Cisco Systems, Inc. (CSCO) Earnings Call Transcript & Summary

Thank you, Michelle, and hello everybody — glad you could join us for Cisco's quarterly earnings conference call covering the second quarter of fiscal 2020. I'm Marilyn Mora, and I lead Investor Relations. With me today are our Chairman and CEO, Chuck Robbins, along with our CFO, Kelly Kramer. You should have received our earnings press release by now. Once this call ends, a webcast with slides, including supplemental information, will be posted on our website under the Investor Relations section. You can also locate income statements, complete GAAP to non-GAAP reconciliation details, balance sheets, cash flow statements, and additional financial information in the financial information area of our Investor Relations' website. During today's call, we'll reference financial results under both GAAP and non-GAAP, and unless otherwise noted, we'll cover product results by revenue while geographic and customer results will be discussed in terms of product orders. Every comparison we make on this call is on a year-over-year basis. Today's discussion contains forward-looking statements, among them the guidance we're giving for the third quarter of fiscal 2020. These are subject to risks and uncertainties described in detail in our SEC filings — in particular, our latest reports on Forms 10-K and 10-Q, which lay out important risk factors that may cause actual results to differ materially from what those forward-looking statements contain. Regarding guidance, please also review the slides and press release accompanying this call for additional details. Cisco won't address its financial guidance during the quarter unless that happens through an explicit public disclosure. With that said, I'll hand things over to Chuck.

