Cisco Systems Inc (CSCO) — Q3 2022 Earnings Call Transcript

Welcome everyone to Cisco's third quarter fiscal 2022 quarterly earnings conference call. This is Marilyn Mora, Head of Investor Relations, and I'm joined by Chuck Robbins, our Chair and CEO; and Scott Herren, 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'll 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 done on a year-over-year basis. Please note, included in the materials that accompany this call is a slide which summarizes the impacts from the war in Ukraine and the extra week in Q3 fiscal 2021. The matters we will be discussing today include forward-looking statements, including the guidance we will be providing for the fourth quarter and full year of fiscal 2022. They are subject to the risks and uncertainties, including COVID-19, 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. I will now turn it over to Chuck.

Thanks, Marilyn, and good afternoon, everyone. When we spoke with you back in February, we entered Q3 in the second half of our fiscal year with optimism despite the supply and component challenges and other headwinds impacting us and many of our peers. Many of those factors that fueled that optimism remain unchanged today. We continue to see strong demand resulting in record backlog, our business transformation is progressing well, and our differentiated innovation across our portfolio is helping our customers embrace and adopt the multiple technology transitions happening. However, there were two unanticipated events since our last earnings call, which impacted our Q3 revenue performance. The first is the war in Ukraine. This resulted in us ceasing operations in Russia and Belarus and had a corresponding revenue impact, which Scott will discuss. The second relates to COVID-related lockdowns in China, which began in late March. These lockdowns resulted in an even more severe shortage of certain critical components. This in turn prevented us from shipping products to customers at the levels we originally anticipated heading into Q3. Our Q4 guidance incorporates a wider than usual range, taking into account the revenue impact of the war in Ukraine and the continuing uncertainty related to the China COVID lockdowns. Given this uncertainty, we're being practical about the current environment and erring on the side of caution in terms of our outlook, taking it one quarter at a time. We believe that our revenue performance in the upcoming quarters is less dependent on demand and more dependent on the supply availability in this increasingly complex environment. While certain aspects of the current situation are largely out of our control, our teams have been working on several mitigation actions to help alleviate many of the component issues that we've been facing. We believe that we will begin to see the benefits of these actions in the first half of next fiscal year. Now let me talk more specifically about our third quarter performance. As I just mentioned, many of the positives we've discussed over the past few quarters remain, resulting in continued solid demand for our solutions. Total product orders grew 8% year-over-year leading to yet another record backlog of well over $15 billion, up 10% sequentially and up 130% year-over-year. This momentum reaffirms the critical role we play in our customers' futures. Our business transformation also progressed nicely. In Q3, we saw ARR growth of 11%, ending the quarter at over $22 billion, and product ARR growth of 18%. We also exited the quarter with over $30 billion in remaining performance obligations or RPO. We also delivered non-GAAP EPS at the high end of our guidance range. This was driven by effective pricing actions and spending discipline, all of which allowed us to offset lower volumes and deliver both gross and operating margins above the high end of our guidance range and deliver on our bottom-line profitability target for the quarter. I want to reiterate what I said earlier. The fundamental drivers across our business are strong. While we are facing some short-term challenges, it does not change our long-term outlook, our alignment to our customers' most critical challenges or our belief in the tremendous opportunities in front of us. Last week, we hosted our Global Customer Advisory Board meeting where we met with close to 100 customers. And they consistently shared that technology is at the heart of their strategy and has become even more important to everything they do. This is driving not just their strategies, but also their overall business transformation. The technology they're adopting from Cisco is driving their business agility, allowing them to move with greater speed and empowering them to deliver differentiated experiences for their customers. Now I'd like to touch on some highlights from the quarter. We continue to see strong demand in several areas of our business. Our web-scale business remains strong as we continue to help these customers build their capabilities to connect and serve their customers and end users at scale from the data center to the edge. This is leading to continued strength in orders, which grew over 50% and on a trailing four-quarter basis, we had over 100% growth. This marks our ninth consecutive quarter of solid demand as we are winning new franchises, expanding our design wins and taking share in web scale. I remain incredibly proud of the progress we've made in the momentum we have in this space. We are also extremely pleased with the traction of our 400 gig solutions, including the Cisco 8,000, which is the fastest growing SP routing platform in Cisco's history. In addition, our Silicon One portfolio, ZR and ZR plus optics and our Acacia portfolio of optical networking products also continue to perform well. From a product revenue perspective, our performance was led by solid demand across a majority of our portfolio, including switching, SP routing, wireless, security and SD WAN. Our performance in these areas reflects ongoing investments that our customers are making to rapidly digitize their organizations to deliver differentiated experiences. Looking forward, the shift to hybrid cloud, 5G, 400 gig, IoT, hybrid work, and the explosion of applications are driving the increased need for next generation networking, connectivity, security, and observability solutions. Cisco is well positioned to deliver for our customers with our end-to-end platforms and solutions. I'm also very proud of our pace of innovation. During the quarter, Cisco announced new innovations across our networking and cloud portfolios along with technologies to enhance experiences and hybrid work environments. We also introduced our new predictive networks to help organizations learn, predict and avoid network disruptions. We have even more innovation, which we'll announce at RSA and our own Cisco Live event in June. In addition to our deep passion for innovation, all of us at Cisco believe we have a unique opportunity to help make the world a better place through both the technology we build and the purpose we rally around to power an inclusive future for all. I believe this intersection of technology and purpose is why we were named the number one Best Company to Work For in the U.S. by Fortune and Great Place to Work for the second year in a row. In summary, while the quarter clearly did not play out as expected, demand remains solid and the fundamentals of our business are strong. We remain focused on executing against the strategy we laid out at our Investor Day. We will also continue to be resolute in our focus to transform our business for more predictability and agility while bringing to market a robust pipeline of innovation. We remain confident in our long-term growth and the opportunities that we have in front of us. I want to thank our teams around the world for all that they do, executing with dedication, focus and excellence in an incredibly dynamic environment. They continue to focus on our customers with unparalleled innovation, resiliency and determination. And with that, I'll now turn the call over to Scott.

