Cisco Systems Inc (CSCO) — Q3 2019 Earnings Call Transcript

Thanks, Michelle. Welcome, everyone, to Cisco’s third quarter fiscal 2019 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 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 will discuss product results in terms of revenue and geographic and customer results in terms of product orders unless stated otherwise. All comparisons made throughout this call will be made on a year-over-year basis. The matters we will be discussing today include forward-looking statements including the guidance we will be providing for the fourth quarter of fiscal 2019. 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. Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. In Q2, on October 28, we completed the sale of our SPVSS business and accordingly had no revenue or expense from that business in Q3 fiscal 2019. As such, all of the revenue, non-GAAP, and product orders information we will be discussing is normalized to exclude the SPVSS business from our historical results. We have provided historical financial information for the SPVSS business in the slides that accompany this call and on our website to help understand these impacts. The guidance we provided during our Q2 earnings call and today's call has been normalized in the same way. I will now turn it over to Chuck.

Thank you, Marilyn, and good afternoon, everyone. We had another strong quarter of performance across the business, demonstrating our ability to execute despite the ongoing uncertainty in both the macro and geopolitical environments. Technology continues to be at the heart of our customer strategy and now more than ever our market-leading portfolio and differentiated innovation is resonating with them as they transform their IT infrastructure. In the quarter, we delivered strong revenue, margins, non-GAAP earnings growth, and operating cash flow. As we continue to help our customers achieve their business objectives, I am confident about the future of Cisco and the growth opportunities ahead of us. New technologies like cloud, AI, IoT, 5G, and WiFi 6 among others are coming together to revolutionize the way we operate our businesses and deliver new experiences for our customers and teams. We are fundamentally changing the way our customers approach their technology infrastructure to address the rising complexity in their IT environments. We are building the only integrated multi-domain intent-based architecture with security at the foundation. This is designed to allow our customers to securely connect their users and devices over any network to any application, no matter where they are. We are integrating capabilities like artificial intelligence and machine learning across the entire portfolio, so customers have greater insights resulting in better and faster business outcomes. Now for some highlights across our business. Starting with Infrastructure Platforms. Over the past several years, we've been working to integrate intent-based networking across our enterprise access portfolio to help our customers manage more users, devices, and things connecting to their networks. We brought to market tremendous innovation across wired, wireless, and enterprise routing, including SD-WAN resulting in a continued strong traction of our enterprise networking portfolio. We are moving into an era of truly immersive and pervasive wireless connectivity, which generates demand for high density, low latency performance, for real-time experiences over both wired and wireless networks. Enterprise networks today must be optimized for agility and security, leveraging cloud and wireless capabilities with the ability to garner insights from the data and security integrated throughout. Cisco is in a unique position to deliver this for our customers. We recently announced several new platforms expanding our enterprise networking portfolio with the launch of our subscription-based WiFi 6 access points and Catalyst 9600 campus core switches purposely built for cloud scale networking. By combining our automation and analytics software with our broad portfolio of switches, access points, and controllers, we are creating a seamless end-to-end wireless-first architecture for our customers. We also expanded our open roaming partnership ecosystem to now include Apple, Intel, Samsung, and others to make Wi-Fi onboarding simple. With our newest Catalyst 9000 family additions, we have completed the most comprehensive enterprise networking portfolio refresh in our history. We have rebuilt our entire access portfolio with intent-based networking across wired and wireless. We also now have one unified operating system and policy management platform to drive simplicity and consistency across our customers' networks all enabled by a software subscription model. In the data center, our strategy is to deliver multi-cloud architectures that bring policy and operational consistency no matter where applications or data reside by extending ACI and our hyperconverged offering HyperFlex to the cloud. Our partnerships with Amazon Web Services, Google Cloud, and Microsoft Azure are great examples of how we continue to work with web-scale providers to deliver new innovation. For example, we recently introduced Cisco Cloud ACI for AWS, a service that allows customers to manage and secure applications running in a private data center or in Amazon Web Services cloud environments. We also expanded our partnership with Google. We announced support for their multi-cloud platform Anthos to help customers build secure applications everywhere from private data centers to public clouds with greater ease. Going forward, we will integrate this platform with our broad data center portfolio, including HyperFlex, ACI, SD-WAN, and Stealthwatch cloud to deliver the best multi-cloud experience for our enterprise customers. Moving to security. We continue to see strong momentum with another quarter of double-digit growth driven by our world-class security portfolio. Cisco is the world's largest cybersecurity company for enterprises with thousands of cybersecurity experts helping our customers globally. Our portfolio covers the entire threat continuum of the modern enterprise and integrates security into every networking domain. We are enabling all of our customers to transform and secure their networks for the rapidly evolving multi-cloud world. We have a platform that continuously detects threats and verifies trust. By combining Duo, Umbrella, Stealthwatch, ISE, and Tetration, we offer an end-to-end zero trust architecture that is strongly resonating with customers. Now turning to applications. We continue to execute very well on our collaboration business. These platforms are becoming increasingly critical to how enterprises operate and manage their workforce. Customers are always looking to enhance their meeting experiences and cognitive collaboration is quickly becoming the de facto standard for delivering more personalized experiences and transforming how we work. At Enterprise Connect, we introduced several new cognitive collaboration capabilities within our WebEx portfolio, integrating AI and ML to bring context and intelligence to meetings. The new innovations we launched include people insights, facial recognition, and WebEx calling, all of which helped to increase our customers' productivity, making work simple and seamless. Going forward, you'll see this greater level of intelligence integrated into every piece of our collaboration portfolio across calling, messaging, meetings, devices, and contact center. We also had another quarter of strong growth in AppDynamics as thousands of customers rapidly adopt our Application Intelligence platform for smarter and faster decision-making. The ability to manage end-to-end application performance across all cloud environments is increasingly important. AppDynamics is the market leader in application and infrastructure analytics, delivering unparalleled innovation. We offer the most comprehensive end-to-end visibility from connected devices and applications to the underlying network, providing better application performance and user experience. To summarize, I'm very proud of the progress our teams have made against our strategic priorities to drive profitable growth, accelerate differentiated innovation for our customers, and successfully execute on our own transformation to more software and subscriptions. Enterprise IT architectures must transform to help our customers get the most out of all of their IT investments. More than ever, our customers need a trusted partner with an end-to-end architecture strategy to simplify, transform, and secure their businesses, and Cisco is that partner. Kelly I'll now turn it over to you.

