Cisco Systems Inc (CSCO) — Q3 2018 Earnings Call Transcript

Thanks, Michelle. Welcome, everyone, to Cisco's Third Quarter Fiscal 2018 Quarterly Earnings Conference Call. This is Marilyn Mora, Head of Investor Relations, and I'm joined by Chuck Robbins, our Chairman and 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 sheet, cash flow statement 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 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 2018. 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 Form 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 the 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'll now turn it over to Chuck.

Thank you, Marilyn. Good afternoon, everyone. We had another great quarter. We are executing well against the strategy we put in place three years ago. Our innovation pipeline has never been stronger, and we continue to transform our business to reflect the way customers want to consume our technology. We delivered another quarter of accelerating revenue growth of 4%, solid margins and record non-GAAP EPS up 10%. Our performance was driven by the acceleration of our intent-based networking portfolio, continuing strong customer demand for our innovative solutions and the increasing value of the network. We also made steady progress in shifting more of our business toward software and subscriptions. This resulted in broad-based strength across our products and geographies. As I talk with customers around the world, it is clear that the network is playing an increasingly critical role in helping them manage their complex environments. They are consuming services from multiple cloud providers, multiple SaaS applications, connecting billions of new devices which are generating massive amounts of data, and the network is pervasive across all of these environments. We have been evolving our portfolio to help our customers deal with this complexity and provide unprecedented simplicity, visibility and security across on-premise, hybrid and multi-cloud environments. Now I'd like to review our momentum across key priority areas and share some of the innovations we're driving across our portfolio. First, let's start with Infrastructure Platforms. We are leading the network industry's transformation to intent-based networking across the campus, branch, data center and the edge. We are paving the way to help customers simplify and manage the network. Only Cisco offers an end-to-end, intent-based networking portfolio that delivers assurance, industry-leading security, policy-based automation and segmentation. We continue to see very strong adoption of the Catalyst 9000, the fastest-ramping new product introduction in our history. This includes another quarter of high uptake of our advanced subscription offer in DNA Center, our automation and analytics platform. The Catalyst 9000 now has over 5,800 customers, up from 3,100 last quarter. This is an excellent example of how we've begun to scale our enterprise networking business into a subscription model. We've also recently introduced additional intent-based networking innovations. These include new access solutions and routing software subscriptions which expand our software-defined WAN capabilities onto any platform. We are extending our leadership in data center and cloud by providing highly secure and differentiated offerings such as our ACI SDN solution. With growing 100-gig deployments, especially in cloud infrastructure, we remain well positioned for future growth with our data center switching and intent-based portfolio. We also announced new hybrid cloud workload management solutions with ACI Multi-Site Management and new flexible consumption models, including SaaS delivery for our Tetration platform. Whether deploying enterprise applications or containers in a multi-cloud environment, customers are increasingly turning to Cisco's unique architectural approach. This is leading to strong momentum with UCS, our compute platform; and HyperFlex, our hyperconverged offering, as customers benefit from simplicity and scalability to support their hybrid cloud strategies. Now turning to Security, which is foundational to everything we do. Our architecture delivers highly effective security from the network to the endpoint to the cloud. This unique ability to bring together networking and security at scale gives us a huge competitive advantage. With the largest customer base in enterprise security, it is clear that our strategy is working. The strength we saw in the quarter is driven by our integrated architecture, combined with best-of-breed products. We are also leveraging artificial intelligence and machine learning to reduce time to detection and remediation. A great example of this is our Talos intelligence platform where we block 20 billion threats every day. We continue to rapidly innovate in security to address key areas of concern for our customers such as security in their complex data centers. We introduced a comprehensive, integrated data center security architecture that is designed to protect the modern data center by seamlessly following any workload anywhere across physical and multi-cloud environments. Now moving to Applications. This quarter, we introduced new innovations across our collaboration portfolio with the convergence of the Cisco Spark and WebEx platforms combined with new WebEx Meetings and WebEx Teams applications. We further enhanced our AI and machine learning capabilities across our collaboration portfolio with the acquisition of Accompany, a relationship intelligence platform with robust insights and intelligence to improve meeting and team experiences. We completed this acquisition last week. We are pleased with the consistent progress we've made to deliver on the strategy we put in place nearly three years ago. We have solid business momentum. We are confident in our pipeline of innovation and future growth opportunities. And our commitment to driving value for our shareholders remains as strong as ever. This is clearly demonstrated by the fact that we delivered record capital returns this quarter. As part of our commitment to shareholders, we are also very focused on our responsibility as a company to drive impact within our communities through innovation and active engagement. It is not only the right thing to do, but a key requirement for long-term business success. We are deeply committed to our long-standing efforts around sustainability, education and disaster relief as well as other key issues such as hunger and homelessness. I could not be prouder of our achievements or more excited about the impact we will have going forward. Now I'll turn it over to Kelly to walk through more detail on our financials.