Thanks, Chuck. We saw solid growth in product orders, net income, and earnings per share despite the challenges Chuck just outlined. Product order growth was driven by strength across most of our portfolio while disciplined spend and supply chain management drove our profitability. Total revenue was $12.8 billion, flat year-over-year. Our non-GAAP operating margin was 34.7%, up 110 basis points coming in above the high end of our guidance range. Non-GAAP net income was $3.6 billion, up 3% and non-GAAP earnings per share was $0.87, up 5%, coming in at the high end of our guidance range. In March, we stopped business operations in both Russia and Belarus, which had a negative impact to revenue of approximately $200 million or two percentage points of growth. Historically, Russia, Belarus and Ukraine collectively have represented approximately 1% of our total revenue. The impact this quarter was a bit higher than our historical run rate due to additional charges to revenue we recorded for uncollectible receivables and other items. As a reminder, Q3 of last year included an extra week, which was a benefit of total revenue in Q3 of '21 of approximately three full percentage points of growth. On a combined basis, the impact of the year-over-year total revenue growth rate for the extra week and the war in Ukraine was approximately five percentage points. Looking at our Q3 revenue in more detail, total product revenue was $9.4 billion, up 3%. Service revenue was $3.4 billion, down 8%, driven by the extra week in the prior year and the war in Ukraine, which combined impacted our growth by approximately 8 percentage points. Within product revenue, Secure, Agile Networks was solid with revenues up 4%, switching grew driven by strength in data center switching with our Nexus 9000 products, campus switching growth was led by our Catalyst 9000 and Meraki switching offerings. Wireless had a double-digit increase driven by broad-based strength across our portfolio, including our WiFi-6 products and Meraki wireless offerings. We also had solid growth in Servers. Enterprise routing declined primarily driven by Edge and Access which was slightly offset by strength in SD-WAN. Internet for the Future was up 6%, driven by strength in Acacia, optical, optics and core networking products including double-digit growth in the Cisco 8000. Collaboration was down 7%, driven by declines in our meetings, calling and contact center offerings, partially offset by the continued ramp of our communication platform-as-a-service. End-to-End Security grew 7% with broad strength across most of the portfolio. Our Zero Trust portfolio performed well with double-digit growth driven by strong performance in our Duo offering. Optimized Application Experiences was up 8%, driven by double-digit growth in both of our SaaS-based offerings ThousandEyes and Intersight. We continue to make progress on our transformation metrics as we shift our business to more subscriptions and software. Total software revenue was $3.7 billion, a decrease of 3% with the product portion down 1%. Total software revenue growth would have been 5 points higher excluding the combined negative impact of the extra week in the prior year and the war in Ukraine. 83% of software revenue was subscription-based, which is up one percentage point year-on-year. Total subscription revenue was $5.5 billion, a decrease of 4%. Total subscription revenue would have been 7 points higher, excluding the combined negative impact of the extra week in the prior year and the war in Ukraine. Total subscription revenue represented 43% of Cisco's total revenue. Annualized recurring revenue or ARR was $22.4 billion, an increase of 11% with strong product ARR growth of 18%. And remaining performance obligations or RPO was $30.2 billion, up 7%. Product RPO increased 13%, service RPO increased 3%, and the total short term RPO grew 9% to $16.2 billion. We had solid product order growth in Q3 of 8% with strength across most of the business. Looking at our geographic segments, the Americas was up 9%, EMEA up 4%, and APJC up 11%. In our customer markets, commercial was up 19%, service provider was up 8%, public sector was up 4%, and enterprise was flat. From a non-GAAP perspective, total gross margin came in above the high end of our guidance range at 65.3%, down 70 basis points year-over-year. Product gross margin was 64.1%, down 80 basis points and service gross margin was 68.9%, up 20 basis points. The decrease in product gross margin was primarily driven by ongoing higher component costs related to supply constraints as well as higher freight and logistics costs, partially offset by strong positive pricing impact. We continue to manage through the supply constraints seen industrywide by us and our peers. To give a sense of scale of the shortages, we currently see constraints in Q4 on roughly 350 critical components, out of a total of 41,000 unique component part numbers. Our supply chain team is aggressively pursuing multiple options to close those shortages. Given our solid product orders, we once again saw a significant increase in our backlog levels for both hardware and software well beyond our normal historical levels. As Chuck said, our ending product backlog grew to well over $15 billion and software backlog grew to more than $2 billion, both up 10% sequentially. And just a reminder, backlog is not included as part of our $30.2 billion in remaining performance obligations. We ended Q3 with total cash, cash equivalents and investments of $20.1 billion. Operating cash flow for the quarter was $3.7 billion, down 6% year-over-year, primarily driven by advanced payments to secure future supply. These advanced payments had a negative 9 percentage point year-over-year impact on Q3 operating cash flow. In terms of capital allocation, we returned $1.8 billion to shareholders during the quarter, that was comprised of $1.6 billion for our quarterly cash dividend and approximately $250 million of share repurchases. Year-to-date, we have returned a total of approximately $10 billion in value to our shareholders via cash dividends and stock repurchases and more than $17 billion available under our Board stock repurchase authorization. To summarize, we're navigating the highly complex environment while continuing to make progress on our business model shift and making strategic investments in innovation to capitalize on our significant growth opportunities and expanding addressable markets. Now let me provide our financial guidance for Q4. In terms of supply, we expect the challenges we experienced in Q3 to continue into Q4. For next quarter, we expect revenue growth to be in the range of minus 1% to minus 5.5%. We anticipate the non-GAAP gross margin to be in the range of 64% to 65%. Our non-GAAP operating margin is expected to be in the range of 31.5% to 33.5% and non-GAAP earnings per share is expected to range from $0.76 to $0.84. For the full year fiscal '22, guidance is as follows. We expect revenue growth to be in the range of 2% to 3% year-on-year. Non-GAAP earnings per share guidance is expected to range from $3.29 to $3.37, up 2% to 5% year-on-year. In both our Q4 and full year guidance, we're assuming a non-GAAP effective tax rate of 19%. I'll now turn it back to Marilyn so we can move into the Q&A.

