to be affected by oil price volatility. Looking at APJC, Japan and Australia performed reasonably well, India remained strong, while China faced tough year-over-year comparisons in the SP Video business. Overall, from an orders perspective, the challenges were mainly visible in Europe for the Enterprise segment and similarly for the Commercial segment. The Public Sector challenges were driven by the U.S. Federal space, while the Service Provider segment remained relatively stable. Kelly, do you have any additional comments on this?

Yes.

Regarding securities, what we observe is that our customers are preparing for the future by adding billions of new connections, which makes the network increasingly important. To manage this scale, they will require significant automation and enhanced insights from their technology infrastructure, particularly through analytics. Additionally, security must be embedded at the network layer to protect the infrastructure from the moment data packets are transmitted. Customers are seeking an end-to-end architecture for security that is open and allows them to choose the best technologies available, which we provide across various aspects of their needs. Furthermore, they aim to leverage cloud capabilities, which align with the subscription model we discussed. We also see many opportunities within this architecture where we currently do not operate, and we are actively evaluating all of these prospects.

I mean, Chuck, I'm just a research analyst. I've noticed you're using AI machine learning quite a bit more recently. So like to get your idea, Chuck and also, Kelly, if you could, in terms of which might be the product areas within Cisco where you're apply AI machine learning to the max initially, where you see kind of low-hanging fruit, immediate kind of business outcomes from AI machine learning. Would it be in which parts of the portfolio?

Thanks, Vijay. Yes, your point is quite accurate that we consider how we use AI and machine learning across our entire portfolio. There are initiatives underway and solutions already available in the marketplace that incorporate these technologies. In our security portfolio, we definitely have elements that are part of our collaboration portfolio as well. We see numerous opportunities when discussing automation, analytics, network assurance capabilities, and self-healing networks for service providers. Overall, we see potential across all areas of our business, with initiatives already in place working with customers, as well as significant efforts within our business units to leverage AI, machine learning, and other technologies moving forward.

I'm hoping for a clarification on certain issues. One, going back to the earlier question on pricing. Kelly, did I hear you say that pricing was relatively stable? And can you give us some granularity in terms of what you're seeing in Europe Switching and Routing in terms of pricing? And just very quickly, 2 quarters ago, you quantified the impact of the shift to recurring revenue model. I think you'd cited 100- to 200-plus basis point adverse impact. Can you give us quantification of that impact this quarter?

Sure. Regarding pricing, I can clarify that we typically experience normal price erosion in our switching and routing portfolio, which is the most sensitive to it. The percentage of price reduction has remained consistent year-over-year, similar to both last quarter and the previous year. We did have one favorable quarter due to some rebates, but overall, the trend hasn't worsened. I will also check for any differences between Europe and the Americas as I respond to the next question, but it seems to be relatively consistent across regions. What was the second clarification, Marilyn?

On the impact of the recurring business.

Yes, I've been indicating it's in the 1 to 2 range. It's definitely moving closer to the 2% range now. This is clearly driven by the balance we shared with you, which is accelerating. I look at the short-term portion of that and try to analyze it on a quarterly basis. It's definitely leaning more towards 2% than 1%. I'll follow up with you, Paul, regarding any differences between the Americas and Europe.

If my numbers are correct, your recurring revenues grew 6% year-over-year and it was 14% the previous quarters. And I'm trying to see what could cause reacceleration. The question I have is whether you focus the recurring part mostly on new types of businesses, such as security and others or you can find ways to go back to Switching and Routing and change either pricing scheme or add features or do something such that recurring revenues outside of maintenance, of course, recurring revenues grow and you can add software features on top will do that. The question is whether the customers will accept it or is this is going to be a traditional business model forever?

Yes, Tal, thank you for your question. Even within our current deferred revenue from Software and Subscription, our core portfolio includes elements of the $4.4 billion primarily through our Cisco ONE offerings that we initiated about 18 months ago, which started to ramp up. Additionally, security is growing significantly, and collaboration has been the longest in this model. We believe that across our portfolio, with future offerings, there is an opportunity for growth, and you will see this as we introduce new capabilities. Kelly, do you have any comments on this?

Yes, on the slowdown, so Tal, we're actually not slowing down. The reason it looks like it's slowing down is for the Services piece, we do have the extra week compare. So if you adjust for that, it's up double digits in total. And if I look at just product, the growth of product which I said is over $900 million, that's growing 34% year-over-year and it was 30% last quarter. So that continues to grow faster.

I believe that was our last question. Chuck, maybe I'll turn it to you for over for final words.

Thank you all for joining the call today. I want to take a moment to emphasize that I believe our strategy is effective, and I am optimistic about our direction over the next three to five years. Eighteen months ago, we aimed to transition our business towards more software and subscription services. At that time, we had $2 billion on our balance sheet, and today, we've more than doubled that to $4.4 billion, reflecting a 57% increase this quarter, which shows our progress. We will continue to expand our offerings in this area. We have also made substantial investments in security and collaboration. Around 15 months ago, we redirected our expenses towards core initiatives, and you can expect future innovations in that space. Our customers will be adding billions of connections and will require a next-generation network with security automation and analytics. We are evolving our business model and network offerings to meet these needs while leveraging both inorganic and organic innovation. Throughout this transformation, we remain committed to our execution model, focusing on profitability and capital returns to our shareholders. That's a summary of our current position, and I appreciate you spending your time with us today. Thank you.

Thanks, Chuck and I'll go ahead and close it up here. Cisco's next quarterly earnings conference call which will reflect our fiscal 2017 fourth quarter and annual results, will be on Wednesday, August 16, 2017, at 1:30 p.m. Pacific time, 4:30 p.m. 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's done through an explicit public disclosure. We now plan to close the call. If you have any further questions, feel free to contact the Investor Relations Department here. And we thank you very much for joining today's call.