Cisco Systems Inc (CSCO) — Q1 2025 Earnings Call Transcript

Good afternoon, everyone. This is Sami Badri, Cisco's Head of Investor Relations, joined by Chuck Robbins, our Chair and CEO, and Scott Herren, our CFO. Cisco's earnings press release and supplemental information, including GAAP to non-GAAP reconciliations, are available on our Investor Relations website. Following this call, we will also make the recorded webcast and slides available on the website. Throughout today's call, we'll be referencing both GAAP and non-GAAP financial results. We will discuss product results in terms of revenue and geographic and customer results in terms of product orders, unless stated otherwise. All comparisons will be made on a year-over-year basis. Please note that our discussions today will include forward-looking statements, including our guidance for the second quarter and fiscal year 2025. These statements are subject to risks and uncertainties detailed in our SEC filings, particularly our most recent 10-K report, which identifies important risk factors that could cause actual results to differ materially from those contained in our 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 that is done through an explicit public disclosure. Now, I'll turn it over to Chuck.

Thanks, Sami. And thank you all for joining us today. Cisco delivered a strong start to fiscal '25, delivering $13.8 billion in revenue for the first quarter, coming in at the high end of our guidance range. This was supported by solid growth in annualized recurring revenue, remaining performance obligations, and subscription revenue, which now accounts for 57% of our total revenue. The strength of our recurring revenue streams is helping to fuel our profitability. Non-GAAP EPS of $0.91 exceeded the high end of our guidance range, driven by the highest non-GAAP gross margin we have seen in more than 20 years, which was further enhanced by Splunk. The combination of Cisco and Splunk and our team's great execution are both driving our strong operating leverage. The strength of our operating performance and free cash flow in Q1 fueled a return of $3.6 billion in value to our shareholders through share repurchases and cash dividends, delivering on our commitment to consistent capital returns. Building on the growing demand we saw at the end of fiscal year '24, product orders grew 20% year-over-year in Q1 and were up 9% organically. This is an acceleration of the 14% product order growth we saw just three months ago and is a clear sign of normalizing demand for Cisco's innovation. Now, let me share some details on our first quarter, starting with the demand environment. Enterprise product orders were up 33%, driven by particularly strong performance in the Americas and EMEA across a broad range of customers. We saw continued strong momentum in service provider and cloud, with product orders up 28%, driven by triple-digit growth in webscale. In Q1, our webscale customers placed AI infrastructure orders in excess of $300 million. Our AI pipeline continues to be strong. We have earned more design wins and remain confident that we will exceed our target of $1 billion of AI orders this fiscal year from webscale customers. After a very strong Q4 last quarter, public sector orders were up 2% year-over-year in Q1. Federal spending in the U.S. was lower year-over-year due to continuing resolutions discussions, the impact of the Fiscal Responsibility Act, and the diversion of funds within U.S. federal. It's important to note that we believe the deals we are working on with U.S. federal customers are simply delayed, not lost. In both EMEA and APJC, year-over-year public sector order growth was strong. Now, let me share some data on demand through the lens of our products to provide some incremental color. Our networking portfolio saw double-digit product order growth overall, driven by switching, wireless, and internet infrastructure. Looking at data center switching in particular, we have seen three consecutive quarters of double-digit order growth and an acceleration from Q4 into Q1. This shows our competitive strength in this key market and the power of our Nexus brand in the build-out of private cloud infrastructure by our customers. We expect this momentum to continue as customers are showing significant interest in our 400 gig and 800 gig switches based on Silicon One. Security orders more than doubled year-over-year, driven by the advanced threat intelligence capabilities of Splunk. Excluding Splunk, growth in security product orders was driven by our renewed security strategy and new product pipeline, which continues to be well received by customers and analysts. We continue to see momentum around our new security products like XDR, Secure Access and Multicloud Defense with now over 1,000 customers deploying these products thus far. In Q1, we had a marquee win for over 75,000 cloud security seats with a multinational IT services and consultancy company. The customer largely replaced an SSE competitor with our solution and moved from planning to implementation in 120 days, highlighting how fast our teams can implement our solutions at scale. We also booked our first seven-figure Hypershield deal in Q1. Collaboration product orders grew double-digits again driven by demand for devices and our Cloud Webex Suite. Finally, in observability, orders were up high-single-digits, driven by our network assurance solution, ThousandEyes and Splunk Observability. I'd also like to highlight some of the progress we've made integrating Splunk. We now have a dozen updated data integrations between Cisco and Splunk across our security and networking portfolio, including Secure Firewall, Catalyst Center, SD-WAN and ICE. We continue our joint selling motions between Cisco and Splunk, including a Cisco Secure Network Analytics and XDR alongside Splunk's SIEM, offering enhanced capabilities to the security operations center. We also continue to build our market-leading observability solutions to accelerate Full-Stack Observability for the enterprise. Overall, our Q1 results highlight continued strong demand for Cisco technologies, driven by the need for modern, resilient networks as AI begins to scale. Findings from our new global AI partner study show that IT partners around the world are anticipating a transformative wave of AI technology demand driven by infrastructure, cybersecurity, and customer experience, which they expect to fuel the majority of their revenue over the next four to five years. With the breadth of our portfolio, we are uniquely positioned to capitalize on this AI technology demand as customers are investing in their critical infrastructure to prepare for AI. In fact, there are three distinct but connected pillars to the AI networking opportunity for Cisco, which we have outlined on a slide as part of our quarterly materials. First, AI training infrastructure for webscale customers: AI networks demand scalable, programmable, low-power switches with advanced load balancing and observability. These characteristics in our products are driving hyperscalers to deploy the Cisco 8000 with Cisco's Silicon One G200 for maximum power efficiency in their back-end AI training networks. As further proof, we also won a new Super Spine AI networking use case with one of our webscale customers this quarter. Second, AI network connectivity: This quarter, we booked further platform sales with global enterprise customers who are leveraging our technology platforms to modernize and automate their network operations to prepare for large-scale connectivity to AI applications. Our technology platforms across switching, routing, security, and observability will help enable our customers by leveraging cutting-edge innovations like AI-powered robotics and unmatched supply chain visibility. Third, AI network inference and enterprise clouds: Most of the CIOs and technology leaders we talk to say that their organizations are planning full GenAI adoption within the next two years, yet only 13% of organizations say their infrastructure is ready for AI today, according to the Cisco AI Readiness Index. To help our customers prepare, we have announced two new additions to our data center infrastructure portfolio, a new Nvidia-based AI server and AI PODs, including Nvidia's AI Enterprise cloud-native software platform and managed through Cisco Intersight to simplify and de-risk AI infrastructure deployment. Our new AI server is expected to begin shipping next month. And our AI PODs are orderable this month. In addition, HyperFabric, our fabric as a service solution, which is expected to be available in early calendar 2025, further simplifies infrastructure deployment and management while providing real-time visibility into network performance. With these solutions, we are bringing the power of open hyperscale AI networking to the enterprise. We also continue to fuse AI capabilities into our products. Hypershield, our first truly distributed AI-native cybersecurity solution built into the fabric of the network, shows how we are delivering secure networking, making it easier for our customers to protect against evolving threats. Splunk's Asset and Risk Intelligence solution is another example of how we are providing insights to help customers understand their security maturity and demonstrate compliance with evolving regulations. In our collaboration portfolio, we recently introduced the Webex AI Agent, AI Agent Studio, and Cisco AI Assistant features for Webex Contact Center. These solutions use advanced conversational intelligence and automation to improve overall customer satisfaction. We have seen strong initial interest from customers and we'll continue to strengthen our collaboration products, increasing AI capabilities. We are also enhancing our own productivity by using AI in our services and customer experience organization. Over 60% of our Technical Assistance Center support cases are now touched by AI-enabled automation backed by our expertise for faster resolutions, which is leading to higher customer satisfaction scores. In addition, our internal AI assistant for TAC works alongside our engineers to improve quality and speed time to resolution, while allowing our people to work on more complex and creative problem solving. To summarize, as we look at what's occurring with AI, there are three key things happening. First, there is significant investment in back-end AI networks with hyperscalers focused on training. Second, as enterprises look to adopt and deploy AI, they need to modernize and secure their infrastructure to prepare for the pervasive deployment of AI applications. Finally, the combination of mature back-end models with enterprise AI application deployment will lead to increased capacity requirements on both private and public front-end cloud networks. Cisco is already playing a major role across all three of these significant opportunities and is uniquely positioned to win with the breadth of our product portfolio and our trusted customer relationships. I will now turn it over to Scott to provide more detail on the quarter and our outlook.