Marilyn, thank you, and hello everybody this afternoon. Last quarter we shared this with you, and we're still observing it today: customers tell us they're firmly dedicated to what we sell, both products and services. That said, as is true for plenty of companies in our sector, decision timelines have stretched out among all the customer groups we serve, driven by various factors, among them uncertainty about the macro picture plus distinct regional challenges. The encouraging part is that when this fog lifts for our customers, we anticipate a rebound in spending, since technology keeps sitting at the core of everything they do. In the figures for this quarter, you'll notice we're still gaining ground on a number of important measures, among them our move toward greater software and subscriptions, with subscriptions now accounting for 72% of our software sales. There's still plenty left to accomplish, but my conviction is strong that a huge opportunity lies in front of us. The secular growth drivers over the long haul — 5G, Wi-Fi 6, 400 gig, plus the migration to cloud — are still in place, and we anticipate reaping the rewards; this transformation will take multiple years, and we're running the business effectively while keeping our attention on assisting customers as they construct networks that are simpler, more secure, and more cost-effective. Multi-cloud and modern application environments are being embraced widely, which is altering the way the biggest networks on earth get built, run, and protected, and Cisco sits at the heart of that shift. We've poured substantial investment into creating software, silicon, and optics — the foundational pieces for the Internet that's coming. Our view is that this approach will reshape the economics behind building the Internet so it can handle 5G, 400 gig, and what future demands bring, while enabling our customers to innovate and advance more quickly than at any point before; in December, we rolled out Cisco Silicon One, the first single unified silicon architecture of its kind; along with the Cisco 8000 carrier-class router family, which is built on Silicon One; and our new iOS XR7 operating system as well. On top of that, we unveiled fresh flexible purchasing choices that let customers take in our technology in whatever manner they prefer. Throughout the development effort, we also worked in close collaboration with a number of the biggest web-scale and SP organizations. Their involvement at our launch shows both their firm backing of our approach and our dedication to ongoing innovation. What we're aiming for is to speed up next-generation Internet infrastructure rollout by giving customers options among components, white box, or integrated systems under a flexible consumption model; now let me offer a quick update on our businesses, beginning with infrastructure platforms. As the worldwide leader in networking, we think our intent-based networking portfolio puts us in a strong spot, thanks to the strategic investments we've been making. Across the last few quarters, we've achieved enormous strides in bringing automation, analytics, and security together throughout our enterprise networking portfolio, even as we moved toward a subscription-based model. A prime illustration of our success is the continued robust uptake of our Catalyst 9000 platforms. Our secure SD-WAN offerings keep expanding as more applications shift to the cloud for our customers. To support that, we're working closely with web-scale providers so that clients can stretch their wide-area networks into the cloud and keep business applications protected. Not long ago, we unveiled integration with Microsoft, Azure Virtual WAN and Office 365, plus a strengthened alliance with Amazon Web Services, aimed at delivering extremely secure connectivity from end to end and improved application performance. Turning now to Security. We posted another solid quarter, with momentum across our advanced threat and cloud-based offerings, among them Duo and Umbrella, which serve as key growth engines for the business. We still see considerable opportunity as we carry out our plan to provide an integrated security platform. With the market shifting toward a multi-cloud environment and demand for visibility rising, our strong standing as customers' most trusted partner is paying off. Our distinctive end-to-end approach spanning network, cloud and endpoint is attracting customers, and 100% of the Fortune 100 now use one or more of Cisco security solutions. During this quarter, we broadened our security portfolio from the cloud out to the edge. We launched an integrated IoT architecture that delivers improved visibility, insights and threat detection throughout our customers' entire environment. This architecture encompasses our new software-based security solutions Cyber Vision; and our Edge Intelligence data collection tool, which helps our customers make smarter business decisions. Lastly, Applications. Without a doubt, customers are going through a major workplace transformation, and they're relying on Cisco to guide them through this shift. As a global market leader, we think we're the only company offering a cognitive, highly secure and analytics-driven collaboration platform that serves as the basis for their workplace transformation; this platform is growing ever more essential to how enterprises empower their teams by letting employees collaborate more effectively. To broaden our value proposition, we keep making strategic investments. For instance, we recently launched several key WebEx capabilities that blend context, AI and machine learning so our customers and their teams can further improve their meeting experiences. We delivered another strong quarter of growth with AppDynamics, showing our capacity to provide unique real-time AI-powered insights from a single pane of glass, giving complete visibility. Our customers want to link application performance monitoring with infrastructure automation to streamline IT and boost productivity. Two weeks ago, we announced that we're combining AppDynamics and our Intersight Workload Optimizer to provide comprehensive visibility of applications and infrastructure both on-prem and in the cloud, leveraging machine learning and AI to proactively fix problems and optimize user experiences. In summary, I'm pleased with our business transformation and with the new innovative platforms we're introducing to the market. Although we still see some pause in customer spending tied to uncertainty in the global macro environment, our long-term growth opportunities remain unchanged. As we move ahead, our attention will stay on creating truly innovative technologies and constructing a fresh Internet suited to the 5G period, which will assist our customers in innovating more rapidly than at any prior time. My confidence stays extremely high that carrying out our strategy will produce profitable growth and yield robust returns for shareholders over the long term. At this point, I'll pass things along to Kelly.