Thanks, Scott. Michelle, let's go ahead and queue up the Q&A.

Great, thanks. Chuck, could you share what you're observing in terms of macroeconomic conditions from your customers? I know that enterprise orders remained flat year-over-year. Are you noticing any changes in their behavior due to the current macro environment, or factors like currency and inflation? That would be helpful, thanks.

Yes, Meta. Thank you. So on the demand issue, I'd point out a few things. Number one, without a 2-percentage point of orders that we de-booked relative to Russia and Belarus, we grew 10% against a year ago growth of 10%. So we feel good about that. Our customers are not signaling any real shift at this point. We're not hearing that from them. Again, we had our global customer advisory board just a couple of weeks ago where we had 100 of our biggest customers and they were all talking about projects in the strategic nature of everything they're trying to accomplish. The last thing I would point out is on the enterprise side, last quarter we grew 37%. Just to keep in mind the way we define enterprise is a finite list of named customers. So it tends to be more lumpy. If I look at how the industry defines enterprise, that would reflect a combination of our enterprise and our commercial business. So for comparisons to what we're hearing in the marketplace, I thought we would give you that combined number. If you combine enterprise and commercial together, we grew 9%, but without the Russia impact, we actually grew 12% and on a trailing 12 months basis it grew 28%. So we are still comfortable with the demand signals that we're seeing, and our customers aren't telling us anything differently right now.

Next question please.

Hi, thanks for taking my question. I guess Chuck, on the demand question again, you're guiding to the fiscal fourth quarter to be now almost sort of similar to what the third quarter is or even down a bit, which is, if I go back historically, I don't see many instances of that. I mean is that really a reflection of the supply environment or are there any other sort of aspects of demand stemming from the geopolitical situation here that's impacting that? And when do we sort of start to see you sort of cycle past some of that? Thank you.

