Cisco Systems Inc (CSCO) — Q1 2023 Earnings Call Transcript

Welcome, everyone, to Cisco's First Quarter Fiscal Year 2023 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. As is customary in Q1, we have made certain reclassifications to prior period amounts to conform to the current period's presentation. 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 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 second quarter and full year of fiscal 2023. They are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent report on Form 10-K, 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. With that, I'll now turn it over to Chuck.

Thank you, Marilyn, and thank you all for joining us today. We are off to a good start in fiscal 2023, delivering strong results, exceeding the top end of our guidance range for both revenue and non-GAAP EPS. We delivered the largest quarterly revenue in our history, driven by excellent execution and the actions our team took to remediate our supply challenges. Given these results, along with the strength of our orders, our visibility, and easing supply constraints, we are raising our full-year outlook, which Scott will cover later. While we are proactively managing through an evolving and complex market environment, we remain intensely focused on executing on our strategy, including our transition to more software and subscription-based recurring revenue. We achieved software revenue growth of 5% year-over-year, and software subscription revenue grew 11%. The easing of supply constraints and our ability to deliver hardware is now releasing software subscriptions that were sitting in backlog connecting to unshipped hardware. Our success is also reflected in our ARR, which exceeded $23 billion, increasing 7%, with product ARR growing 12%. We also ended the quarter with RPO of nearly $31 billion, up 3% year-over-year with product RPO up 5%. Over $16 billion of the RPO will be recognized as revenue over the next 12 months with a backlog that remains elevated at near-record levels. These metrics give us increased visibility and predictability and provide additional confidence in our ability to perform through the current market cycle. It also underscores our unique position, helping customers become more agile and resilient as they continue to navigate a complex set of challenges. As I've done in the past, I'd like to provide an update on the supply chain before discussing our Q1 results. Like you've heard from others in the industry, we are encouraged by what we are seeing with modest improvement in certain component availability as shortages continue to ease from last quarter. The redesign of many of our products has also helped bring supply stability and more resiliency. Over the last few quarters, you've heard me talk about the actions we've taken to navigate supply constraints. These actions are paying off and are contributing to our results. We now have greater visibility in the ramp of our customer product deliveries, which in turn gives us greater confidence in our fiscal 2023 outlook. Now moving to performance highlights in the quarter. We delivered revenues of $13.6 billion, up 6%, and non-GAAP EPS came in at $0.86, our second highest quarterly non-GAAP EPS in the history of the company. We also generated $4 billion in operating cash flow and returned over $2 billion to our shareholders. These metrics show we remain committed to operating discipline and our balanced capital allocation priorities. We are continuing to invest in our long-term growth opportunities while also returning capital to shareholders. In terms of our product orders in the quarter, it's important to note that the year-over-year comparison is against an unusually strong period of 34% growth in Q1 of fiscal year '22. From a geographic perspective, we saw some emerging cautiousness in Europe. This is driven by a dramatic increase in energy costs and market volatility, which is leading customers to assess their overall spend. However, this also presents an opportunity for us as our technologies like, IoT, Silicon One and power over ethernet drive a significant reduction in power consumption. To