Appreciate that, Chuck. I'll begin by walking through how we did financially this quarter, then move on to what we're expecting for Q3. When you look at Q2 overall, the numbers landed right where we thought they would. Execution was solid, with healthy margins and growth in EPS. On the top line, revenue came in at $12 billion, which was a decline of 4%. Our non-GAAP operating margin rate reached 33.7%, which is a gain of 1.6 points. Non-GAAP net income came to $3.3 billion, unchanged from a year ago; and non-GAAP EPS landed at $0.77, an increase of 5%. Let me drill down a bit further into the revenue picture for Q2. Product revenue overall fell 6%, coming in at $8.7 billion. Infrastructure Platforms dropped 8%. On the switching side, we saw declines in both Campus and Data Center. Growth did show up, though, thanks to the ongoing ramp of Cat 9K along with the strength of Nexus 9K. Routing came down because of softness among service providers. Wireless was lower as a whole, yet Meraki grew strongly and our WiFi six products are beginning to ramp. Data Center revenue fell, pulled down by servers, though HyperFlex grew strongly enough to offset some of that. Applications dropped 8%, weighed down by Unified Communications, though double-digit growth at AppDynamics partly made up for it. Security came in at 9%, with solid results in identity and access, advanced threat and unified threat management. Service revenue rose 5%, powered by software and solution support. We keep reshaping this business by putting out more software and pushing more subscriptions. Software subscriptions made up 72% of total software revenue, a gain of 7 points from a year ago; when it comes to orders in Q2, product orders overall fell 6%. Turning to our geographies, the Americas dropped 8%, EMEA fell 1% and APJC declined 4%. Emerging markets overall were down 7%, with the BRICs plus Mexico off 20%. Among our customer segments, public sector stayed flat, whereas enterprise fell 7%. Commercial dropped 4% and service provider declined 11%. Remaining performance obligations, or RPO, stood at $24.9 billion when Q2 closed, up 11%. On the non-GAAP profitability side, gross margin for Q2 overall was 66.4%, a gain of 2.3 points. Product gross margin was 65.9%, up 3.1 points; and service gross margin was 67.7%, unchanged from a year ago. Moving to the bottom line on a GAAP basis, Q2 net income was $2.9 billion and EPS was $0.68; we closed out Q2 holding total cash, cash equivalents and investments of $27.1 billion. Operating cash flow came to $3.8 billion, flat versus a year ago. On capital allocation, we gave back $2.4 billion to shareholders over the quarter, made up of $0.9 billion in share repurchases plus $1.5 billion for our quarterly dividend. Today we announced a $0.01 bump to the quarterly dividend, bringing it to $0.36 per share, up 3% from a year ago; that works out to a yield of roughly 2.9% on today's closing price; raising the dividend like this underscores how committed we are to returning capital to shareholders and how confident we are in the strength and stability of our ongoing cash flows. We'll keep investing in our innovation pipeline, both organically and inorganically. During the initial part of Q3, we completed the purchase of Exablaze, a company that designs and builds sophisticated networking equipment intended to cut latency and boost network efficiency. In short, we performed strongly, with solid margins and earnings-per-share improvement. The payoffs from what we're investing in innovation are becoming visible, and our push toward greater reliance on software and subscription offerings is producing durable expansion and value for shareholders. Let me restate the outlook we've given for Q3 of fiscal 2020. That outlook contains the same kind of forward-looking statements Marilyn mentioned before. We project sales will fall somewhere between minus 1.5% and minus 3.5% compared with the same period last year. We expect the non-GAAP gross margin rate to land between 64.5% and 65.5%. The non-GAAP operating margin rate should come in somewhere between 32.5% and 33.5%, while the non-GAAP tax provision rate is projected at 20%. Non-GAAP earnings per share should fall in a range of $0.79 to $0.81. Possible interruptions to our worldwide supply chain stemming from the coronavirus are not factored into this outlook. We'll keep watching the situation carefully. At this point I'll hand things back to Marilyn so we can begin the Q&A.

Thanks Kelly. Michelle let's go ahead and open the line for questions.

Yes. Thank you. Chuck, perhaps I could kick things off by discussing the macro picture and how that longer decision-making process unfolds. From where you sit, what's your sense of how long this might persist — especially when you factor in what you brought up, namely all those industry catalysts at play with 400 gig and WiFi 6? And of course, you've rolled out some fresh router and silicon offerings. So perhaps you could touch a bit on when that rebound arrives, and how you believe you can beat it, given all the varied dynamics running through the businesses this year?

Yes. Tim, thanks. That's a wonderful question. So to begin with, I'd say there are numerous secular growth catalysts lined up: the 5G transition, the 400-gig transition, WiFi 6, and the move toward cloud. And what customers are showing us is really just — they're simply pausing, just attempting to figure out what's happening. Now, what I would say is that obviously, late in the quarter, if you examine a few of the matters that remained unresolved and were generating part of that uncertainty, such as Brexit, we moved nearer to a resolution. We clearly secured a signature late in the quarter on a first phase of the U.S./China trade deal, and USMCA has now passed in the U.S.. So with luck, those things will provide our customers a bit more visibility. Whenever I talk with customers, they remain entirely committed to pressing ahead. They're merely a touch cautious and trying to determine what's happening. Obviously, we now have the virus, and we'll see how that unfolds. But on the whole, my view is it isn't deep. And we anticipate that, since some of this uncertainty has now cleared, despite what we clearly observe from the virus, with luck, we'll see our customers start to pick up once more.