Yes, Samik, that's a great question. To start, there's no indication of a demand issue in our Q4 guidance; it’s unrelated to that. Let me explain further. In our Q3 results, we experienced a $200 million impact due to ceasing operations in Russia and the related revenue write-downs, which were one-time events. Additionally, our quarter ends in April, while most others end in March, meaning we faced the full impact of the China lockdowns. Specifically, the lockdown in Shanghai began on March 27. The Shenzhen lockdown lasted a week but didn’t significantly affect us. Therefore, we accounted for $200 million lost from Russia and another $300 million due to our inability to obtain power supplies from China. We had 11,000 PCB assemblies built but couldn't get the necessary power supplies because of the lockdown, which is a straightforward explanation of our Q3 challenges. Looking ahead to Q4, the situation in Shanghai affects our ability to source components for power supplies. While Shanghai is set to reopen on June 1, we're uncertain about what that means for our supply chain and when we will begin receiving materials again. We anticipate significant congestion and competition for transportation and logistical capacity as they reopen. Given these factors, we believe it will be extremely difficult to resolve these issues in Q4, which influenced our guidance. While the top line results may not look favorable, the reasons for this are clear. As for your follow-up question regarding when conditions might improve, if we assume that China does reopen, we expect a more normal flow of power supplies. Over the past six to nine months, our teams have been implementing various mitigating strategies by redesigning over 100 products to enhance component diversity. We believe these efforts will begin to show benefits starting in Q1 and through the first half of the year. Therefore, we're optimistic about improvements after the next 90 days, and I'm just being transparent about our outlook and expectations for recovery.

Thanks, Samik. Next question please.

Thanks. Hi, guys. I guess I want to dig into that a little bit, Chuck, on the supply chain. You seem to be much more impacted than some of your peers in the industry. So I'm just trying to gauge whether you have an unusually high exposure to China that others do not. Is there any color you can give us on what percentage of your components come from China and why is it that you stand out relative to a couple others? And I understand that you had in April quarter, some of them had in March, but they did report mid late April and none of them have signaled anything. And then I guess as a second part of this, just thinking kind of longer term, just given the challenges to a geopolitically Ukraine, Russia and the risks that are associated with China on a geopolitical standpoint, but also clearly in their COVID policy, is there some sort of a long-term planning that disconnects you from China as a source for components longer term?

Yes, thank you for your questions. Regarding the first one, the significant differentiation we observed was in April. I've talked to industry peers who share our experience of reporting the full month's impact, which was not just an April-specific issue for us. On a normalized basis, across our portfolio, each of us designs products with various components, which means there could be unique challenges or advantages linked to specific components we choose. This is why I've mentioned that we are redesigning to address unique problems, as well as general issues that others may also face. We believe the overall exposure was primarily due to April. Additionally, we handle massive volumes, which, while typically seen as a major advantage, can also amplify the impact of these issues. For perspective, we generated more revenue in the last week of our quarter than many competitors did in their entire quarter. Consequently, if they face similar challenges, it could represent a $20 million impact for them, while for us, it could be anywhere from $200 million to $400 million. On the second point, we consistently assess our global supply chain. It’s not just about one country; it’s about resilience. Over the past 15 to 20 years, the way we’ve structured supply chains is evolving as we navigate current challenges. Our teams are managing this dual task of addressing immediate issues while driving geographic resilience. Before COVID, we had built-in regional redundancy, but we didn’t have plans to account for a country shutdown. Establishing this geographic resilience takes time, but our teams are currently focused on these efforts.

Thanks, Ittai. Next question please.

Thank you for the question. I'll do my best to clarify. Your gross margin appeared to be quite stable this quarter, and your revenue went in a different direction compared to some of your competitors. I'm curious if part of the issue stems from using brokers and incurring high fees for parts in the secondary or tertiary markets. Did avoiding this approach help you achieve a better gross margin despite lower sales? I'm just trying to grasp how your practices compared to your peers enabled you to maintain a solid gross margin while having lighter sales. Does that make sense?

Yes, it absolutely does, Simon. Let me start and then I'll hand it over to Scott to discuss it further. First and foremost, we are very active buyers in the broker market. With our buying power, they approach us first. This is not a related issue. We've spent considerable time with our supply chain team, who provided examples of recent purchases made in the broker market. So, I don't believe that’s the case. However, Scott can clarify what actually occurred.