Great. Thanks, Chuck. I'll start with a summary of our financial results for the quarter followed by the guidance for Q4. Q3 was a strong quarter across the business. We executed well with solid orders momentum, strong revenue growth, margins, EPS, and operating cash flow. Product orders grew 4%. Total revenue was $13.0 billion, up 6%. Our non-GAAP operating margin rate was 32.2%, up 0.2 points. Non-GAAP net income was $3.5 billion, up 8%. And non-GAAP EPS was $0.78, up 18%. Let me provide some more detail on our Q3 revenue. Total product revenue was up 7% to $9.7 billion. Infrastructure platforms grew 5% with solid growth across all businesses. Switching had another good quarter with growth driven by the continued ramp of the Cat 9K and strength in our ACI portfolio. Routing grew driven by SD-WAN. We saw solid growth in wireless driven by growth across the entire portfolio. And Data Center was up with growth in both HyperFlex and servers. Applications were up 9% with growth across all the businesses. We saw solid growth in Unified Communications software, TelePresence, and AppDynamics. Security was up 21% with strong performance in identity and access, advanced threat, and unified threat. We're very pleased with the integration of Duo into the Security portfolio. Service revenue was up 3% driven by software and solutions support. We continue to transform our business, delivering more software offerings and driving more subscriptions. Software subscriptions were 65% of total software revenue, up 9 points year-over-year. When we look at the impact of acquisitions on our Q3 results year-over-year, there was a 40 basis point positive impact on revenue. We saw solid momentum in Q3 with total product orders growing 4%. Looking at our geographies; Americas was flat, EMEA was up 9%, and APJC was up 6%. Total emerging markets were up 5% with the BRICS plus Mexico down 2%. In our customer segments; Enterprise was up 9%, Commercial grew 5%, Public Sector was up 10%, and Service Provider was down 13%. From a non-GAAP profitability perspective, total Q3 gross margin was 64.6%. In terms of the bottom line from a GAAP perspective, Q3 net income was $3.0 billion and EPS was $0.69. We ended Q3 with total cash, cash equivalent, and investments of $34.6 billion. Q3 operating cash flow was $4.3 billion, up 79%. Normalized for the $1.3 billion of foreign taxes related to the Tax Cuts and Jobs Act we paid in Q3 of fiscal 2018, operating cash flow was up 16%. From a capital allocation perspective, we returned $7.5 billion to shareholders during the quarter, that was comprised of $6 billion of share repurchases and $1.5 billion of our quarterly dividend. We continue to invest organically and inorganically in our innovation pipeline. In terms of M&A, we closed on the Luxtera acquisition. These moves are consistent with our strategy of increasing investment in innovation and R&D for our growth areas. To summarize, we had a strong Q3. We executed well with strong top line growth and profitability. We're seeing the returns on the investments we're making in innovation and driving the shift to more software and subscriptions delivering long-term growth and shareholder value. Let me reiterate our guidance for the fourth quarter of fiscal 2019. This guidance includes a type of forward-looking information that Marilyn referred to earlier. Note that we have normalized our fourth quarter guidance to exclude the SPVSS business for Q4 of fiscal 2018 which we divested on October 28, 2018. We expect revenue growth in the range of 4.5% to 6.5% year-over-year. We anticipate the non-GAAP gross margin rate to be in the range of 64% to 65%. The non-GAAP operating margin rate is expected to be in the range of 31% to 32% and the non-GAAP tax provision rate is expected to be 19%. Non-GAAP earnings per share is expected to range from $0.80 to $0.82. I'll now turn it back to Marilyn so we can move into the Q&A.