Thanks, Chuck. We executed well in Q1 with strong order momentum, margins, and operating cash flow. For the quarter, total revenue was at the high end of our guidance range at $13.8 billion, down 6% year-over-year. As a reminder, Q1 of fiscal '24 was the last quarter of significantly elevated backlog shipments. Non-GAAP net income was $3.7 billion and non-GAAP earnings per share were above the high end of our guidance range at $0.91. Looking at our Q1 revenue in more detail, total product revenue was $10.1 billion, down 9%, and service revenue was $3.7 billion, up 6%. Networking was down 23%, primarily driven by the elevated level of shipment we saw a year ago. As Chuck said, we saw strong order growth across our networking products as customers have worked down inventory and deployed the networking products we shipped them last year. Security was up 100%, primarily driven by growth in our threat intelligence, detection, and response offerings, which includes the offerings from Splunk, network security, and SASE. Excluding Splunk, security grew 2%, and our security portfolio was particularly impacted by the delays in spending in U.S. federal. Collaboration was down 3%, driven by declines in our on-prem Webex Suite and collaboration devices, partially offset by growth in our contact center and CPaaS offerings. Observability was up 36%, driven primarily by Observability Suite and growth in network assurance offerings. Excluding Splunk, Observability grew 1% for the quarter. Looking at our recurring metrics, ARR ended the quarter at $29.9 billion, which increased 22%, with product ARR growth of 42%. Total subscription revenue increased 21% to $7.8 billion, representing 57% of Cisco's total revenue. Total software revenue was up 24% at $5.5 billion with software subscription revenue up 35%. Total RPO was $40 billion, up 15% year-over-year. Product RPO grew 24% and total short-term RPO was up 15% to $20.3 billion. Q1 product orders were up 20% year-over-year. Excluding Splunk, product orders were up 9% year-over-year. Looking at our product orders across our geographic segments, the Americas was up 17%, EMEA was up 26%, and APJC was up 25%. In our customer markets, enterprise was up 33%, service provider and cloud was up 28%, and public sector was up 2%. Total non-GAAP gross margin came in at 69.3%, up 220 basis points year-over-year and exceeding the high end of our guidance range and reaching the highest level in more than 20 years. Product gross margin was 68.9%, up 240 basis points, driven by Splunk, favorable product mix, productivity improvements, and the one-time benefit of duty drawback, partially offset by price. Services gross margin was 70.3%, up 130 basis points. We continued our focus on profitability and financial discipline with non-GAAP operating margin above the high end of our guidance range at 34.1%. On the bottom-line, Q1 non-GAAP net income was $3.7 billion, and earnings per share were $0.91. Shifting to the balance sheet. We ended Q1 with total cash, cash equivalents, and investments of $18.7 billion. Operating cash flow was $3.7 billion, up 54%. From a capital allocation perspective, we returned $3.6 billion to shareholders during the quarter comprised of $1.6 billion for our quarterly cash dividend and $2 billion of share repurchases. We continue to invest organically and inorganically in our innovation pipeline. During Q1, we closed two software acquisitions: DeepFactor, to accelerate innovation in the Cisco Security Cloud and augment our Secure Access offerings, and Robust Intelligence, which brings enhanced protection for AI models throughout their life cycle from development to production. Additionally, we announced our intent to acquire Deeper Insights AI to expand our Customer Experience team's technology footprint and engineering talent, accelerating innovation and momentum of Cisco's CX AI capabilities and services. These investments are highly complementary to our internal R&D, in line with our strategy to strengthen our position in security and AI with targeted strategic M&A. To summarize, we started the fiscal year with a solid quarter, highlighted by strong order growth, margins and non-GAAP EPS. We remain focused on making strategic investments and accelerating innovation across our business to best capitalize on the significant growth opportunities we see ahead, all underpinned by disciplined expense management. It's this powerful combination that continues to fuel our strong cash flow generation, as well as our ability to return significant value to shareholders. Turning to our financial guidance. For fiscal quarter Q2, our guidance is as follows: we expect revenue to be in the range of $13.75 billion to $13.95 billion; we anticipate non-GAAP gross margins to be in the range of 68% to 69%; non-GAAP operating margin is expected to be in the range of 33.5% to 34.5%; non-GAAP earnings per share is expected to range from $0.89 to $0.91. For fiscal year '25, our guidance is: we expect revenue to be in the range of $55.3 billion to $56.3 billion; non-GAAP earnings per share guidance is expected to range from $3.60 to $3.66. In both our Q2 and full year guidance, we're assuming a non-GAAP effective tax rate of approximately 19%. Sami, let's now move into the Q&A.