provide a normalized perspective, our Q4 to Q1 sequential growth was just slightly below the normal range over the last 6 years. It's also important to note that this was the second highest Q1 orders in the history of the company. We have strong product revenue momentum in key parts of our business, including Secure Agile Networks, Security and Optimized Application Experiences. We also saw record performance from a number of products, including the Catalyst 9000 family, Cisco 8000, Wireless, Meraki, ThousandEyes and Duo. Networking is becoming increasingly critical to every organization, led by digital transformation, hybrid cloud, AI and ML workloads. This is driving demand for our technologies. As we've discussed, there are also tailwinds to our business, such as hybrid work, 400 gig and beyond, 5G, WiFi 6, security and full stack observability. We believe these broader technology transitions will require every customer to rearchitect their network infrastructure and, in turn, fuel long-term growth across our portfolio. As I speak with customers, they tell me that, while they're closely watching the economy, they remain focused on making the right investments across their business to increase their agility and drive greater innovation and productivity. In our web-scale business, demand remains solid, driven by their growing investments with Cisco to build out AI fabric and massively scalable cloud networks. Once again, we saw strong momentum with our Silicon One-based Cisco 8000 routers. We are experiencing robust demand for our 400 gig products and now have nearly 1,200 customers. On a trailing 12-month basis, web-scale orders were up double digits or greater for the eighth consecutive quarter. Network capacity and demand continues to increase, driven by 5G, IoT, pervasive video and other technology trends I've mentioned earlier. With our commitment to powering next-generation networks while also driving sustainability, we launched new 800 gig switching platforms built on our Silicon One G100 chip to help meet customers' demand for more programmability, bandwidth and energy efficiency. Let me now touch on our innovation, as I'm incredibly proud of how our teams have come together to deliver market-leading solutions for our customers. Security and hybrid work are now more critical than ever. We continue to extend our capabilities to enable customers to work more securely anywhere while reducing cost and complexity. In security, we introduced new data loss prevention, firewall and Zero Trust capabilities across our portfolio. And in collaboration, we announced more than 40 new innovations to power hybrid work and deliver exceptional customer experiences. We're also committed to giving our customers more choice. An example of this is our partnership with Microsoft to bring Microsoft Teams to Cisco meeting room devices. By doing this, we are driving interoperability and demonstrating our openness to meet our customers' needs and provide greater flexibility. To wrap up, we delivered another strong quarter of revenue and non-GAAP earnings growth. The strength of orders, increased visibility and easing supply situation provides us with enhanced visibility and predictability, which underpins the confidence we have in our business and our increased outlook for the year. Our performance this quarter is a testament to our innovation and execution to support our customers during these complex times. Additionally, it reinforces Cisco's strength, durability, and discipline in how we manage the business while investing to capture the multiyear growth opportunities ahead. Our portfolio is in great shape, and our business model is resilient with 43% of our revenue now recurring, which is very important as we navigate the current macro environment. The hard work and dedicated commitment of our leadership team and employees over the last few years to transform our business model is reflected in the performance we delivered this quarter. Combined with the strength of our balance sheet and our position in the market, we have an excellent foundation for delivering long-term results. I will now turn it over to Scott.