Yes guys. Thanks a lot for the question. I guess I'm going to ask an obvious one and then from the order volumes another obvious one. I wonder if you could comment on the trade situation and the 25% rate increase, and just kind of give us some idea for how much is contemplated in guidance of that? And anything else you can tell us about the exposure of the business? I know that you guys had said that you thought, if it went to 25% there would be price elasticity effects, so that's the first question. The second one is obviously the Service Provider orders down 13%. That is quite a lot worse number than we would have expected. So, I wonder if you could just give us any more color on what's happening there? Thanks.

Thank you, Rod. Regarding the tariffs, several months ago when the 10% tariffs were introduced, we outlined a three-phase strategy. The first phase involved maintaining dialogue with the administration to highlight the impacts. The second phase was to continue optimizing our supply chain, a practice we have followed for the past 20 years. The third phase included making necessary pricing adjustments if required. I want to emphasize that our team has been extremely diligent over the past six months. When we learned last week that tariffs would increase to 25%, our teams swiftly implemented the necessary actions to address this. We are now fully prepared operationally and expect minimal impact as a result of the hard work by our teams, which is reflected in our future guidance. Regarding the service provider business, we have always described this sector as unpredictable and heavily dependent on large customers. We have experienced quarters where significant customers have held back, affecting our results, particularly in the Americas. Looking at the year-over-year CapEx spending data, there's been an almost 20% decline in the U.S. We have consistently mentioned that these fluctuations would occur until we engage in substantial 5G network development. This downturn is largely specific to the Americas, and I believe the ongoing strength in our public sector, commercial, and enterprise segments demonstrates that our innovations are still appealing to our customers.

Great. Appreciate it guys. Nice job on the execution in such a tough environment too.

Thank you. Next question please.

Thanks, and again congrats on a great quarter and execution. Chuck, maybe you could talk about applications, a big deceleration from the level we've seen over the last four quarters. Clearly AppDynamics is doing well in there, but they'll zoom out now in the marketplace, making a lot of noise. Help us think about WebEx, how that business is doing, how do you feel competitively positioned in the marketplace and how do you think about addressing potential competitive headwinds over there?