Yes, that's a great question, Simon. I'd like to add that we implemented two price increases this year. The first occurred at the end of the calendar year and the second at the beginning of our second quarter. At that time, we indicated we would start to see the effects of these price increases toward the end of the third quarter, which is now behind us, and that’s exactly what happened. While unit shipments were affected by supply chain issues and component shortages, we managed to counterbalance this with strong pricing. Our pricing actually increased by about 160 basis points in Q3, as mentioned in our quarterly report. Although we faced unit challenges due to the component supply, we began to see the benefits from our pricing strategy. We are actively exploring various avenues to source components, focusing on qualified vendors and working to qualify different sources simultaneously. We are engaging with brokers and distributors to pursue all available channels, and this effort is presenting a bit of a challenge for us.

Michelle, next question please.

Hi, thank you. First one is a clarification on the product order growth number that was reported at 8%. Could you give us an idea on how much price increases contributed to the product order growth number? That's the first question. And then just a second question is, we're just trying to piece together and explain even after accounting for the Russia, Ukraine contribution, why enterprise would grow 0% versus some of your peers that are reporting far greater reports and trends in specifically enterprise? Could we just try to maybe triangulate a little bit more about what's going on there?

Okay. First, I'll let Scott add on the price increase in a moment, but first of all, the price increase really did not have significant impact on our growth. We only passthrough pricing at the time that was offsetting our incremental cost. And to be honest, we've incurred more cost since then. So we were at a place right now where we have not even passed through all the costs that we have incurred. We're getting price increases all the time now. So that's the first answer. On the second one, the easiest thing for me to tell you is what I said earlier that the way our peers view and report and the industry views and reports enterprise would be the combination of our enterprise and commercial business which last quarter would have grown 9% and would have grown 12% without Russia. So if you think about the size of that those two businesses combined growing 9%, I'm pretty comfortable that the demand is still there. And if you look at our commercial business, which usually is the leading indicator of a shift of demand momentum, they grew 19% in the quarter. So I'm not seeing any weakness in demand at this point.

Yes. And Sami to the first part of your question, the 160 basis point impact that we saw in Q3 from pricing is a revenue statement. Obviously to go from bookings to revenue, it first has to flow through the backlog and then get realized. So the impact on bookings while we haven't quantified, it would be a little bit higher than that 160 basis points.

Next question please.

Thank you for the question. I want to address the main concern from investors regarding product orders. While I understand what you’ve said, the recent trends show that the sequential movement on those orders is significantly below normal seasonal patterns. Even considering a 10% growth year-over-year, we're seeing a decline of mid-single digits sequentially, which is much lower than expected for this time of year. We recognize that we are coming off historically high levels for these product orders. Could you provide some insight into the trajectory of product orders as we move into the next quarter? There’s a possibility that product orders may drop to levels seen in July 2019, which would mean a double-digit decline, yet still remain in a reasonable range. I would appreciate any additional information on how you see this trajectory and the normalization of orders over time. Thank you.

I understand your point, Rod, and you're on the right track. The first thing I want to mention is that any seasonality we typically expect is not applicable under the current circumstances and the order demand we've been observing. We had been planning for 18 months with certain customers, and if they ordered 18 months' worth last quarter and are now pausing, we might be working with three fewer customers this quarter. It's challenging to process all this. There are two aspects I focus on. First, I look at our quarterly growth rate compared to the previous year to assess the momentum of demand from one quarter to the next. We need to analyze that change because if you grow 30% from 1% and then 30% from 15%, that signifies declining demand momentum. That’s how I approach the numbers. The second point, which aligns with your observation, is that I've been discussing this with the team. When we start comparing our performance against the 30% growth quarters, we should actually look back two years for an accurate assessment since we know some of those figures were inflated. We don't know the exact extent, but you're right that we need to analyze data from two years back to understand the current situation accurately. Navigating this will be difficult because our traditional methods for assessing these metrics no longer apply. After going through another year or four quarters, we might reach a more normalized perspective. As I’ve mentioned, we will experience a period where the growth in order demand will lag behind our revenue growth, and I hope we'll eventually find a balance that allows us to return to a more predictable model. We just need to get there.

Okay, that's great. Chuck, on that subject, I know you've spoken with many CIOs and CEOs. What are their thoughts right now? It seems like there's a lot of negative news, and it's hard to believe people are eager to spend significantly, yet the demand still appears strong. I'm curious about what you're hearing and how the tone of these conversations is.

I believe COVID has fundamentally altered how our customers approach technology. Before COVID, many customers would cut back on technology spending during slow periods. However, the pandemic made them realize the consequences of such choices. Now, they are more cautious about halting important projects that provide customer differentiation, modernize their infrastructure, support hybrid work, or keep them competitive. The mindset of CEOs and public sector leaders regarding the significance of technology has changed considerably. While they recognized its importance three years ago, their current understanding is much deeper. I’m not suggesting they won’t make cuts, but the threshold for making those decisions is now higher.

Next question please.