Thank you, Scott. Before we start the Q&A portion of the call, I would like to remind analysts to ask one question and a single follow-up question. Operator, can we move to the first question in the analyst queue?

Hello. I'll ask both my questions together. What is driving the significant growth in cloud orders, which increased by 22% excluding Splunk, compared to only 2% last quarter? Can you provide more details about your involvement in cloud areas such as switching, routing, and optical? Are you engaged with all cloud providers, or do you focus on specific ones? My follow-up question is about margins. There is a very strong gross margin and operating margin this quarter. Can you discuss the factors behind these margins and their sustainability? Thanks.

Thank you for the question. I'll address the first part regarding our service provider business, specifically cloud orders. Overall, we were satisfied with our performance. Starting with cable, while it remains under pressure, it represents the smallest segment of our business and its decline has less impact as it shrinks. On the telco side, we experienced some low-single-digit growth, which was encouraging, particularly in Europe and APJC. In terms of cloud or webscale customers, we recorded over 100% growth in orders, with four of the six largest players each showing significant triple-digit growth, indicating a broad-based demand rather than reliance on a single customer. Regarding our involvement in various areas like routing, switching, and optical, we have orders exceeding $300 million in Q1 for AI and webscale solutions, positioning us well to exceed our $1 billion target for the year. Our participation in AI focuses on systems that support GPUs in backend networks, including a noteworthy Super Spine win that connects clusters. We provide both systems and optics for necessary connectivity from backend to frontend, securing several design wins in this domain. We're confident in our ongoing progress. A key advantage of our strategy is selling to customers according to their preferred technology consumption models, leveraging our own silicon, which enhances our competitiveness. Additionally, while AI infrastructure accounted for just under half of our total webscale business, we also saw strength in traditional cloud areas, which contributed positively to our performance. Scott, would you like to discuss the margins?