Thanks, Ittai. I want to share a couple of observations. First, the WebEx business is experiencing strong growth, and we are pleased with recent developments. The team has excelled in modernizing the platform this past year under Amy's leadership. It's also important to note that this is the first quarter where BroadSoft's impact is reflected in our run rate, which has positively affected our growth rates in recent quarters. On the numbers side, I believe the cognitive collaboration features announced at Enterprise Connect will be transformative. While some competitors are focusing on integrating four collaboration endpoints to provide a seamless experience, our new WebEx can also deliver an even richer and simpler experience with those four endpoints. Currently, we are concentrating on transitioning all our customers to our modern platforms, as we have been in this business for a long time and our customers use various combinations of technologies. A key priority for us is to migrate everyone to the most advanced platforms, which we believe are very competitive. When we incorporate the cognitive capabilities, which I encourage you to see in a demo, it is quite impressive. We are very confident about our position in this area.

Very good. Good luck.

Thanks, Ittai. Next question please.

Yeah, thanks. Hey, Chuck, Kelly, Marilyn…

Vijay, can you speak up a bit? We're having a hard time hearing you.

Yeah. Can you guys hear me?

Yeah. That's better. Thank you.

Yeah, yeah. First, I mean honestly, I would like to commend you for your recent social contributions. We do monitor that news flow in addition to what's going on in the business with many programs, mitigation programs. Honestly, I'd like to commend you on that. And then on the earnings call question, your General Manager seemed quite excited on this WiFi 6, the Campus core switch. So my question to you and helpful for all of us is, how impactful is this new Wi-Fi 6 refresh and the new Campus core, the Catalyst 6000 refresh heading into the back half, and is there a pull forward across the portfolio or would this just be kind of a point product swap? Thanks.

Thank you for your comments, Vijay. We should take a moment to acknowledge what the team has achieved with the enterprise networking portfolio. We launched the first Catalyst 9000 in the summer of 2017, and just two weeks ago, we completed the full portfolio. Our enterprise routing platforms are undergoing a refresh, and the Catalyst 9000 switching family, along with all access points, has been updated. Two years ago, we had no networking product with a software subscription, and now every product in the enterprise routing, enterprise Wi-Fi, and enterprise campus switching sectors is sold with a mandatory subscription. The progress made by the teams is outstanding. We previously had multiple operating systems across different platforms, which have now been consolidated to a single operating system running on a unified automation platform, allowing our customers to implement policy easily. The amount of work done by the teams has been significant. However, as we've noted, we are still in the early stages of the transition with customers. Historically, customers typically kept campus switching products for around five to seven years. We've been working with only small portions of this portfolio over the last two years. Wi-Fi 6, formerly known as 802.11ax, is now enabling organizations to harness high-performance access points and achieve low-latency, immersive experiences, which will necessitate back-end upgrades. Our team often emphasizes that a robust wired network is essential for a successful wireless network. We view this as the start of a broader refresh for our customers as they modernize their infrastructure in line with the ongoing cloud transition. That's our current perspective.

Thank you.

Next question please.

Hi, thank you for the question. I'd like to focus in on security and more specifically in the strength in the quarter that you saw. Is that being mainly driven by the new acquisitions you guys have made? Or is that more from legacy? Given that you are refreshing the campus, are you pulling forward some of the more legacy security offerings that you had? Or is this predominantly just strength in the M&A, all the acquisitions you've made being integrated and finally going to market?

I will provide some insights and then let Kelly elaborate on the specifics of the numbers. The current situation for our customers is evolving; they initially designed their security frameworks based on the idea that users were located at the edges of their networks and applications were housed in private data centers. Their architecture focused on protecting the perimeter. However, our customers now face a reality where mobile users are widespread, branches exist in various locations, and there is a significant increase in IoT connectivity. Applications are also being deployed across numerous platforms, including SaaS solutions, private data centers, and public clouds. As a result, the concept of security architecture has completely transformed, and our teams have been adapting to this shift over the past few years. We must safeguard our customers' data and traffic in any location, which is why we've been investing in new capabilities and making acquisitions. The ability to identify threats across the entire landscape and dynamically respond to those risks is a key factor driving our growth. Additionally, this segment of our business is heavily focused on software and is primarily subscription-based. This recurring revenue is something we aim to enhance throughout our entire portfolio. Kelly?