Thank you.

Thanks Tim. Next question please.

Thanks. My question was more of a strategic one. Given the routing announcements in December plus the Cat 9K earlier, much of Cisco's approach now centers on offering added automation software to bring customer OpEx down; that appears to demand a major shift inside your company. So where do you stand on the sales and channel overhaul needed to match that objective? Thanks.

Great question. Thanks. We've put in substantial effort toward transforming ourselves so we can back the software model — especially subscription software — alongside automation. And we have — looking back to 2017, the year we introduced the Catalyst 9000 and unveiled subscription offerings across our enterprise networking lineup, the back half of this year will include some — a modest volume of — early renewals tied to that. So our people have been working diligently to get ready for those renewals. Then, during fiscal 2021, we'll see a meaningful figure, a fairly significant figure, connected to that. So as I see it, on the sales side, we've tested pilots and by now scaled operations. We're conducting additional pilots while scaling further; and we also have the customer experience group led by Maria Martina, which has been developing its own capabilities. So there's still more for us to do, yet I'm encouraged by the headway we've achieved, and I believe we're sitting in a fairly solid spot at present.

Let's take the next question.

Thanks so much. I'd like to hear a bit more about the service provider vertical, since that's been a tough area for a long while, and it seems like Cisco may be paying somewhat less attention to it now that it has — it's turned into a smaller piece of the business. Still, I'd love for you to discuss how you expect this market to ultimately bounce back — the timeline and what will drive it — and maybe go deeper than the usual vague 5G gestures, so we can grasp what's actually going to propel it and when? Thank you.

Simon, gesturing vaguely is much easier. Let me share a few thoughts, though. This isn't a market we're overlooking or — actually, if you look at what we announced in December, let me bring you up to speed on that. What we unveiled in December reflects roughly five years of R&D work; that's a significant investment in this market. So we do think a resurgence is coming. I'll address 5G and 400 gig too; but first, an update on — in December, as you're aware, we introduced Silicon One, which sits at the core of the new systems we launched, called Cisco 8000. We also said we'd be open to selling our silicon for use in a white box, or selling it straight to a customer, if that's the way they prefer to buy it. Across the cloud titans, I can tell you we're working with every one of them on different versions of those architectures. A number of them joined us at the December announcement, which demonstrates their confidence in what we're doing. We've booked orders for both from various cloud players, so the reception to that launch feels good to us. The 8000 series is going to be a foundational backbone product for 5G networks, and I can share that we have early wins on IP infrastructure supporting 5G rollouts with more than 30 customers globally. These are early. A few are cell site, aggregation, backhaul, some are core wins. The majority fall under non-standalone, meaning they're upgrading their existing networks, and afterward they'll aim to construct standalone networks. As we've stated, we expect that to begin in 2021, when we could start to see some of that accelerate. So we believe the 400 gig shift, along with the 5G build-out, will be the catalysts we're watching for across the coming couple of years.

Thank you.

Thanks Chuck. Next question, please.

Apologies — I still haven't figured out how to operate this cellphone. Kelly, your margin structure came in especially strong this quarter, and that reflects a pattern that's been in place for a long time, both in the near term and over the longer term. I understand the guidance implies some easing. My guess is that part of it stems from the run-up in DRAM pricing, or the run-up that's coming. Could you walk back through the drivers and what you anticipate across the coming year or two, at both the gross and the operating level?