Thanks, Chuck. We began the fiscal year with a strong first quarter, showcasing effective execution and careful management. Our total revenue reached a record $13.6 billion, surpassing the upper limit of our forecast, fueled by higher product shipments than expected and ongoing advancements in component supply. The non-GAAP operating margin was 31.8%, a decline of 150 basis points, aligning with our guidance, primarily due to increased component and logistics costs stemming from supply challenges. Non-GAAP net income stood at $3.5 billion, reflecting a 2% increase, while non-GAAP EPS was $0.86, a rise of 5%, exceeding our forecast. Examining our first quarter revenue more closely, total product revenue was $10.2 billion, an increase of 8%, with service revenue remaining steady at $3.4 billion. Within product revenue, Secure Agile Networks performed exceptionally well with a 12% increase. Switching revenue grew, driven by double-digit growth in campus switching from our Catalyst 9000 and Meraki offerings, although data center switching saw a slight decline. Enterprise routing fell mainly due to the transition to our Catalyst 8000 series routers and supply constraints. Wireless experienced strong double-digit growth, primarily from our WiFi 6 products and Meraki wireless offerings. Internet for the Future declined 5% due to decreases in Cable, Optical, and Edge, though we noted growth in our Cisco 8000 offering and strong double-digit growth in web scale. Collaboration decreased by 2%, influenced by a drop in meetings, somewhat balanced by growth in calling services. End-to-end security saw a 9% increase, bolstered by unified threat management and Zero Trust solutions, with our Zero Trust portfolio performing strongly, particularly our Duo offering. Optimized application experiences increased by 7%, driven by double-digit growth in our SaaS-based product, ThousandEyes. We continue to advance our transformation metrics, moving our business towards more software and subscription models. Our annual recurring revenue reached $23.2 billion, a 7% increase, with product ARR growing by 12%. Total software revenue rose to $3.9 billion, a 5% increase, with software subscription revenue up 11%. Subscriptions accounted for 85% of software revenue, up 5 percentage points year-over-year. We also maintained over $2 billion in software orders within our product backlog. Total subscription revenue was $5.9 billion, an increase of 6%, representing 43% of Cisco's overall revenue. Remaining performance obligations stood at $30.9 billion, up 3%, with product RPO rising 5% and service RPO increasing by 1%. Short-term RPO grew to $16.4 billion. During the first quarter, we achieved the second highest Q1 orders in our history. While product orders dropped 14% for the quarter, it's essential to note they compared against a 34% growth from last year. Our cancellation rates remained low and below pre-pandemic levels. Regionally, the Americas saw a 10% decrease, while EMEA and APJC experienced declines of 23% and 10%, respectively. In terms of customer segments, service provider sectors fell by 23%, commercial by 14%, enterprise by 13%, and public sector by 7%. Our total non-GAAP gross margin was 63%, within our projected range and down 150 basis points from last year. Product gross margin decreased to 61%, down 280 basis points, while service gross margin increased to 68.8%, up 230 basis points. The decline in product gross margin stemmed mainly from increases in component costs as well as higher freight and logistics expenses. This decline was somewhat mitigated by pricing strategies implemented in the previous year and some favorable product mix impacts. Backlog levels for both hardware and software remain well above historical figures. We managed to increase our shipments this quarter, resulting in approximately a 10% sequential decrease in total backlog, which still ranks as the second highest level we've seen. It is important to remember that backlog is not included in our $30.9 billion in remaining performance obligations. The combination of our substantial backlog and RPO continues to provide excellent visibility for our revenue prospects. Regarding our balance sheet, we concluded Q1 with total cash, cash equivalents, and investments amounting to $19.8 billion. Our operating cash flow for the quarter reached $4 billion, representing a 16% year-over-year increase. In terms of capital allocation, we returned $2.1 billion to our shareholders during the quarter, consisting of $1.6 billion for our quarterly cash dividend and about $500 million for share repurchases. This aligns with our long-term goal of returning at least 50% of free cash flow annually to our shareholders. We also concluded the quarter with $14.7 billion in stock repurchase authorization. In summary, we executed effectively in Q1 amidst a complex environment, achieving better-than-expected revenue growth and non-GAAP profitability. We are making strides in transforming our business model towards recurring revenue while strategically investing in innovations to leverage significant growth opportunities. In line with this aim, we announced restructuring actions aimed at prioritizing investments in our highest growth prospects and adjusting our real estate footprint to maximize long-term shareholder value. Turning to our Q2 financial guidance, we anticipate revenue growth to be between 4.5% and 6.5%. We expect non-GAAP gross margins to range from 63% to 64%. Our non-GAAP operating margin is projected to fall between 31.5% and 32.5%, and non-GAAP earnings per share is expected to be between $0.84 and $0.86. For fiscal year 2023, we’re raising our revenue growth expectations to a range of 4.5% to 6.5% year-over-year, up from the previous forecast of 4% to 6% growth. Non-GAAP earnings per share guidance is now projected to fall between $3.51 and $3.58, also reflecting a 4.5% to 6.5% increase year-over-year. For both our Q2 and full-year guidance, we are assuming a non-GAAP effective tax rate of 19%. Our Q2 guidance reflects the improved visibility gained from our substantial backlog and the RPO generated by our business model transformation, coupled with easing supply constraints. Our full-year guidance carries forward our Q1 overperformance with a cautious outlook for the rest of the year.