Yes, I think the only thing I'll add is that the revenue growth, which includes the Duo acquisition mentioned earlier, was very broad-based across the entire Security portfolio. This included significant contributions from network security, advanced threat, and cloud security. Additionally, as Chuck mentioned, by embedding security into the Enterprise Networking portfolio, we benefit from the strong growth in the Enterprise portfolio as well.

Got it. Thank you. And then just a small follow-up after this. It's just, are you disclosing recurring revenue percentage of total revenue this quarter, just because some of the comments around subscription? Just wondering if you're giving that out.

Yes. No, we haven't really given out the software revenue actual number, but I think the last time we gave it out was at our Financial Analyst Conference. And again, we're growing very quickly the software portfolio in line, if not faster than what we had talked about then.

So, well on track or ahead of where we told everyone we would be at the Financial Analyst Conference in 2017.

Okay.

Thanks, Chuck. Next question?

Thanks. Two quick clarifications and a question. Kelly, you announced this shortly, but can you talk about the rate of price erosion and what you're seeing specifically with respect to DRAM? And then, Chuck, on your comment earlier about the 25% tariff, I apologize if I misunderstood, but I just want to make sure. Are you telling us that you shifted all of your supply chain out of China, so there's no exposure going forward? Or is it just a matter that you've incorporated into your guidance? And then for the question, some of your smaller peers have commented about a pause in wireless LAN and related switching deployments. As customers are waiting for Wi-Fi 6, you've now rolled out your Wi-Fi 6 Access Points, you upgraded the new 9600, etc., are you seeing that pent-up demand?

I'll begin with the first few points and then Chuck can address the wireless aspect. Paul, regarding pricing, we remain very disciplined. In terms of our product gross margin rate, it improved by 1.1 points year-over-year, which aligns well with or slightly exceeds the trends from the previous quarters. As for DRAM, it performed as we expected this quarter and has become a positive contributor for us in Q3. This is part of why I provided guidance for Q3 gross margin, which turned out to be 64.6%. We're benefiting from this situation. Regarding tariffs, as Chuck mentioned, we have accounted for it in our guidance. While we still have some manufacturing in China, we have significantly reduced our exposure by collaborating with our supply chain and suppliers. We anticipate managing the impact, which has been factored into our Q4 guidance, and we plan to monitor it throughout the quarter.

Yes. On the Wi-Fi, I don't think we've seen any significant change. I've noticed some of the same comments earlier this week. Overall, I believe our customers are continuing to expand their networks and will shift to the new Wi-Fi 6-enabled products as they progress.

We launched in the last week of our quarter, so it was too early for the market to respond.

Yes. We wouldn't have any, given when we launched. And the tariffs, I'll tell you, our teams have just done an amazing job. I mean that's the bottom line. And so everybody worked so hard to a point where literally last week the teams executed on everything incremental we needed to do to deal with it. And it's relatively immaterial at this point and it's baked in the guide.

Super. Thank you.

Thanks, Paul. We'll take our next question?

Thank you very much. Some companies have mentioned experiencing pauses in demand due to inventory digestion and the uncertain economic environment. However, it seems that you haven't faced these issues based on your outlook and results. Can you clarify whether you have a better understanding of the inventory in the channel or if the end markets are different? If I recall correctly, your cloud sales are over 20% but possibly under 30%, while many have reported a slowdown in cloud spending. Thank you.

Yes, the only significant change we noted was in the service provider sector. For the rest of the business, we are aware of the same global challenges and risks that everyone else is seeing. However, if you review our quarterly performance, it was relatively consistent from the start to the end of the quarter compared to the same period last year. Aside from the service provider segment, we did not observe any major changes.