Thanks, Chuck. I'll start with a summary of our financial results for the quarter, followed by the guidance for Q4. We were pleased with the financial performance in Q3 with broad strength across the business. We executed well with very good orders momentum, strong revenue growth and solid margins. Total revenue was $12.5 billion, up 4%, and non-GAAP EPS was $0.66, up 10%. We continue to focus on driving margins and profitability with a strong non-GAAP operating margin rate of 31.5%. Let me provide some more detail on our Q3 revenue. Total product revenue was up 5%, demonstrating the strength of our portfolio. Infrastructure Platforms grew 2% with strength in all businesses with the exception of routing. Switching returned to growth with revenue growth in both data center and campus. Campus growth was driven by our new switch, the Cat 9K. We saw solid growth in wireless with strength in Meraki and our Wave 2 offerings. Data center had very strong double-digit growth driven by servers as well as HyperFlex. Routing declined largely with the continued weakness in service provider. Applications was up 19% in total with broad strength across the businesses. We saw very solid growth in TelePresence endpoints, UC infrastructure and AppDynamics. Security was up 11% with strong performance in unified threat, advanced threat and web security. Deferred revenue grew 38% as we continue to drive more subscription-based software offers. Service revenue was up 3%, driven by growth in advanced services as well as software and solutions support. We continue to transform our business, delivering more software offerings and driving more subscriptions and recurring revenues. In Q3, we generated 32% of our total revenue from recurring offers, an increase of 2 points from a year ago. Revenue from subscriptions was 55% of our software revenue. We drove good growth in deferred revenue, which was up 9% in total, with product up 18% and services up 4%. Deferred product revenue from our recurring software and subscription offers was $5.6 billion, up 29%. We saw strong momentum in Q3 product orders growing 4% in total. Looking at our geographies, Americas grew 4%, EMEA was up 6% and APJC was up 3%. Total emerging markets was up 7%, with the BRICS plus Mexico up 12%. In our customer segments, enterprise was up 11%, commercial grew 7%, public sector was up 2% and service provider declined 4%. From a non-GAAP profitability perspective, total Q3 gross margin was 63.9%, down 0.5 points. Product gross margin was 62.9%, down 0.3 points. And service gross margin was 66.9%, down 0.9 points. We continue to be negatively impacted by the higher memory pricing we have discussed over the past several calls, which we expect to continue in the near term. Our operating margin was strong at 31.5%. When we look at the impact of acquisitions on our results year-over-year, there's been a 120 basis point positive impact on revenue and a negative $0.01 year-over-year impact on our non-GAAP EPS. In terms of the bottom line, non-GAAP net income of $3.2 billion was up 6%, while GAAP net income was $2.7 billion. We grew non-GAAP EPS 10% to $0.66, while GAAP EPS was $0.56. We delivered operating cash flow of $2.4 billion, down 28%. We paid $1.3 billion of one-time foreign taxes during the quarter related to the Tax Cuts and Jobs Act. Operating cash flow increased 11% normalized for these tax payments. We repatriated $67 billion of our offshore funds to the U.S. and ended Q3 with total cash, cash equivalents and investments of $54.4 billion, with $47.5 billion available in the U.S. From a capital allocation perspective, we returned $7.6 billion to shareholders during the quarter that included $6 billion of share repurchases and $1.6 billion for our quarterly dividend. We recently announced an agreement to sell our Service Provider Video Software Solutions business. We expect this transaction to close in Q1 fiscal year '19 subject to any regulatory approvals and customary closing conditions. We are continually looking to optimize our portfolio. To summarize, Q3 was a good quarter with solid top line growth, strong profitability and order growth. We continue to make solid progress on our strategic priorities, making key investments to drive our long-term growth. Let me reiterate our guidance for the fourth quarter of fiscal year '18. This guidance includes the type of forward-looking information that Marilyn referred to earlier. We expect revenue growth to be in the range of 4% to 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 21%. Non-GAAP earnings per share is expected to range from $0.68 to $0.70. I'll now turn it back to Marilyn so we can move on into the Q&A.