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

Congrats on the quarter. Chuck, could you elaborate on the commentary you provided about Europe and also share what you're observing regarding the level of activity or approvals required within the U.S.? That would be helpful.

Thanks, Meta. Yes, Europe is indeed affected by energy costs, prompting companies to reassess their profit and loss statements and spending. We continue to observe milder temperatures there. This week, we spoke with some team members, which is encouraging. An important point is that customers are actively seeking solutions to manage energy costs. We have several technological solutions to assist them, such as our Silicon One technology that reduces network power consumption. Additionally, our IoT capabilities can enhance the efficiency of energy systems, and our Power-Over-Ethernet solution minimizes power usage for customers. This also brings some opportunities. Regarding Asia, it has shown considerable resilience. While there is awareness of the current economic challenges, we noted positive results across five regions last quarter, notably India, which experienced significant growth following a strong performance last year. This is a promising indicator, suggesting that Asia remains resilient. In the Americas, the situation is somewhat mixed; some customers are moving ahead while others are adopting a more cautious approach. By December, we expect to have clearer insights into the 2023 budgets, which will be beneficial. Concerning the request for more signatures, we have observed our customers increasing signature requirements. However, the deals we are working on are being signed, albeit at a slower pace than we anticipated.

It was a strong quarter, and I'm noticing an upward trend in the numbers, but I'm curious about how much of this is due to backlog flush versus the overall market conditions. Specifically, I see that your product orders have declined by 14%, compared to a 6% drop last quarter. So, I'm wondering about the state of the market. Is it showing signs of weakening in terms of order bookings and backlog? Are we seeing a temporary acceleration due to easing supply constraints, or is the market itself remaining stable? It would be helpful if you could provide insights into some of your major product categories to illustrate the trends.

Thank you, Tal. This is a question we anticipated, so I’ll provide more detail than usual. First, the past two quarters and the current quarter have major year-over-year comparisons from the previous year. As we mentioned before, we believe it's more important to focus on sequential growth as a measure. We were slightly below our usual quarter-to-quarter range by about 1%. While this is not significant and somewhat lighter than our typical expectations, it is still within bounds. Both enterprise and commercial sectors globally fell within the normal sequential range; however, the public sector was slightly out of range, and service providers showed variability that isn't really indicative. Demand did not dramatically decline; in fact, U.S. enterprises, after seeing upper 20s growth last year, achieved low single-digit positive growth this time, which is a good sign. Our order flow during the quarter was consistent, and remember that this was our second-largest Q1 for orders ever, following only last year's quarter. That’s encouraging. Now to address your underlying concern—whether this year’s performance is solely backed by backlog and if things will deteriorate after that. Let me share some data: even if our orders decrease by 10% this year, which is not what we forecast, we still anticipate finishing the fiscal year with two to three times our typical year-end backlog. Normally, that backlog ranges from $4 billion to $5 billion. So, I’m sharing concrete numbers here. Moreover, with 43% of our revenue now coming from recurring sources, as shown in our RPO, we have considerable confidence and visibility in the near term. I hope this clarifies things, Tal.

Chuck, I just want to clarify something. You mentioned the sequential decline was a bit worse than expected for this time of year. You also indicated that the backlog decreased by about 10% quarter-over-quarter. Can you help me understand those figures better? Last year in the fourth quarter, the decrease was around 13.1%, and it seems like you might be falling a bit short of that.

David, I think we may have lost you.

Can you guys hear me?

Now we can.

Just can you help square the backlog versus the sequential commentary? If I look at your quarter-over-quarter backlog commentary, that was slightly below seasonal, but it sounds like you took down backlog by about 10%. So it seems like there's about $600 million or $700 million of revenue that we're unable to triangulate on. So if you can kind of talk just walk through that, that would be helpful.

Sure. Yes. The backlog came down about 10%, leaving us with an ending backlog at the end of Q1 that was the second highest in our history and higher than what we had seen at the end of Q3. So we took a spike up a little more than 10% in Q4 and came back down in Q1. What Chuck was talking about on the sequentials is really about the overall product bookings that came in versus where we're standing in backlog. So the flow-through of orders come in, drop in the backlog, that backlog then converts into revenue. The way you got to think about it is less about does the change in backlog convert to revenue growth and more of does the change in backlog convert to build.

And remember, bookings contribute to both backlog and RPO.

Got it. And maybe just one final thing on profitability. When software comes out of backlog, I would imagine that would have been a tailwind for gross margins in the quarter. Can you kind of quantify what that might have been in the quarter, given obviously, there's some supply chain pressure and logistics pressures on margin?