I still find it challenging to forecast next year because we haven’t begun comparing the high growth rates of orders yet. Right now, we are still comparing last year's 10% to this year's 10%. In the next quarter, you will see a jump to 30%, and there will be several quarters of 30%. At that stage, revenue growth should accelerate since the supply chain is expected to improve or due to our strategies. However, we are actually noticing a slowdown in order growth instead of an increase. When considering the upcoming quarters, is there a possibility that both order growth could decline significantly, potentially even going negative, while revenue growth might also go negative? I’m trying to grasp how to approach the next few quarters. Thank you.

You want to take it, Scott?

Yes, Tal, I think the way to think about it is back to one of the statistics that we gave you first time last quarter and then again this quarter. We've got backlog now greater than $15 billion in product. And within that, more than $2 billion of software sitting in backlog. You add that to the $30 billion plus of RPO we've got and we're sitting on about $45 billion of sales we've transacted that have not yet accreted to the revenue line. So as you think about the way you want to model out next year, you need to think about the rate and pace of revenue growth being dependent on supply versus being dependent on in-quarter bookings growth. And that's certainly the way I think about it.

And when you think about the order trends, I mean order is dollars, but not all the product has the same trends. There are some of the products that are very big in terms of contribution like service provider side, etc. I have to guess that the trends there are better than the trends in the enterprise, etc. So does it mean the order numbers that you provide, can you dig in a little bit deeper below just a single number for orders and tell us the areas where order growth is better and the areas where order growth is actually worse?

Yes, I think some of that information is available in the slides we'll post online, and it may also be included in the press release. We discussed enterprise orders, which remained flat for the quarter. However, if we account for the impact of ceasing operations in Russia and Belarus, this would indicate a 3% growth in orders. This follows a quarter where enterprise orders increased by 37%, and the previous quarter saw a 30% growth. As Chuck mentioned, our definition of enterprise includes our largest customers, and that segment tends to be somewhat inconsistent. Nonetheless, over the trailing 12 months, the performance has been quite solid. We are also experiencing good growth in SP, especially within web scale, and we shared some of those statistics during the call. Public sector demand is holding steady, and commercial sales, which we noted declined before overall sales during the pandemic, started to recover in late fiscal '20 and has shown an increase since. Last quarter, commercial product order growth rose by 19%. Since commercial performance has been a leading indicator for us and remains strong, we are not currently observing any decline in demand.

Got it. Thank you.

Thanks, Tal. Next question.

Guys, if I could ask for two clarifications. First of, I think I heard you say the $300 million kind of what's showing high revenue impact in Q3. I didn't hear you say what's the expected revenue impact is in Q4. Can you share that list?

Hi, Paul. Thanks. In Q3, it was straightforward for us to explain because we knew what we were expecting. However, in Q4, we don't have clarity on when things will reopen and how much we'll receive, which led us to establish the range we did. We're being realistic about our expectations for what we can achieve, but linking it specifically to power supplies is challenging. The main concern right now is really about getting China reopened, getting shipments moving, and we need to see that happen. Scott, do you want to add anything?

Yes, I would like to add that we used the example of power supplies because it was a constraint in the third quarter. The impact of this constraint emerged late in the quarter; when Shanghai entered lockdown, we didn't immediately feel the effects. The repercussions became apparent more towards the second half of April, which fell within our quarter but not within the quarters of many of our peers. Unfortunately, there was no time to recover from it. However, I don't want to oversimplify this situation. It’s not solely about power supplies. We are experiencing challenges in several areas. To give you an idea of the scale, while we have around 41,000 unique components, approximately 350 of them are currently facing potential supply issues. We are addressing these concerns daily, with some getting resolved each day, while others are added to the list. It would certainly be easier if it were just one or two issues we could pinpoint, but it is a very dynamic situation. Looking at the bigger picture, we are not assuming that the situation will improve or worsen as we move through the fourth quarter, and this is what is factored into our guidance.

But Chuck and Scott, the obvious question regarding the $1 billion plus shortfall in guidance related to Street expectations is whether all of that is due to the lack of visibility you have, particularly concerning supply. Is the shortfall entirely linked to supply issues? Considering the numerous questions that have been raised about your order book, the slowdown in orders, and the quality of demand, should we be worried that any part of the shortfall in your guidance pertains to demand, or is it strictly a supply issue?

Zero. There is no demand impact on our Q4 guide.

It's a 100% supply.

100% supply.

One other quick clarification on this topic. If we look at the linearity of your order book. I know, normally we talk about linearity of revenue. But if you look at the linearity of your orders during the quarter, post the quarter, up to this call, what do we see?

It was normal, very normal.

So you've seen no degradation at all?

No.