Yeah. Tal, the margins were very strong. Of course, we had non-GAAP total gross margins of 69.3%, as Chuck said earlier, highest that we've had in 20 years. The product non-GAAP gross margin is 68.9%, up 240 basis points. So, a handful of things driving that. Obviously, the year-on-year increase includes the addition of Splunk, which is favorable at the gross margin line, of course. We had other favorable product mix built into that. A nice job continues to be done by the team on what I'll call productivity enhancements. So, continuing to drive cost out of the cost of goods sold line. The supply chain team has done a really nice job on that front. That is sustainable. We did have a one-time benefit in Q1 in the cost of goods sold line for a project that's been on flight for several years around duty drawback. So, these are components that we imported that incurred a tariff. They were built into final product and then subsequently exported. When that happens, of course, you get the ability to get a return on that. We've been working to get a return of the tariff that you paid at the point of import. We've been working on this project for some time. During the quarter, those filings were accepted. And so, we got a one-time benefit that's fairly substantial in Q1. Having said that, on the back of the great work the team has done, as I look at the next three quarters of the year and you see this in our Q2 guide, I would expect to see gross margins continue to settle into this range of 68% to 69% for the full year. And that of course, will be a tailwind to operating margin as well.

Thank you, Tal. Michelle, we can go to the next question.

Hey, guys, thanks so much for taking the question. So, my question is mainly around macro. Just wondering maybe, Chuck, if you can speak to how the macro backdrop has evolved over the last three months? And then, maybe to double-click on that as a quick follow-up, as it relates to the election, just wondering if there's any hesitation, any impact in terms of buying behavior across different verticals, given some of the uncertainty around U.S. elections intra-quarter? Thanks.

Thanks, Matt. So, on the macro front, I think, first and foremost, I would say that Scott mentioned the U.S. federal challenges, and that will tie into your second question. So, I'll cover a little bit of that there. I think the U.S. federal business was impacted by the continuing resolution pressure and then also the Fiscal Responsibility Act, which expires at the end of this calendar year. Both of those put pressure on federal spending. I think we've heard that from some of our peers in their earnings announcements. If you normalize out or if you actually look at our product orders without Splunk, so the organic product order growth and you just remove the U.S. federal year-over-year, the rest of the world was up in the mid-to-high teens. So, what that tells you is that we saw very balanced strength around the world. Geographically, we saw good strength in Europe, good strength in Asia. Without U.S. federal, we saw good strength in the United States. We saw really strong recovery in enterprise. We're pleased with that. I discussed already the service provider performance that we had during the quarter. And so, I think the only real vertical I would call out is the U.S. federal issue that I just explained. I don't think there's anything else that we've seen relative to the elections at this point.

No. The delays we're experiencing with U.S. federal projects are just that—delays. These are not lost deals. The pressure is stemming from the ongoing funding issues related to the Fiscal Responsibility Act. We do expect some of these projects to resume once we move beyond the continuing resolutions. It appears that the Republicans will maintain control of both Houses of Congress and the White House, so I anticipate a budget will be established fairly quickly. Therefore, I believe these transactions are not lost. Additionally, as Chuck mentioned, total organic product order growth, excluding the impact of U.S. federal, is showing growth in the mid-to-high teens, which aligns with our expectations.

Lots of strength everywhere else.

All right. Thank you, Matt. Michelle, we can go to the next question.

Hi, good afternoon. Thank you very much for the question. I wanted to ask about security. It was encouraging to hear about the first seven-figure Hypershield deal in the quarter. Could you just talk a little bit more about that, the nature of that deal? I think it was only recently made available. So, it feels like it's early days, but maybe you can talk about the reception to that? And then secondly, I think you had mentioned security orders had doubled year-over-year, including Splunk. Could you just give us the organic number as well? And if you could speak qualitatively to the trends, that would be helpful. Thank you.

Thanks, Michael. Regarding your first question about Hypershield, we are working with a very large financial institution that was involved in our early adopter program, which is showing promising results. This solution proves to be highly effective in some of the most advanced data centers globally. We have noticed significant customers starting to implement it, and we expect a steady increase in adoption. Currently, we are offering a personalized support program to assist these customers in getting started. The commitment from a major bank reinforces the credibility of the technology, often leading the way for broader enterprise deployments of new security technologies, which is encouraging. In terms of security orders, we encountered challenges similar to those faced with U.S. federal accounts impacting overall product order growth. U.S. federal is our largest customer, and our security orders, excluding Splunk, rose in the low- to mid-single digits. However, if we disregard the federal year-over-year impact from the continuing resolution and the Fiscal Responsibility Act, those organic security orders increased in the mid to high teens. We have now surpassed 1,000 customers deploying the new technologies introduced over the past 12 to 15 months, and we are pleased with this ongoing adoption. Analyst feedback suggests a widespread belief that our innovation pipeline and the technologies we've introduced will significantly benefit our customers, and we anticipate even more developments ahead, so stay tuned.

Thank you, Mike. Michelle, we can move to the next question.