Yes, you are correct. In the long term, the growth of the software component and our ability to deliver from backlog will positively impact margins. Currently, much of what we are clearing from backlog consists of older products. We made significant progress reducing our aged backlog this quarter, but most of what is being shipped still includes orders placed before the price increases. This creates two simultaneous issues: rising costs and revenues linked to earlier sales, which negatively impacts margins. However, the increased software shipments provide some support. Overall, it remains a considerable challenge. We recorded a 61% product gross margin this quarter, consistent with our Q4 performance. The good news is that we have been successful in shipping a significant portion of the aged backlog, though there is still some remaining for Q2. I anticipate that margins will improve by the end of the year, with product margins expected to increase by 50 to 75 basis points.

Nice results. Chuck, I want to go back to your answer to Tal's question. It's very clear that with orders down and your ability to fulfill now much more enhanced that the backlog over the next few quarters will just continue to decline. So help us get our hands around what would be a level of decline that would make you worry versus a level of decline that you'd think as a normal pace in going back to historical normal levels. What would be the line in the sand would you say where you would say, more than this, we probably have an issue, but if it's around X, then it's perfectly normal and reasonable that, that will happen over the next 12, 18 months?

Yes, Ittai. We've actually modeled out various bookings scenarios for the year, and it would have to be significantly worse than what I told you for it to be concerning. Scott, do you have any other comments?

No. I think what you're trying to get at is when do we get back to more seasonal patterns, right? Obviously, seasonality went out the window, both going into the pandemic and then coming out of it with those 3 consecutive quarters of north of 30% growth. We are beginning to see signs of normal seasonality returning. It's going to be a little complex to see, though, because, as supply constraints loosen up, we'll be able to reduce lead times. We've already done that for a handful of product lines. And as we do that, of course, that will have an effect on just the current period bookings. So it's going to be a little bit difficult for you to spot those trends over the next few quarters as lead times normalize.

I have two quick questions. Chuck, regarding the cloud vertical, could you discuss the double-digit orders? Can you explain the deceleration in terms of the normalization of extra quarters of ordering versus the potential for normalization of spending by the cloud players next year? Also, on the software side, I'm curious if you could provide an update. It sounds like a lot of hardware was converted, which contributed to growth. Could you comment on the 9K renewals and any standalone software offerings that might also support growth over the next few quarters?

Yes, those are two important questions, Tim. Regarding the cloud sector, I believe you're correct in noting that the normalization of orders is likely to take place over the next few quarters. I wouldn't be surprised if our trailing fourth quarter rates dip negative in the coming quarters due to the high volume of orders we've received. However, we continue to observe strong overall demand from our clients. We've engaged in extensive long-term planning with them, and we have several orders that are not yet reflected in our bookings because they fall outside our usual bookings lead time. This is a positive sign. We're successfully securing new franchises and feel optimistic about our position there. On the software front, the renewals for the Catalyst 9K are showing improvement, though they remain minimal at this time. I anticipate we will see significant growth in that area next year. We recently announced that we will manage the entire Catalyst portfolio through the Meraki dashboard and platform, which will be available to customers with the DNA and premium licenses. We've already launched monitoring and management capabilities, and we believe this will further enhance our renewal rates. Additionally, we achieved a record quarter for Catalyst 9K, which we are very pleased about. Scott?

Yes. To add to that, Tim, the software subscription growth is noteworthy, with a 11% increase in the subscription portion of our overall software, which now represents 85% of the total. Since the overall software revenue grew by only 5%, there has been a continued decline in perpetual licenses, which now account for 15% of our total software revenue. We are reaching a point where the subscription model is significantly outpacing the perpetual model, and the challenges associated with perpetual licenses will have less of an impact moving forward.

I appreciate you taking the question. At the risk of asking something you can't or will not respond to, Scott. I was hoping to ask go back to the margin question, two related questions. One, well, just for clarification, the 50 to 75 basis point product margin improvement, I assume that's off of the current quarter. Is that the reference point?