Thanks, Kelly. Michelle, let's open the line for questions. So with that, I'll turn it to you, Michelle.

Great. Chuck and Kelly, I wanted to ask you about the continued growth in subscriptions. It seems like the deferred numbers are increasing nicely. One of our main questions is regarding the good demand for the new Catalyst 9K products as distribution expands. What are you observing in terms of subscription attach rates for this new product? Are they holding steady at the levels you saw at launch, or are they starting to return to more traditional levels? I’m trying to understand how effective your tying strategy is.

Yes, James, thanks for the message. I'll comment. And then if Kelly wants to add anything, we'll let her do that as well. I would say it's been very consistent over the last four quarters, I think, since we put it in the marketplace in Q4 of last fiscal year. I think we had one month of activity. So it's been incredibly consistent. We're really pleased with the acceptance of this product. I think adding 2,700 more customers in the quarter, if you think about that, that means we added over 40 customers per day that acquired a Catalyst 9000 for the first time. And the acquisition of that product, in my opinion, is a clear belief in the next-generation architecture with the automation platform that we're announcing, which is what the advanced subscription model requires. And so I think that's reflected in the continued high uptake that we see on the advanced subscription. Kelly?

Yes. No, I think that covers it. The vast majority is the Advantage, which has the advanced features and the higher margin profile. And then the only other thing I would add is, it is very evenly spread across commercial, enterprise and public sector in terms of the demand and where we're seeing all the business.

I just wanted to try to dig under the covers a little bit on the revenue guidance. Obviously, service provider orders are weak and sounds like routing's weak, in line with that. Just wondering if you could, Kelly, maybe give us any idea how much service provider video is affecting that guide and also the routing within that guide, like what are you assuming there. Are you assuming routing continues to kind of drag that growth down? And then I have a follow-up.

Yes. So in general, I think the trends on both routing and service provider video, which is in the other bucket, have been consistent. And we're not assuming any improvement in either of those. So I would say our guide includes what we see. We feel really good about the rest of the portfolio, actually. And we see very good growth there, but those two trends are not improving. So that's basically what I have included.

Okay. And then, Kelly, could you also comment on the OpEx to sales? It's ticking up a little bit in the guide, at least implied. And I'm wondering if you could maybe give us any color on what's moving around in OpEx for fiscal Q4.

Yes, certainly. The increase in operating expenses is primarily due to the acquisitions we've made, particularly AppDynamics. When we acquired AppDynamics, we were in the early stages and heavily investing in them, which contributes to this increase. Additionally, we've consolidated BroadSoft, which also has a significant impact on our operating expenses. If you examine our OpEx growth for the quarter, it rose by just under 6%, and four percentage points of that is solely attributable to the acquisitions. This impact from acquisitions is reflected in my top line and is negatively affecting our earnings per share, primarily showing in the operating expenses. We are being very disciplined in managing the rest of our portfolio, so I expect this trend to persist as we look ahead to Q4, but that’s the main driver behind the increase.