No. It was really SP. And Jim just to clarify because I saw your note that you published when you say cloud – if you're meeting the subset web scale, I guess that's not the correct number out there what our – we've never – we haven't given it out but I just want to make sure that that's not really kind of like what our web-scale exposure is.

Got you. Okay. Thank you so much for the clarification. Its greatly appreciated. Thank you.

Next question please.

Great. Thank you very much. I just wanted to ask a couple of questions perhaps maybe for Kelly on a couple of small things. First deferred revenue was down a little bit quarter-over-quarter and I know that there's been some adjustments around 606. So I'm just wondering, if we can get a little reflection kind of what the mix is doing there. And then also I know you addressed gross margins and some benefit and tailwind you got from components there. But at least the numbers were reported it seemed like a lot of that improvement was concentrated in the APAC region. And just wonder, if we're interpreting that correctly. And if so was there anything unique happening there perhaps that we didn't see in the rest of the world?

Yeah. So first the deferred revenue. Yeah – no it's a great pickup. I will say the only thing that's kind of changed in the deferred revenue is – and we kind of talk about this maybe a couple of calls ago is really driven by our collab business. They've gone much more to month-to-month billing. So therefore, it doesn't flow through deferred revenue anymore whereas in the past we might – it might be financed with customers or it would go through – they'd pay upfront. Now it's really going month-to-month which again is just how it's recognized through the balance sheets. So that's really what's driving it. If you look at the rest of our businesses like with the ramp of the subscriptions of the Enterprise portfolio as well as Security those are all growing quarter-on-quarter. And as you know, the big tick-down from a year ago is because of the change of the accounting standard down. But from a business operational thing the only change is – quarter-on-quarter is really just the shift to the collab business going more month-to-month versus paying upfront.

And can I just ask just a quick follow-up there? And so when should we expect that to stop being a drag? And – or are we going to see that happen across other parts of the business that you could see some volatility there?

No. I think you're going to continue to see – I mean, again the collab I think is just going through that just how we're changing our offer and what we're offering there. But I think the rest of the business is going to continue to start building up. So, you'll see that get back to I'd say growing here over the next few quarters.

Okay. And then the gross margin is seemingly concentrated in APAC. Any major reason for that?

Yeah. Actually, the gross margin in APAC was literally very focused mostly in Japan and mostly driven by our – some big deals in Service Provider that had some lower margins and the typical average that we have in Japan. But it's very isolated to that.

Michelle, let's go ahead and take the next question please.

Hey, guys. Thanks for taking my question. I only have two. One in kind of the securities side and secondly maybe some back half update. On the security side, growing with 20% plus. I think that back a couple of years ago people would never believe that and would have viewed Cisco as kind of a shared owner. So I guess what has changed in terms of the products that you guys are selling? And then secondly do you think that's something that's more sustainable or let's call it teens growth instead of the historical 10% growth? And then secondly, I know Cisco used to kind of give kind of IT spend number. Can you maybe provide us any sort of commentary in terms of what you guys think of the back half? I mean is the demand environment you guys view better worse or kind of the same? Because I think it's a little bit difficult to figure out what you guys are going to grow out considering the first half has already been solid. So I just wanted to know if you can give any color there as well.

On the security front, the architectures for our customers have evolved. I recall discussions from a few years ago where our team was focused on building solutions for where our customers would be in the coming years, and they were correct in their investments. We have made strategic acquisitions that have helped us grow in this area. The current architectural approach differs from the past, where defense was about picking the best products for each specific need. Now, we need a platform that can integrate threat information from various sources to provide comprehensive defense. Regarding growth rates, we will have to see how they fluctuate due to acquisitions and other factors, but I am confident in the direction our teams are heading. This is a solid business for us long-term. As for IT spending, I don’t have additional insights beyond what has been shared. I've expressed my appreciation for the resilience of the global economy in recent years, despite the geopolitical and macroeconomic dynamics present. We will continue to focus on what we can control, but I don't have any clearer visibility on what will happen in the next six months than anyone else.

Thanks, Mitch.

Got it. Thank you so much.

Yep. Apologies for that. Next question please.