Q3 was right in line with normal pattern. And I think Paul, the thing to remember is, yes, we're a little skewed because we had three quarters of 30%. If we went back a year and a half and I said we're going to grow 10% product orders on top of a 10% quarter from a year ago, we would have been quite happy with it. We're just worried about it because it's fallen 330s when there was a lot of planned purchase built into. So we will tell you. Obviously next quarter we'll have an update, but right now, it doesn't feel like there's any significant shift.

Thanks, Paul. Next question.

Great. Thanks everyone for taking the time to take my question. I just had a follow-up on backlog and near term RPO. If I'm not mistaken, I think your near term RPO is flat sequentially at roughly $16.2 billion, $16.3 billion. And if I tack on sort of a $1 billion increase quarter-over-quarter in your backlog, given sort of the supply chain constraints that you've articulated and maybe what some of your peers are saying, I mean, I guess I'm trying to triangulate on what the revenue trajectory looks like as we go into next year? I mean you mentioned Chuck that there is seasonality out of the window, but within the realm of possibility that we could start the year, next year and the first half at sort of a run rate on where we are today as we exit this year. I mean is that a realistic probability given on how revenue kind of flows through? And then I have a quick clarification follow-up.

Sure. Regarding the RPO we mentioned, the short-term RPO is $16.2 billion, reflecting a 9% increase. Short-term, by definition, means it will contribute to the revenue stream over the next 12 months. This 9% growth is a strong leading indicator of how this aspect of our business is performing as we approach Q4. We'll provide an update on short-term RPO growth at the end of Q4, which will help you understand how it stands as we close out fiscal '23.

Great. As a follow-up, when considering the peak of our backlog and where purchase order commitments might peak at year-end, it obviously involves various factors in our supply chains. Looking at your order book and the demand you're observing from customers, how do you anticipate reaching that peak commitment to ensure you have the necessary components and parts to meet long-term demand? With order growth decelerating from 8% this quarter and potentially slowing further, are we closer to our peak on both of those metrics than we were a quarter or two ago?

Yes, there is kind of two angles to that David that I'll try to touch on. One is the, when does the backlog itself peak and while we don't forecast that, it would not surprise me to see it grow again in Q4. On the second piece in terms of purchase commitments you saw they were up pretty substantially again in Q3, I guess, back to the earlier question of as our supply chain team not being aggressive enough in pursuing parts, purchase commitments now set at a pretty high level and inventory sits at a pretty high level. And that's so that as we clear the supply constraints on a few critical components, we can actually quickly convert that into finished goods product and get it in the hands of our customers who want those products. So is the peak now, is the peak in Q4, Q1, really a lot depends on the fluidity of availability of these critical components that we're chasing down?

Yes. No, that makes sense. We're trying to understand sort of your cash flow conversion, so that's helpful. Thanks.

All right. Next question, please.

Hi, thanks for taking the question. This is Ben Harwood standing in for Pierre. We had a couple of questions. So firstly, you talked about most of your issues arising in April. So the full cost was around 4%, 5% below expectations. Does this mean productivity was around 10%, 15% below your expectations? And then secondly, what happens to this demand economy in the third and fourth quarter? Do you think it spills over into 2023 and then what would give you confidence on that? And then what kind of timeframe should we expect that lost demand to be met? Thank you.

You want to take it, Scott?

Yes, regarding the first part of your question, I didn't fully understand your calculations, but in relation to our expectations, we mentioned that in April, the decision to halt operations in Russia and Belarus had a $200 million impact for the quarter. This included two months of revenue we had to forgo, along with some receivables that were written off. On the supply chain front, we could have covered the remaining difference to meet our expectations for the quarter. I hope that clarifies your question, although I am not entirely sure I grasped what you were aiming to convey.

All right, thanks, Ben.

Okay. He asked a second one, too, about the backlog rolling over into '23.

Yes, regarding the backlog, I think what you're trying to understand is its durability. We have been closely monitoring this. In terms of order cancellations, they are currently at a rate lower than pre-pandemic levels, so we are not experiencing significant cancellations. Our pipeline and pipeline growth remain very strong, which you would typically expect to decline if there were a decrease in demand. Looking further out at what we have in the backlog, we've implemented a policy stating that orders are non-cancelable within 45 days of the committed ship date, effective from early February. Therefore, any orders we receive that are within 45 days of shipment cannot be canceled. Additionally, for our largest customers, we have been creating tailored agreements to ensure supply in exchange for their commitment to not reschedule or cancel orders. Overall, we feel confident about the durability of our backlog.

Okay, thank you. Next question.