Yes. Yes. Yes, of course. Glad to. And I know we feel really good about where both gross margins and op margins stand; but as you're aware, Paul, a few factors are behind it; our software transformation has been paying off for us on both fronts — you can see that in our product mix when we present the gross margin walks in our Qs, and just overall, so that's a benefit we're getting. The second major factor, I'd say, is price. We've shown a lot of discipline on price, which means we seize opportunities to lift prices where elasticity allows — for instance, on much older products we're looking to move customers off of toward newer ones, or in areas where we're confident there's room to raise them. We've been executing on that, I believe, quite well. We've handled the pricing decline in the server market pretty effectively, offsetting it against DRAM prices that have been falling sharply. So here's what you'll observe in this quarter's reporting, Paul, and I know this is something you always bring up — you'll see our pricing. On last quarter's call I noted that pricing's impact hit its lowest point ever, meaning it was the most favorable it has ever been. We're right back at 1.1 points in our year-over-year gross margin walk, so that remains really, really strong for us and closer to what it looked like, I'd say, 2 quarters prior to Q1. So that piece is going well. DRAM is definitely helping us this quarter; and as you're aware, that benefit keeps shrinking for us now as DRAM prices begin ticking back upward. But once again, we handle that relationship between pricing and DRAM cost quite effectively. So broadly speaking, I think you should anticipate somewhat more pressure from DRAM pricing as the year-over-year comparisons grow smaller, which explains the guidance I gave. Still, on the whole, you'll continue to see the upside flowing through from our business becoming ever more software-driven.

Kelly, one quick follow-up if I may. When we look past this quarter and past April, with the move toward software continuing, is there any reason margins shouldn't keep climbing, setting aside the ups and downs from quarter to quarter?

Yeah. Again, I'd say yeah, since what we're doing with the portfolio involves an increasing amount of software content; so inherently that benefits us. There will always be the possibility of big fluctuations from items such as component costs, like DRAM, up or down. But as we always do, we'll tell you when those things are occurring; but yeah, if you look back 3 years, from where we stood then to where we stand today, over the long term it's simply the overall portfolio's shift that we've been pushing.

Appreciate it. Thank you.

Thanks. Next question please

Thanks a lot for how clear things have been up to now. There's one thing I wanted to ask about that's a bit wider in scope. I'm not sure which one of you this is meant for. Regarding product orders, I was just sort of reviewing and pondering them; it seems enterprise product orders became slightly more of a struggle. The public sector also became somewhat more of a struggle. Service provider got marginally better versus the same quarter a year earlier. So could you perhaps give us some detail on product orders? It seems maybe enterprise faced somewhat tough year-over-year comparisons. Did enterprise have a major product cycle last year? Or why exactly are we seeing enterprise decline a bit more incrementally? Thanks.

Yes. Hey, Jim, good question, and let me give it a try. So when I examine the segment — if I zero in on enterprise, much of it comes down to the really, really strong product cycle ramps we had in Q2 2019. So going back to Q2 2019, that was a record for campus switching — and also for Collaboration back in Q2 2019. Not an excuse, but that's what happened there. Beyond that, I'd say, if I isolate our regions overall from a bookings standpoint, the Americas fell 8%; and looking at that, the U.S. on its own was slightly better but within that range, and I'd say two areas drove it; the routing portfolio, largely the SP segment, drove it. That was the largest driver; and the second largest driver was the decline we're seeing in the server market. And again, that ties directly to DRAM prices declining and flowing through the whole market, and we saw that last quarter too; so that drove the Americas. Europe came in at minus 1%, basically flat. But the largest driver when I look at Europe was really the U.K. We are seeing a slowdown because of Brexit, and we saw it significantly in the public sector, which is always a big growth driver for the U.K. for us. So the U.K., both enterprise and public sector, has slowed for us, which drove Europe. Europe would have been up 2 points without the U.K. And then for APJC, it continues to be the rapid decline of China. China, as I've discussed, and the BRICS plus Mexico being down, China was down again over 30%. It's still only about 2% of our total business, but it still hurts the overall — I mean, Asia Pac, excluding China, would have been up a couple of points as well, 3 points. So from a geography standpoint, those are the key drivers. And, again, to your point, we are going off against some tough compares in enterprise for both the Catalyst 9K ramp a year ago and Collab just had a record quarter.