Chuck, I had a couple of questions. First, on the Catalyst 9K, good progress, but help us understand how big is your Catalyst installed base from a customer standpoint? What percent of it do you really think the Cat 9K is relevant to? Because it's hard to gauge whether you're moving too slow or too fast. 40 customers a day sounds like a lot, but maybe for a company like Cisco it's not fast enough. So help me understand how you think about driving that throughout your installed base especially with now Arista potentially coming to the marketplace. And then second question, I had a question about China. Clearly, relations there have not been on the good side recently. And you've been somewhat a little bit more optimistic on that country over the last year. What are you seeing out of there? And how do you take that into your outlook commentary?

Thank you, Ittai, for your positive comments. Regarding the 9K, we currently have approximately 840,000 customers, and there is a significant number still available for us to reach with this platform. Our products, including the new Catalyst 9K family, are designed to replace older platforms like the Catalyst 3000 and 4000, meaning there are still many customers we can target. It's important to note that many of these customers are choosing the 9K, which is becoming the standard platform, leading them to refresh their networks. As mentioned in a previous call, we anticipated that the enterprise segment would lag behind the commercial sector with the 9K, and we've observed improvements in enterprise business thanks to the 9K. We are optimistic about the future of this architecture and the products within it. Honestly, the decision for many customers to upgrade to the 9K is less about it being a groundbreaking switch and more about their commitment to our automation strategy that encompasses the entire portfolio. As for our business in China this quarter, we've seen strength in switching across both enterprise and commercial segments. While there is still some uncertainty, I remain optimistic that trade issues will be resolved, leading to stability in the region. We believe in the potential of China as it will likely be the world's largest economy in the next decade, and we are performing well there. Although our SP routing business in China faces challenges similar to the global situation, we are happy with the performance of our other portfolio elements.

Chuck, Kelly, these are solid results here. You beat on all major categories. A quick question for you. A bigger-picture question actually, Chuck and Kelly as well which is, as your software subscription attach rate sees strength, could we see the sales OpEx, for example, start to trend down? Are you already seeing that impact to your sales OpEx line? And then just a quick tactical question in terms of, approximately, what was the run rate of the SP Video business you've sold to Permira? Because that would help us to inflate your July quarter guidance if it wasn't sold so that it helps us in kind of this if-what scenario basis.

Yes. Let me share some insights into how we envision the sales model evolving. After that, Kelly will address the financial aspects of your questions. Vijay, what you will notice is that we are establishing a traditional software model that includes a customer success organization. Over time, this team will assume greater responsibility for all functions within the software company, particularly focusing on adoption, expansion, and renewals. This approach will enable us to renew many offers over time within a multiyear renewal period, and at a significantly lower cost of sale. I believe this could provide us with operational leverage or the chance to invest more in R&D or other areas. This model is a key reason we brought in Maria Martinez as our Chief Customer Experience Officer, who is instrumental in developing this capability based on her extensive experience in various software companies. This is a major initiative we currently have in place to boost our renewal rates and do so with a more efficient cost structure moving forward. Kelly?

Yes. Regarding the SPVSS business, it is currently included in my guidance because we will continue operating this business until the deal closes. It accounts for the majority of what's in the other category. Similar to when we divested the set-top box business, once the transaction is completed, we will provide all historical data so we can adjust the model and move forward from there. You will have full visibility through the income statement once we finalize the transaction.

I just wanted to...

Pierre, can you speak up just a bit?

Yes. Okay. Is it better now?

Yes.

Yes.

Regarding the gross margin, are you still experiencing issues with DRAM prices? Has the situation improved, or has the pressure become greater compared to the previous quarter? Given that this pricing has been in the market for a while, how do you plan to adjust your pricing strategy? When can we anticipate you will start transferring these additional costs to your clients? Finally, I assume your share of software and subscription services in your revenue mix continues to grow rapidly, which should have a positive effect on gross margin. Could you provide some insight on that as well?