Thank you for taking my question. First, Chuck, you mentioned that half of your webscale orders were from AI, while the other half were more traditional front-end. Did that drive the enterprise order growth, or is there an indication of campus recovery in those numbers? For Scott, regarding gross margin, I appreciate your insights on the quarter. From a Splunk perspective, was there anything else we should consider? We are trying to assess the contribution from Splunk subscription versus term licenses and how to approach that as we progress through the remainder of fiscal '25. Thank you.

So, thanks, David. If I interpret your first question right, I think what you're asking is, was the non-AI portion of the cloud spend responsible for the enterprise growth that we saw. And so, I'm going to try to answer this. So, when we talk about the enterprise segment, we don't include any technology sold to the webscale customers regardless of what it is. So, the enterprise segment is simply enterprise customers buying whatever they buy from us. So, that growth that we saw in enterprise was purely them. And I would also say that the majority of all of the webscale purchases from us were in the Internet infrastructure space. There was a smattering on the non-AI side that would be attributed to sort of classic enterprise technologies, but it was very small in the context of what they procured from us. Most of it was Internet infrastructure systems, optical routing, switching, etc. Scott, the second one?

On the gross margin, we experienced a favorable product mix, with Splunk contributing to the improved margins. There was a one-time benefit in the first quarter related to duty drawback, which involved refunds for import duties and tariffs we had previously paid on components imported, assembled into our products, and then exported. It took time to gather and approve the necessary paperwork for this refund, which we received in the first quarter. This is a non-recurring benefit that reflects a catch-up for a couple of years' worth of refunds. There will be a minor continuation of this impact in the second quarter and slightly more in the third and fourth quarters. Additionally, the team has effectively reduced costs across the board, which supports our expectation that gross margins will remain in the 68% to 69% range through the end of the year. While Splunk has been beneficial, the primary factor for the quarter's outperformance was the one-time impact from the duty drawback project.

Thank you, David. Michelle, we can move to the next analyst.

Hi, thanks for taking my questions. Can I ask both of them at once? Chuck, you mentioned that the data center switching portfolio had strong order growth for the third straight quarter. How do you see that in relation to enterprises preparing for their AI deployments, or do you still think that’s mostly ahead of us? What does that order momentum signify to you? On the second question about AI orders, you seem optimistic about surpassing the $1 billion target, but does that imply anything about revenue realization this year? Is revenue realization possibly higher than you initially expected in terms of timing? Thank you.

Thank you. On the data center switching side, it is clear that our customers are balancing their workloads between the public cloud and private infrastructure. We see that customers are modernizing their infrastructure. Even if they are uncertain about which AI applications they might deploy in six, nine, or twelve months, they recognize the need for modern infrastructure to be prepared. We see them making forward investments for this purpose, and this trend has been consistent for the past few quarters. Much of this build-out is still ahead of us on the enterprise side. Regarding AI orders, I believe we are on track to exceed the $1 billion target. The order landscape is very dynamic, with customers facing rapidly changing requirements. Opportunities arise, and as we secure design wins, these lead to bookings and ultimately revenue. Generally, a design win is an indication of the customer's confidence in our ability to design the necessary silicon, integrate it into a system, and deliver it. The timing varies based on our requirements from them, which is why you'll see this reflected in our guidance as we continue to execute. I feel confident about the team's performance, which will inform the revenue projections.

Yes, regarding the revenue question, as Chuck mentioned, the situation with shipments is quite dynamic. We only recognize revenue once we have shipped the product, and several factors influencing this are beyond our control. However, we do anticipate that revenue will align with our previous statements, indicating that we expect higher revenue in the second half of the year, with most of it occurring during that period.

Thank you, Samik. Michelle, we can move to the next analyst.

Thank you for the question. I'd like to get an update on the partnership you announced with Nvidia and how that is progressing in terms of traction and its place in the pipeline. I noted you mentioned having an AI server, so I'm curious if that is a result of that collaboration. Additionally, I would appreciate an update on the potential customers you mentioned earlier regarding Splunk opportunities and your outlook on closing some of those deals. Thank you.

Thanks, Simon. Regarding the Nvidia partnership, we are still in the early stages of bringing these solutions to market. A couple of quarters ago, we announced Hyperfabric, a fabric as a service solution designed to provide public cloud simplicity for AI workloads in enterprises, which will be available in early 2025. This quarter, we introduced two new platforms: our AI compute platform, with the initial phase utilizing Nvidia GPUs, and AI PODs, also based on Nvidia GPUs. As market demand evolves, we plan to support other GPUs as well. The partnership is progressing well, but it's still early, and we expect to see real enterprise deployments of these technologies in 2025. On the Splunk customer update, we're seeing solid progress. The acquisition was completed in March, and now being November, that's about eight months. If you consult Gary, he would mention that their average sales cycle is nine months, so we’re still in the early phases, particularly since we launched this initiative only in the second quarter after the acquisition. Our criteria for identifying potential clients were based on specific attributes that indicate they would be suitable candidates for Splunk, and we have added around 1,500 more customers to that list. Furthermore, a positive development is the hundreds of Cisco partners that have been trained on Splunk and are actively establishing Splunk practices. Some have even made strategic acquisitions of Splunk partners to enhance their business. We are very optimistic about the progress in this area.