Thanks. That explanation was really good, and I truly appreciate it. Many thanks.

Thank you, Jim.

Appreciate it, Jim. Let's take the following question.

Thank you. Chuck, I'd like to look more closely at applications, which came in 8% lower than the same period last year. I get the challenges facing the unified communications unit, and it's encouraging that AppD continues to expand; however, WebEx hasn't come up in your remarks. Should I take that to mean WebEx isn't expanding either, sort of caught in between? Walk me through the transformation AMI has been undertaking there, and where that effort currently stands? Also, what's the right way to view future growth and competitive standing for that platform?

Right. Well, I'd say — number one, they've rebuilt the architecture across each of those platforms, merged the back ends, and now offer a highly current lineup of solutions for the market. And right now we're engaged — just yesterday I spoke with the team. As I recall, 11 workshops are set with key accounts over the coming 30 days focused on planning, to move them onto the current portfolio, since a number of customers have been using versions of what we've offered for 10 to 15 years, so we're positioned well. Actually, a fantastic analyst piece came out only a couple of days back covering — an industry analyst, covering the portfolio, its progress, and just how well it performs today. So I'm confident in their efforts. Looking back 12 months, plainly — Collab had risen 24%. I mean — that's an enormous operation to grow by that amount. So the comparison base was quite demanding, yet I'm happy with their position. Competition exists. Clearly, there are strong rivals in this area, which honestly ought to simply push us to improve; still, the team is doing, in my view, a genuinely strong job. Kelly, would you like to add anything on —

Right. So, I'd say the main factor was our UC segment, with revenue declining; that accounted for the vast bulk of it, trailed somewhat by the endpoints on the TP. Conferencing dipped only slightly — barely at all. So without question, the primary contributor came from Unified Communications.

That's great. Okay then. Best of luck to you both.

Thanks.

Let's take the next question.

Sure. Thanks a lot for fielding this. I was wondering if you might break down what looks like a somewhat larger drop in IP than we'd anticipated, offset by stronger results in the services line. Could you walk us through the underlying dynamics, and perhaps how some of that reflects where software gets recorded? I'd appreciate getting a clearer picture of that, if you don't mind.

Sure. As I've mentioned before, on the services side increase, nothing has shifted in terms of accounting for how software is handled. When it comes to service improvement, we've been pushing hard on that. Maria Martinez, who leads CX for customer experience, has concentrated heavily on boosting renewal rates and adoption. And from a revenue standpoint, you've watched our services business rise across the past four quarters. So that 5% growth in services you observed is simply that team continuing to deliver. Regarding the infrastructure platform side, it really traces back to — once more — we were extremely, extremely high in terms of ramping Campus switching during last year, so that makes for a harder comparison. It's still expanding rapidly, but that's a major factor. Routing remains down, pulled lower by the SP segment. Then for the final piece versus a year ago, as we've discussed, applications came in up 24%, which was essentially all Collab, also a year back. So there's nothing beyond those factors, I'd say. Along with the data center server market — we're beginning to sense that, and you can observe what's taking place in that market.

Kelly, does that mean that 5% rate of growth in services is something we can count on lasting? Or ought we to assume it'll swing back and forth between that figure and the low single-digit expansion we've been observing?

Well, we're definitely working hard to keep it within a range that holds up over time. Letting it slow down is not something we want at all. That said, the team is putting in maximum effort on all fronts. Beyond simply relying on maintenance tied to product orders, they're bringing forward new solutions and looking for additional avenues to generate incremental growth. On top of that, they're pushing a lot more solutions involving software and other areas, so within services they're running quite a few different plays.

Obviously they are. Congratulations. Thank you.

Thank you.