Yes, 50 to 75 off the current quarter, that's right, by the time we get to Q4.

Right. Now, concerning the longer-term outlook, I understand there are many variables at play, making it challenging to predict. However, do you believe it's possible to return to or even surpass the nearly 67% growth and 34% operating margin levels from early 2021? Those figures represented a 15-year peak for your gross margin, and you'd have to look back to 1997 for a similar operating margin. Clearly, you and others are currently far from those numbers compared to what was achieved 1.5 years ago, before the pandemic. Considering that, what is your perspective on where you could potentially reach over the long term? Additionally, how do you plan to approach OpEx growth? I assume you're looking to maintain some level of leverage on your gross margin. Any insights you could provide would be appreciated. I noticed this quarter's OpEx growth was about 4% or 5%, which seems a bit high. What are your thoughts on this for the future?

Sure. Let me start with the gross margin part. There are several factors affecting the gross margins. One of them is the backlog, which includes items still at pre-price-increase levels. We will be shipping those as we work through the backlog, which should be beneficial. The increasing contribution of software to our revenues will also support this. To return to a 65% gross margin, we would need to see either additional cost reductions in areas such as freight and logistics, and we are starting to notice some easing in those costs, although they are up year-over-year. We also need to see further reductions in component costs or potentially a price increase. While I can't provide a specific number, there are many factors to consider, and we see more advantages than disadvantages going forward. On the operating expense side, part of this quarter's results reflects the normalization of our bonus plans, as last year's plan did not pay out effectively. As we enter this year and normalize it, that contributes to OpEx growth. We also had a slightly larger annual merit increase cycle, which is also driving OpEx growth. Looking at the long term, our focus remains on balanced profitable growth. Our guidance for the year anticipates a 4.5% to 6.5% growth in both top line and bottom line. Over the long term, we have discussed expectations of 5% to 7% growth for both top and bottom lines. This is the framework you should keep in mind.

I wanted to ask about the impact of foreign exchange. Obviously, U.S. dollar at 20-year highs. Maybe you can talk about how you're broaching that conversation with customers internationally. Are you seeing any diminishment of demand? What's the picture?

Yes, I'll begin with the figures on that, George. We derive approximately 90% of our revenue in USD, so the strength of the dollar has a limited translation impact on us. While it isn’t negligible, it is counterbalanced by the advantages we see in our operating expenses. Therefore, foreign exchange from a translation perspective hasn’t materially affected us. However, selling in USD at a higher exchange rate certainly has some impact. One factor contributing to the situation that Chuck mentioned earlier is that Europe is not only facing high inflation, but the increased local currency costs for transactions have posed a challenge. Nonetheless, we've handled this before as we've always sold in USD since our company’s inception. We don't anticipate it having a long-term effect on us.

I guess, maybe the first one, I was hoping you could touch on the service provider market. I think you said orders were down 23%. That seems a bit more severe than the rest of the portfolio. What's happening there in any newly service provider versus web scale would be helpful.

I couldn't understand the question.

Can you repeat the question?

Yes, sorry. So I was hoping you could talk a bit about the service provider order decline of 23%, seemed a bit more severe than the rest of the business. And then anything over there between web scale and kind of the traditional service providers would be helpful.

Yes. Amit, thank you for that. And I think the reality around that one is simply if you go back a year ago, that segment grew 65%. I think that's the fundamental issue. I don't think there's anything else going on.

Got it. And I guess maybe if I could just ask you just about the full year guide. I mean, you folks have guided it, right? And you just did 6% growth against a very difficult compare, and I guess the way to your guide, but you aren't really assuming much of an acceleration for the rest of the year despite compares are getting easier. So I guess, Chuck, is that just being conservative, or are you seeing signs in your backlog or your orders that give you a pause on that business? If you could show how easily the compares here, I would imagine the growth rate accelerate a bit for the year.

No, there's nothing that's giving us pause in that. I mean, we guided up the full year in revenue from what had been a guide of 4% to 6% growth to 4.5% to 6.5%. That effectively rolls forward the outperformance that we had in Q1 into the full year. There's no change in the way we're looking at the second half of the year either plus or minus. But it's a prudent view of what we expect in the next 3 quarters.