Yeah. The only thing I'd add to that is from just overall perspective on Splunk integration, it's progressing in line with our expectations on the topline and in the ARR in particular and actually ahead of our expectations on profitability at this point. So, Splunk overall is tracking quite well for us.

Thank you, Simon. Michelle, we can move to the next analyst.

Hey, guys. Scott, for you, just circling back on RPO, what was RPO and product RPO growth at Splunk? And then, Chuck, for you, how are you guys thinking about not just enterprise refresh potential, but also the campus refresh opportunity with Wi-Fi 7 availability that you guys I think even announced this week? And will that Wi-Fi 7 encourage any campus switch refresh as well? Thanks, guys.

Yeah, Jim, regarding the RPO, we won't continue to separate the figures with and without Splunk. This is largely because the integration is progressing well. We have launched several joint products between Cisco and Splunk. On the organizational side, we've consolidated all of the G&A functions and are swiftly integrating across product lines. As a result, it's become increasingly difficult to distinguish what is attributed to Splunk and what isn't. That distinction is becoming less clear each quarter. Therefore, I don't intend to separate those figures. I will say that excluding Splunk, we still see a positive growth rate that aligns with our historical performance, but I'm looking for a better way to clarify that distinction for you.

During the quarter, our overall enterprise networking business performed very well, and we are seeing continued demand for upgrades. We announced the high-end versions of Wi-Fi 7 recently, marking a significant step forward for us as it allows deployment under either an on-prem management system or a cloud management system using the same license and hardware. We have focused on making hardware portable between both environments. Customers are continuing to invest in upgrades, especially as AI applications become more prevalent in enterprises. Initially, we observe AI deployment in backend systems, but as these applications expand within enterprises, there will be two main effects. Firstly, there will be a demand for network connectivity to the cloud to utilize AI models. Secondly, enterprises will need to modernize their networks to support edge-based AI versions. Therefore, we believe the upgrade opportunity will remain strong for some time, largely driven by the AI trend.

All right. Thank you, Jim. Michelle, we can move to the next analyst.

Great. Thanks. Maybe circling back to Michael's question, where you answer that kind of organic security growth would have been in kind of the mid-to-high teens if you stripped out kind of U.S. federal. Just wanted to get a sense of kind of what was driving some of that strength? Is that data center modernization, or just what products are kind of driving some of that upside? And then just second question, just on data center modernization as a tailwind, just where are you kind of seeing kind of prioritization the most kind of within the data center? Is it kind of around security or updating switching? Just kind of any commentary around kind of categories you're seeing that data center modernization take place in? Thanks.

Thanks, Meta. When we examine the security performance without considering the U.S. federal aspect, we're observing the effects of our new products such as XDR, Secure Access, and Multicloud Defense. More than 1,000 customers have now adopted these technologies, which were not part of our portfolio 18 months ago. The early feedback for Hypershield has been very encouraging. While it hasn't significantly contributed to orders yet, I believe it will, and it generates interest among our customers due to its innovative nature, prompting them to revisit the rest of our offerings. Additionally, we completed a refresh of the low-end firewall in the most recent quarter, following the refresh of the high-end in early 2024 and the mid-range later that same year. There's a lot happening that I believe enhances the energy in the security space. Overall, the market, analysts, and customers all recognize that our current position in security is fundamentally different from three or four years ago. Regarding data center modernization, which I've been discussing primarily in relation to switching infrastructure, the momentum we're experiencing with Hypershield indicates that security represents a significant opportunity in this area. As we've noted, if we operate on the assumption that malicious actors are present in your infrastructure, it becomes crucial to halt east-west traffic within the data center, a key role for Hypershield. Consequently, this remains a major focus for our customers. However, most of the activity we've observed in data center modernization and its associated momentum has primarily centered around switching.

Thank you, Meta. Michelle, we can move to the next analyst.

Hey, thanks a lot. It's great to be chatting with you. Hey, Chuck, I asked this last quarter, and I was wondering if you had any update. I understand that customers are getting ready for AI and feel they need to have the latest and greatest year for it. Are you getting a sense of what they're engaging you for? Is it they feel like there's going to be more inference? Is there specific applications that they're citing? I think investors would love to know what you potentially are hitching a ride to there on that comment. And then, I had a follow-up question for you and Scott is just, these performances where the orders move around ex-Splunk given the excess backlog can be a little confusing for investors, but you said one thing at your Analyst Day where you're going to grow 4% to 6%. And I know that's next year and beyond. But is there anything happening near-term that makes you feel better about that long-term target where you're a mid-single-digit grower? Anything that happened that making you feel better or worse regarding it, that'd be great to hear. Thanks.