Sure, I'll take that. First, regarding memory, we are still experiencing year-over-year challenges. Our product gross margin was adversely affected by approximately 60 basis points compared to last year, which is more than our overall decrease. However, it's slightly better than last quarter, which was in turn an improvement over the previous quarter. The rate of increases is slowing down, but we continue to see a year-over-year rise. In terms of pricing, we had another strong quarter. While we do experience price erosion, it was at the very low end compared to the past three years, and this trend persists. A significant reason for this is that we have been passing on the increases in memory DRAM costs through price hikes on our servers, and other product managers across our portfolio are also being disciplined in identifying areas for price elasticity. I'm pleased with our price index this quarter, consistent with the previous quarter. On your point about the software being beneficial, that holds true; however, part of that benefit is being offset as we rapidly ramp up the Catalyst 9K. A portion of that revenue is deferred due to the subscription model, which negatively impacts our rate. This quarter alone, the Cat 9K contributed about 30 basis points to that impact. In summary, the three key points are: 60 basis points regarding memory, 30 basis points from the Cat 9 impact, and strong pricing coupled with a favorable mix from software. Lastly, we had an exceptionally strong quarter in our UCS server business, although it did contribute some negative mix for us as well.

Against my better judgment, I'm going to ask you a wide-open question, which is for either or both of you, Chuck and Kelly. What are you most excited about in terms of upside opportunity, whether revenue or margin? And what are you most concerned about in terms of downside risk?

I'll start, Paul, and thank you for the opportunity. I am most optimistic about the renewed innovation we are bringing and will continue to bring in our enterprise portfolio, especially within our core franchises, which has been our top priority since I became CEO three years ago. While we will continue evolving our business model, stabilizing the enterprise portfolio, particularly the switching business, has been paramount. Our teams have done an excellent job with this. When you look at the security portfolio, our team has been working diligently, and regarding the enterprise routing, our teams have been focused on integrating the Viptela acquisition. I am encouraged by the progress we are making there and optimistic about its future. I'm also very optimistic about the innovation within our intent-based networking portfolio that we will introduce in the coming months, quarters, and years. If I had to mention my biggest concern, it's the macroeconomic factors and potential geopolitical risks. We've seen trade discussions, and while I remain hopeful, uncertainty means we need to be cautious. Additionally, the rising dollar presents another macro challenge, but I am pleased with our team's execution this quarter, particularly in emerging markets.

You spoke about your progress in the data center switching side of things. I'm wondering if you could help us understand how things are going in the enterprise data center market and how your relationships are progressing in the web-scale data center market or just web-scale in general would be helpful to us outside of data center switching.

I'm very pleased with what our teams are achieving in the data center switching market. Generally, the transition to 100-gig is going well, and we’re happy to see growth returning in both the data center and campus switching areas. The situation on the web-scale side remains consistent with my previous statements. We are making progress, as highlighted by our recent announcement with Google. We are diligently working on the details of the solutions we've introduced with them, and there will be more developments from us later this year. We are deeply engaging with all these players and have seen ongoing progress and positive discussions with several of them. However, as I have mentioned before, some of these are long-term architectural decisions that take time. Nonetheless, I'm optimistic and satisfied with our current position. It's also worth noting that our enterprise customers are facing a challenging environment. Just four or five years ago, they anticipated a transition to the public cloud that would simplify their IT landscape. Now, they find themselves relying on multiple public cloud providers and dealing with numerous SaaS providers. We are witnessing a notable increase in IoT devices at the edge, and private data centers still play a crucial role. The mobility of customers and suppliers adds further complexity. Therefore, a robust network is essential for everything to function smoothly. The web-scale providers recognize this, which has helped us establish broad relationships that extend beyond just the data center. Overall, we are pleased with our progress, but we have a long journey ahead.