I wanted to see if there was some way you could characterize your own lead time. So if you had customers placing orders today from Meraki products or campus switches or data center gear, what are the lead times for getting the product for your customers? And how does that compare to the prior quarter and prior year?

Yes, I'll make some comments, and then, Scott, if you want to add some color, feel free. The range on the products is very wide right now. We still have a couple product areas that we have component issues that we're doing some work, and I think we've got probably one more quarter before we start improving those. We've got other products like we have certain firewalls that are down to 3-week lead times. We have some of the products we've redesigned that I've talked about before. It went from 40 weeks to 12 weeks and will continue to improve. I think we made improvements in roughly half of the portfolio. Half of the product families improved during the last quarter, and we would expect to continue that progress as we move forward.

And just as a quick follow-up. As you're showing improvement, do you see that affecting your ability to maintain or take market share where perhaps you were more vulnerable when the lead times were more extended?

Yes, the entire market share discussion reflects our backlog. That is the key point. As we continue to ship products, I believe we will gain market share over the next 12 months since we have a significant backlog to deliver. I expect this to have a positive effect.

On the restructuring plan, I understand these situations are challenging. We noticed that the collaboration side was experiencing layoffs. What product areas are most affected by this? How should we view the overall reduction in headcount? What is the strategy to improve some of the growth businesses that have been struggling, particularly in collaboration? Additionally, how much are you considering this impact in your top-line guidance?

Yes, we will be addressing our employees about this tomorrow, so I prefer not to go into too much detail until after that. What I can share is that we are adjusting certain businesses to better align our resources, especially in enterprise networking and our platform strategy. We plan to invest significantly in security and enhance our team and innovation in that area. Those are key priorities for us. I’d like to wait until we speak with our employees tomorrow for more comprehensive updates. However, rest assured that we are rightsizing certain businesses, but nothing is being deprioritized. Regarding collaboration, our Cloud Calling and Cloud Contact Center businesses are currently performing very well. The upcoming comparisons for our meeting solutions are looking favorable as well. I am optimistic about our collaboration portfolio over the next year. The team has done an excellent job creating what I believe is the best platform in the market. Our devices and the interoperability we have fostered with Microsoft are significant advantages for our customers, providing them with flexibility. Overall, I feel positive about this business moving forward, although we do need to adjust some operating expenses.

And James, to clarify, this should not be viewed as a headcount reduction aimed at saving costs. It is truly a rebalancing effort. We have identified areas where we want to increase our investment, such as security, our transition to new platforms, and additional cloud-based products. However, we will also uphold our financial discipline during this process. Essentially, this is a matter of rebalancing across all areas. Ideally, we would have a perfect match of skills, allowing us to simply transition people from certain areas to those where we want to invest. Unfortunately, we do not live in a perfect world.

We have opened slightly fewer jobs in the areas where we plan to invest compared to the number of people we believe will be affected. We will work diligently to match our employees with those roles as long as their skills align. We are committed to making this work.

If I could just follow up quickly on that. I appreciate the information you provided, and I understand the sensitivity surrounding the topic. Regarding the $600 million impact, should we expect that to be the net savings? Or will the net savings actually be lower since you are reallocating some of the workforce?

Yes, it's not primarily driven by cost savings. By the end of the year, we expect to maintain a headcount similar to what we had at the beginning of the year. There are two aspects to consider. The first is the impact on headcount we've discussed. The second involves adjusting our real estate portfolio. We have numerous small offices around the world that are largely underutilized or even completely unused in some instances. The costs associated with this will contain two components. One will relate to our people, while the other will focus on optimizing our real estate. This will lead to some savings, although minimal in fiscal '23. However, in the long run, it should result in greater savings.

Congratulations on the strong results. I have a question regarding your comments on the hesitation from EMEA customers in light of the macroeconomic conditions. You mentioned the opportunities you see despite this. Could you elaborate on when you started noticing this hesitation among customers? How are they prioritizing their spending across your portfolio, particularly between data centers, campus solutions, and security? Are some areas being more affected than others as they reassess their investments?