Hey, Ben, thanks. So, on the first question relative to AI in the enterprise in particular, I think we're all seeing customers focus on customer experience. That's one of the big early applications that virtually every enterprise that we engage with is looking at, including Cisco and everybody else. So, everybody is focused on that. Then, the second, I think, is largely they are building different applications that are contributing to automation and efficiency like we've talked about with robotics or supply chain management. We also see a lot of AI activity around deeper engagement with the customer. So, customer experience on the support side, but then upselling, cross-selling customers, we see a lot of focus on that on understanding purchasing trends. And in those cases, what we see customers doing and this is leading to my belief about what's happening in the AI shift right now is customers are needing to leverage the value provided by the foundational models, but they also need to be able to train their custom data, and then the inferencing applications are actually making calls into both of those datasets, obviously. And we think that's going to lead to the front-end network buildout that we've talked about a lot in addition to the back-end. It also is leading some customers to build out some of this data center modernization in their private clouds, and it's leading them to think about modernizing their overall infrastructure for edge-based versions of that over time. So, that's generally what we're seeing. I'll make a quick comment on the second one, then I'll hand it to Scott. I would say that as we continue to see more and more success and more progress relative to the webscale customers and their acceptance of the AI solutions that we're delivering and our team is delivering and us achieving the numbers that we put out there and exceeding those numbers, then that contributes to my confidence in the next few years. Scott?

I agree with you, Chuck. Right now, it is challenging to compare the year-on-year product order growth rates due to last year's inventory adjustments. A good approach would be to examine the sequential product order growth rates, excluding Splunk, to gain insights into the returning demand in that market. As we move past these more typical demand periods, it will be easier to understand the overall demand trends. I believe that our investments in AI and our networking portfolio, particularly with the recent launch of Wi-Fi 7, are yielding positive results. We aimed to be somewhat conservative with our projections to ensure we not only meet but potentially exceed our targets by 2026 and 2027. Currently, I feel confident that our growth-driving investments are showing benefits.

Thank you, Ben. Michelle, we can move to the next analyst.

Yeah, thanks for taking my question. I guess, I'll ask a question and follow-up at the same time. Scott, networking revenues were down 23% this quarter. Just talk about how did that stack up against your expectations? And now that backlog has normalized, should we expect this business to grow sequentially for the rest of fiscal '25? Would be really helpful to understand how that grows for the rest of the year. And then, Chuck, over the next three years, are you more excited about Hyperscale or Hypershield, which one is the bigger opportunity that you're seizing? Thank you.

Yeah. I got to say, Amit, I'll start on the first one, but there was some background noise as you were asking the question, I'm not sure I got the entire question, but it started with networking revenue being down 23%. Of course, remember, that's comparing to Q1 in '24 where we had a very substantial shipment of excess backlog. Basically backlog that had built up during the supply constraints that we cleared very quickly. Q1 of '24 was the third of three consecutive quarters with very heavy backlog shipments into it. If you net that out, and I think we did some of that math for you on the last call, gives you a better sense of what's happening in network demand. It's trending in line with our expectations. I'd say AI has been a bright spot for us. The bookings that we're seeing inside AI haven't yet turned into revenue, but we certainly are seeing good momentum from that standpoint. DC switching, as Chuck just pointed out, has continued to be strong for us. So, feeling good overall relative to our expectations about what we're seeing in networking. And if I missed the second part of your question, we will circle back to you afterward and get to it.

Yeah. And then, your second question relative to, am I more excited, I think you said about Hypershield or Hyperfabric. I know there are both hyper-words. So, those are probably the two you mentioned. I am equally excited. I think from a security perspective and a strategic security perspective, our large enterprise customers are incredibly optimistic about what Hypershield means for them, but from an AI application deployment perspective, our customers are very excited about what Hyperfabric will mean to them. So, if you think about two of the most important objectives our customers have, which is east-west data center security and secondly, how do I simplify the deployment of AI applications, these are two very core technologies to both those things that we think will be important to our customers for the next few years.

All right, Amit. Thank you. Michelle, we can move to the next analyst.

Hi, everyone. Thank you. I wanted to get more insights on the improvement in gross margin. Could you provide details on the impact of the duty drawdown for the quarter? I'm also interested in the sequential improvement in gross margin, especially since Splunk was included in both this quarter and the last. It seems that product mix might have played a significant role here. Was there a notable difference in the mix of UCS servers or other product lines that contributed to this? Any details would be appreciated. Thank you.

I discussed the improvement in gross margin during Q1, particularly noting a one-time benefit from the duty drawback, which results from a couple of years' worth of duties that we've navigated through, including the necessary filings, approvals, and cash recovery. This contributed significantly to the benefits we observed in Q1, likely around 0.5 to 1 point of improvement attributed to that factor. Moving forward, while we’ll have some residual benefits from this process, they are expected to be much smaller in Q2, Q3, and Q4. On the product mix side, we received a boost from Splunk, which, as you know, has gross margins in the 80% range and has positively influenced our overall margins. Additionally, there's been a favorable product mix across other product lines as well, which should continue. Our team has done a commendable job in reducing costs, and I credit our supply chain and product teams for their efforts in this area. For the full year, I anticipate our gross margins settling within the range we indicated for Q2, between 68% and 69%. I should also mention that pricing has returned to the normalized trend we experienced before the pandemic, which reflects a headwind of about 1 to 2 points, similar to what we encountered pre-pandemic. Therefore, there has been no change regarding pricing.