I wanted to circle back to a conversation from prior earnings calls. You guys had talked about the revenue headwind associated with the move to more subscription-oriented models. And Kelly, I'm wondering if you can give us an update there. Is that still a headwind this quarter? And how do you see that progressing going forward?

Yes, sure. Thanks. And so yes, the headwind is still there because we are very much increasing the number of offers that we have as well as the revenue dollar that we're putting on the balance sheet. So the headwind is increasing. And just as we had talked in the past, now that the enterprise portfolio with the Cat 9K is starting to hit revenue, the headwind is increasing. So we said in the past it was 1.5 to 2 points. It definitely now is approaching the 2 to 2.5. And as we ramp more and more of the portfolio, we'll continue to see that.

I guess my question is on the recurring revenue. It dipped a little bit to 32%. If you could give some color on that. And also, I think your target long term is exceeding 37% in fiscal '20. Is that primarily a function of Cat 9K ramping in volume? Are there any other products that could contribute to that? And also, I'm wondering if you need to expand the subscription model to other products to achieve that goal.

Yes. So thanks for the question. So yes, on the recurring revenue, it's basically in the rounds. If I look at our product recurring revenue, again, it continues to grow over 30% to over 30% of our total product revenue. And overall, total recurring revenue is again growing in the double digits. So it's really the math and a little bit of the mix now that we have product revenue growing so much faster than services that's driving kind of just the pure math of the round from 33% to 32%. But we feel great about how it's progressing. Yes, if you go to our Financial Analyst Conference, we feel we're right on track of what we projected as that goes out to fiscal year '20. The only caveat I'll give you on that is, when we go into our fiscal year '19, we have to adopt the new revenue standard, which will have some implication on some of the products that are included in this. So we plan to have a call where we can go through the anticipated area that will be impacted to give you guys more clarity. And then we'll adopt that Day 1 of our fiscal year '19. But overall, we feel great about the traction. We're executing very well. And we're on track, if not slightly ahead, of what we expected when we talked at the Financial Analyst Conference.

And Srini, just one last comment on the part of your question where you asked if we would need to extend this to other parts of our portfolio. I mean, we will. If you look at the new enterprise routing, some of the comments I made in my opening was that we're extending our software and subscription business in the routing space. Many of those are software solutions. So we'll continue to evolve. And frankly, it's driven by how our customers want to consume the technology, which is great. And as Kelly said, it will create a short-term headwind, but we think long term for the business it's absolutely the right thing to do.

I have a brief question for Chuck and then Kelly, more of a clarification one. But Chuck, there wasn't any mention yet, at least on the Q&A, about competitors going into the campus side of things with Arista making an announcement. How do you look at that? I know competition isn't anything new. But do you need to step up your sales efforts? Or how should we think about that? And then Kelly, for the CFO question. How should we think about, you've got time now to think about the tax law, sort through all the changes. Is your outlook kind of 21% outlook long term? And stock cadence, you did a lot more stock buyback this quarter than normal with your new announcement. How should we think about those financial metrics?

Yes. Let me address the first point. Regarding competition in the campus sector, we launched this architecture last June, and our customers have shown significant enthusiasm for it. One key aspect of our approach is that we ensured the architecture and DNA Center are backwards compatible with at least one generation of our wireless, switching, and routing products. Evaluating all of these products is crucial because our customers seek an automation platform that supports the entire enterprise network. Over time, as we integrate our automation platform across the data center and campus, we will enable automation from the data center to the campus, wireless network, routing, and security architecture. This presents a distinctive architecture that we are able to provide. Currently, we are leading in this area and witnessing strong acceleration in the adoption of the Cat 9K among our customers. We are confident in our position during this transition.