Thank you. Two if I could as well. First, Chuck, the gross margins we talked about was good. A lot of that was pricing. It seems like you guys are in a strong pricing position now. If you look out a few quarters if and when things normalize, do you think pricing pressure remains or do you think that's something that will be a give back to the industry or to the customers? So is that sustainable from a margin standpoint? And second, I was hoping you could dig into software more? I heard a lot of that kind of unique one-time factors in there, but still even ex those, probably not great growth when you look at the software opportunities ahead of Cisco. Could you just give us the things to watch over the next few quarters that could start to reaccelerate growth in that software line?

Thank you for the questions, Tim. Regarding the first point, we will consider passing any reductions in our input costs to customers if they occur over time. We've absorbed many cost increases without transferring them to customers, and we will evaluate this comprehensively when those situations arise. I appreciate you bringing up software growth, as it's an important topic that requires clarification. This quarter has complexities due to an extra week last year, the situation in Russia, and supply chain issues. Specifically, we currently have over $2 billion in software backlog tied to hardware, and we won't recognize that revenue until the hardware ships. This backlog has increased by $1 billion year-over-year. Furthermore, the extra week of revenue recognition from last year, along with the write-down of software revenue due to our ceased operations in Russia, has negatively impacted our software growth. While it's difficult to assign a specific figure to the backlog issue, we estimate that the effects from Russia and the extra week collectively pose a 5-point headwind to our software growth. Despite the current complexities, I expect software growth rates to normalize, especially without the impacts of the Russia situation and the extra week. As the supply chain issues improve, we should see our anticipated growth rates begin to emerge.

Okay, it looks like we have time for one more question.

Perfect. A lot of snuck in here out. I guess I would be the dead horse in China supply chain issues. And maybe to the answer from the perspective of the billion-dollar shortfall, I know it's supply chain, not just China, if you have in July. A, what's the conviction that there is no share loss happening? Because your peers might be one month after that sounded much better for your conviction that others were not able to get the power, analog product that you were not and they were able to get the demand. So A, could you just talk about conviction, you are not having share loss? And then B, China has had no COVID cases in Shanghai for a few days now. So assuming they open up in June, does that imply that you could be perhaps at the higher end of your guide and things get better in Q1? Or just what are you embedding from a Shanghai recovery in your fiscal Q4 guidance?

First of all, I find it challenging to assess market share at the moment due to the backlog and supply chain issues, along with our complex portfolio. While I suspect we may be losing share in certain areas, I feel positive about our performance in our core markets, where we've seen strong demand, particularly in WiFi, switching, SP routing, and web-scale operations. I don't believe there's a widespread share loss, although there are specific areas that our teams are working to improve. Regarding China, we've factored in a lot of uncertainty into our guidance. We don't know what "opening up" will entail—whether it will be a gradual reopening of grocery stores and salons or if logistics will resume all at once. We are concerned that every company will be trying to ship out simultaneously. Many factories have been allowed to continue operating, and their products are ready to ship. This will increase competition for port and air traffic resources, which are already strained. We're worried about how long it will take to resolve these issues, which is why our guidance reflects caution. Additionally, it's important to note that the situation extends beyond just Shanghai. Recent reports indicated that approximately 45 cities in China were under lockdown, affecting over a quarter of the population. This broader context influences our outlook, and we will have to wait and observe how things develop.

Fair enough. Thank you.

Thank you.

Thank you, Amit. Chuck, I'm going to turn it over to you for some closing remarks.

Thanks, Marilyn. So first of all, I want to thank everybody for spending time with us and diving into this complex situation that we face. It's clearly a dynamic and challenging environment. We clearly faced unanticipated events during Q3 with the COVID lockdowns and the war in Ukraine. We think the short-term challenges that we will manage through, our teams have been working really hard on these mitigation actions that we believe will begin to benefit us in the first half of our next fiscal year, which is good. We're successfully realizing price increases, which is good. And also in Q3, even though we had a miss on the top line, I just want to point out that it was a record EPS quarter for us as a company. And at the low point of our guidance for Q4, we will deliver record EPS for the full year. So while the top line is disappointing, we have navigated this complex year and actually will deliver solid EPS when we're done. The fundamentals are strong a lot still in our favor. Demand, business transformation is working, the technology transitions and the number that we're participating in. We have great teams around the world and that leads me to have a high degree of confidence despite the short-term challenges that we face. So thank you all for spending time with us and we look forward to connecting with you next quarter.

Thanks, Chuck. And I'll just wrap it up by saying Cisco's next quarterly earnings conference call, which will reflect our fiscal fourth quarter and fiscal 2022 results will be on Wednesday, August 17, 2022, at 1:30 PM Pacific Time, 4:30 PM Eastern Time. So this concludes today's call. But if you have any further questions, feel free to reach out to the Investor Relations team. We thank you very much for joining us today.