Yes. Thank you. Just following up on the prior question about web scale. Your progress on web scale has been a little bit TBD for a number of years. I'm wondering, what you can tell us about when you think your efforts in that regard might pay-off, if you think the 400-gig migration is an entry point for you. Or what do we have to look forward to in that particular vertical?

Yeah, it's a very valid question. And we have a lot of things going on with the web-scale providers today. I think 400 gig certainly will represent an opportunity for us to insert. I think that the architectural transition points is really where you have an opportunity. We've known that for decades from working with the telcos and service providers. You typically don't insert into an existing architecture. It really requires a transition. So, I think thinking about those kinds of things and 400 gig would be representative of that. But to give you any time line I think we're just going to have to wait and keep plugging away. We're still making progress. We've made a ton of progress on the relationship side. We've got a lot of deep technical discussions that are going on. They're spending a lot of time on our Campus with us. So, we continue to make progress but these are big long-term decisions that they're making and we're going to keep plugging away.

Okay, I'll keep asking. Kelly, what can you tell us about the increasing software mix? Where would you like the gross margins to be over the intermediate timeframe or any timeframe you prefer? Fingers crossed.

Yes, if you look back over the past few years, you'll see that we've consistently increased our gross margins. Three years ago, we were guiding for margins of 61% to 62%, and we've gradually improved since then. In my guidance for Q3, I increased the target by another 0.5 points to reach 63% to 64%. We're experiencing growth in our gross margins, although there are always various factors to consider. Each quarter, we face natural price erosion, but we're enhancing productivity, and the turnaround in DRAM is significantly contributing to our positive outlook. This will help us manage any incremental costs, whether from tariffs or otherwise. Our current guidance of 64% to 65% is solid. Our primary aim in shifting towards software is to drive margin growth through innovation, and you'll see us continue to adjust our portfolio in that direction.

Okay. Thank you.

Yes. All right Michelle, let's tee-up the next question.

Hey Chuck and Kelly congrats on a fantastic quarter and execution here. Maybe just going back to Rod's initial question specifically around 5G. Maybe what products do you expect to benefit with or are you seeing orders for already? I know its early days. But then Kelly maybe you could discuss is there going to be any impact related to the shift of VNS on the model? Like should we expect lower revenue contribution in the cycle but higher gross margin kind of going off to what you were just saying before to? Thanks.

On the 5G front, there are a few important points to highlight. Firstly, the capital expenditure data we observed last quarter and the forecasts don't appear very promising for the companies involved. Currently, they are primarily investing in the macro radio aspect of their networks and utilizing their existing core networks for early 5G trials. We anticipate that in the future, as the number of connections rises and capacity improves, they will start developing new backbones dedicated to 5G infrastructure, which is where we will typically engage. We're also supplying packet core technology for the new 5G networks at this time, but the significant opportunity for us will arise once they upgrade their networks to handle the increased traffic. We have consistently believed this transition would happen sometime in 2020. We are collaborating with many of them on architectural designs and plans, but it will mainly be in core routing backbone technology that we expect to see a substantial impact from 5G. However, we will need to wait and observe how this unfolds.

Yes. I would just like to mention that service provider customers differ from enterprise customers. Everyone is seeking automation and software-defined solutions, and our entire portfolio is progressing in that direction. This is simply the nature of both service providers and enterprises. Prices for core services are continually decreasing as we drive more throughput and other enhancements. This trend isn't unique to service providers; it applies to our entire portfolio. The value lies in the software and the automation we are delivering to our customers.

Great. Thanks. Congrats again.

Thank you, Chuck. This is Marilyn. Just want to close up the call here. So Cisco's next quarterly earnings conference call which will reflect our fiscal 2019 fourth quarter and annual results will be on Wednesday, August 14, 2019 at 1:30 PM Pacific Time, 4:30 PM Eastern time. Again, I'd like to remind the audience that in light of Regulation FD, Cisco's policy is not to comment on its financial guidance during the quarter unless it'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 Cisco Investor Relations department and we're very much looking forward to speaking with you through the remainder of the week. Thank you for joining today.