Thank you, George. Michelle, can we move to the next analyst?

Yeah, thanks for taking the questions. I'll keep two right together here. So, on this AI opportunity and as we kind of focus on the backlog converting into revenue, I'm curious of how you see the AI back-end possibly leading into front-end opportunities. Have you seen that at all with any of these hyperscale customers? Any kind of color on that front would be great. And then kind of sticking to the AI networking theme, I'm curious as we move forward, how you would characterize the competitive positioning of Nvidia in the Ethernet back-end network side. Thank you.

Thanks, Aaron. On the topic of back-end to front-end, there is significant investment being made today in back-end training models. Enterprises are focusing on two main aspects: updating their infrastructure for AI and preparing for widespread deployment of AI applications. I believe this will drive a substantial demand for front-end capacity, as customers will utilize both back-end and front-end cloud infrastructure to deliver their AI applications. Investments in the front-end continue, and customers are still transitioning workloads to the cloud without interruption. However, I do think that the widespread deployment of enterprise AI will be the key factor driving increased demand for front-end network capacity. In terms of Nvidia's competitive positioning, we operate in a landscape with excellent customers and partners with whom we also compete. We have meaningful partnerships with Nvidia, as mentioned earlier with the products that incorporate their technology, including GPUs and some software components. Nevertheless, with Spectrum-X, there will be competitive areas. We have 40 years of experience in building highly-featured Ethernet and a deep understanding of our customers' needs. Our largest customers seek vendor diversity, and this, along with our proprietary silicon and intellectual property across our entire stack, positions us well in the competitive landscape.

Thank you, Aaron. Michelle, we can move to the next analyst.

Yes, thank you. I have two as well, if I may. Scott, I want to focus first on the January quarter outlook, which implies that OpEx is down about $90 million. I think most of the roughly 10% workforce realignment this calendar year has been completed. And so, I was hoping you could address which areas of your business do you believe you need to accelerate investment to drive growth into '25 and '26 versus having some excess cost savings passed on profitability. And I have a follow-up.

Good. Do you want to go ahead and ask your follow-up now, Karl?

Sure. Yeah. In terms of follow-up, just you spoke about four cloud hyperscalers growing orders triple-digits, which is quite amazing and great. But I guess, are these product orders all four top of rack switches, or is the growth in AI networking hardware primarily driven by one hyperscaler today, which now appears to be across silicon and switches? Thank you.

Yeah, I'll start with the OpEx, and then Chuck, let you talk about the cloud partners that are growing triple-digits. On the OpEx, there is growth. Of course, you got to remember, Q2 of this year will compare to Q2 of last year when we did not have Splunk as part of the company. We closed Splunk in the middle of our Q3. So, a lot of what you see driving the year-on-year growth rate in OpEx is simply the addition of Splunk. We talked about when we did the restructuring that it was not necessarily about driving cost savings. There are some cost savings coming out of it, but that was not the motivating factor. It was more about finding efficiencies across the company and turning around and reinvesting those in the fastest growing parts of our business, namely AI and security, and you see some of the great results coming out of that. So, think about those as the two areas we're investing, but the year-on-year growth rate and OpEx being driven mostly by the addition of Splunk.

And then, on your second question, Karl, I think we are pleased that four out of the six largest were all in excess of 100% growth year-over-year. And I would say that it was not just one customer on the AI infrastructure front; it was pretty balanced across all of them. So, we'll continue to keep plugging away, but it was pretty balanced, and we're pretty happy with the distributed nature of the business in that segment.

All right. Thank you, Karl. I'm going to hand it over to Chuck for some closing remarks.

Yeah, I just want to thank everybody again for joining us. And I want to particularly thank the Cisco teams for the innovation that our teams are delivering as well as the strong execution that we've seen in the first quarter of this year really got us off to a strong start. I think that as we talk about this whole AI transformation that's happening, I think, again, there are three big areas that we're focused on. Number one is the infrastructure required in the back-end networks to help our customers continue to build these training models. I think the second is, we look at the enterprise space. And again, we see upgrades and refresh opportunities for customers who are preparing for AI, and then we see the ability to work with them in their data centers with this simplistic deployment of AI applications that we're going to enable. And then, the final area is continuing to work with the cloud providers and the enterprise customers on private data center and the front-end requirements that we see happening in the cloud side to support this AI transition as well. We think that the breadth of our portfolio gives us a great opportunity. We also think that our continued momentum in security, notwithstanding what happened in U.S. federal this quarter, gives us a high degree of confidence. And we look forward to talking to all of you again next quarter. Thank you.

Cisco's next quarterly call, which will reflect our fiscal year 2025 second quarter results, will be on Wednesday, February 12, 2025 at 1:30 P.M. Pacific Time, 4:30 P.M. Eastern Time. This concludes today's call. If you have any further questions, please feel free to contact the Cisco Investor Relations department. And we thank you very much for joining the call today.