Regarding the tax question, we are very confident in our current position. As mentioned during the call, we have repatriated $67 billion from overseas. Furthermore, as noted in last quarter's earnings, we increased our share buyback authorization significantly, leaving us with $25 billion for future repurchases. We plan to utilize this amount over the next 18 to 21 months and are proceeding aggressively, as we had indicated we would once our cash was returned. Concerning the tax rate, we previously stated in Q2 that we expect it to be around 21% for fiscal year '18, with a decrease to 20% in fiscal year '19, benefiting fully from the new U.S. federal rate. Overall, we have a positive outlook on the tax law and its implications for us.

I actually wanted to circle back a little bit and poke at the recurring revenue piece. And now that it's 32%, and you're noting that you got 120 basis points from acquisitions. Can you help me understand what really drove the decline Q-over-Q from 33% to 32% given that the acquisitions you guys had done have been software in nature?

Yes. I mean, again, I think, basically, AppDynamics has been in the numbers as we go along. I would say, BroadSoft has a mix of both perpetual and recurring, so it is not all recurring. I would say the bigger impact on the numbers, and again, it's really just the mix of the products. When we have product revenue growing 5%, services growing 3%. And within that product revenue, we had very, very strong server revenue growth, which has a very low software recurring proponent of it. That's what's really driving it. As I said, overall, the growth of product recurring revenue was over 30%, like it has been for the last five quarters. So that just continues to grow. It's really more the denominator of total revenue that's driving just the slight round down to 32%.

Security grew by 11%, marking an increase compared to the last two quarters. Can you explain what contributed to the successes and challenges in security this quarter, and what factors are driving this growth?

Yes, thank you, Tal. We are still confident in the security architecture we have established, despite some fluctuations in the revenue run rate over the past year. Our architecture encompasses e-mail, endpoints, the network, and the cloud, along with a comprehensive state machine that allows us to identify threats and respond effectively, which is a distinctive advantage. We offer an integrated architecture paired with top-tier products. Where we successfully demonstrate the value of our architecture to customers, we see success. Our teams are performing well, and the engineering team continues to introduce new features and capabilities that customers are increasingly adopting. It's straightforward; we have solid traction in the field at the moment.

And can you share with us maybe the areas where you think you need to strengthen your portfolio?

The great thing about this architecture is that it allows for the addition of virtually any source of threat intelligence, as it is designed to process massive amounts of data. We encounter 20 billion threats every day, making it clear that we can incorporate any capability we choose. This applies to threat sources as well as defensive measures. Within our portfolio, there will always be opportunities for our teams to enhance and expand features. The competition in this space is robust and fragmented, so we will continue to focus on executing our architectural vision.

Just one more revenue question for me. Kelly and Chuck, how should we think about the second half of calendar '18 relative to your fourth quarter revenue guidance in terms of the 4% to 6% goalpost year-over-year? Is there any inflection point with respect to the selling cycle? We've heard anecdotally from some of our checks that it is a slightly longer selling cycle as customers try to understand more the subscription element. And as they do become more receptive, could you actually see accelerating revenue growth maybe closer to that 6% or better as you go into the October, January quarters?

Mark, as you know, we provide guidance one quarter at a time. We are confident in our guidance of 4% to 6% growth. Looking ahead, I want to emphasize that demand for the Cat 9K is strong. We are seeing an incredible amount of orders and significant customer adoption that we believe will continue. We feel optimistic about this situation. However, there are many factors to consider, and we will approach it one quarter at a time. I also want to remind you that when our fiscal year starts in August for '19, we will discuss the implications of the new revenue standard. We are pleased with our Q4 guidance and will continue taking it one quarter at a time.

All right. Good.

So I want to just thank everybody for joining us today. We appreciate you spending time with us. Appreciate the opportunity to answer your questions. And Marilyn, I'll kick it back to you for the details on the next call.

Great. Thanks, Chuck. Cisco's next quarterly earnings call, which will reflect our full year 2018 fourth quarter and annual results, will be on Wednesday, August 15 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 is done through explicit public disclosure. We now plan to close the call. If you have any further questions, feel free to contact the Cisco Investor Relations department, and we thank you very much for joining the call today.