It's a good question. Recently, Gartner conducted a survey of executives from our customer base, and nearly half indicated that their technology investments would be the last area they would cut. This highlights how essential customers consider their technology investments currently. Many are proceeding with hybrid work initiatives and building the necessary infrastructure for this new environment. Customers are also balancing their private and public cloud workloads, requiring a complete rearchitecture of their infrastructure to adapt to changing traffic patterns. In Europe, energy costs are a significant concern, and there has been notable acceleration in IoT adoption over the past few years, with record bookings in Q1. Customers are eager to connect systems to optimize power usage and efficiency. Additionally, many are undertaking greenfield real estate projects centered around low-voltage architectures, which leads to Power-over-Ethernet solutions and infrastructure upgrades. Cybersecurity and full stack observability continue to gain focus, along with 5G build-outs. Despite the short-term challenges in the environment, there are many positive trends at play.

Chuck, I wanted to go back to a comment you made regarding market share and some of that sitting in the backlog. Now if we assumed that there was nothing in the backlog and all the numbers that you generated were publicly reported through your financial statements, would that show that Cisco actually maintained or increased or even lost market share?

You mean if all our backlog was actually shipped and reported?

Correct.

Yes, I think that's likely. We operate in various markets, so I can't say it's true for every market. However, I believe that as we ship our Secure Agile networks and our enterprise and networking products, that's certainly going to help. Catching up on our data center infrastructure will also contribute positively. There are reporting dynamics at play as well; some competitors categorize certain routing products as data center switching while we categorize them as routing, which complicates things. It's not a perfect science. But as our backlog normalizes over the next 18 to 24 months, I think you'll see that dynamic.

Got it. Just to be clear, that is Cisco gain share? I don't know, just to make sure I heard you correctly.

I think that's right. In certain key areas. I mean, not perhaps across everyone. I'd have to go do the analysis. But in some of the key ones that I know all of you are worried about, the answer is yes.

In the bigger markets.

Got it. And then one question just for Scott. So Scott, maybe you could tell us where in fiscal 1Q of '23 did shipments begin to start accelerating just because we want to kind of understand the trend here going from now through fiscal 4Q and putting into that product gross margin comment into perspective. What I'm really trying to understand is, as shipments start to accelerate, how much will software attach to those shipments just so I can understand the glide path here, what happens in some of the other segments outside of just secure network, agile networks, et cetera, right? I'm just trying to get this kind of like this pull dynamic that may occur from the other segments related to shipments going out the door.

We discussed the overall backlog reduction of about 10% from Q4 to the end of Q1. A part of that is related to software, which also experienced a similar reduction of around 10%. Software continues to make up over $2 billion of our total product backlog. Looking ahead, I expect the improvement of 50 to 75 basis points that I mentioned will likely be more pronounced in the second half of the year compared to the second quarter, as reflected in our guidance for Q2.

I'll turn it over to Chuck for some closing remarks.

Thanks, Marilyn, and thank you all for joining us today. I just want to reiterate it, we feel like we had a very strong quarter, largest quarterly revenue in history. As I said earlier, the orders, the visibility, the easing of supply chain gives us the confidence to raise the year, obviously. We're very focused. We're managing the business for growth. We are going to go through this process of reinvesting into strategic areas. And the people impact is difficult. And I just want our employees who are listening in today to know that this afternoon and tomorrow, we'll be communicating about how we're going to go about this. It's always a difficult decision, but we have a lot of opportunity. I'm very optimistic about the future. I'm proud of the teams and what they've accomplished and really excited about the visibility and the confidence that we have in the near term. So thanks for joining us, and we look forward to next time.

Thanks, Chuck. Cisco's next quarterly earnings conference call, which will reflect our fiscal year 2023 second quarter results will be on Wednesday, February 15, 2023, at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. This concludes today's call. If you have any further questions, feel free to contact the Cisco Investor Relations group. We thank you very much for joining today's call.