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

Appreciate it, Michelle. Hello everybody, and thanks for joining us for Cisco's conference call about quarterly earnings for the third quarter of fiscal 2020. I'm Marilyn Mora, and I serve as Head of Investor Relations. With me are Chuck Robbins, who is our Chairman and CEO, and Kelly Kramer, our CFO. You ought to have already viewed the press release about our earnings by this point. After this call wraps up, a webcast that matches it, complete with slides that contain supplemental information, will be posted in the Investor Relations area of our website. You can likewise locate income statements, complete reconciliation details from GAAP to non-GAAP, balance sheets, cash flow statements, plus additional financial data within the financial information portion of the Investor Relations site. During this call, we'll refer to financial results under both GAAP and non-GAAP, and when we talk about product results, it will be in terms of revenue, while geographic and customer results will be discussed in terms of product orders, unless we say otherwise. Every comparison we make on this call is on a year-over-year basis. The subjects we'll cover today, which include forward-looking statements and the guidance we're giving for the fourth quarter of fiscal 2020, carry risks and uncertainties, among them those tied to COVID-19, which we go over thoroughly in the documents we've filed with the SEC, in particular the latest reports on Forms 10-K and 10-Q. Those reports point out significant risk factors that might lead actual results to differ materially from what's stated in the forward-looking statements. Regarding guidance, please also check the slides and press release accompanying this call for more information. Cisco won't address its financial guidance at any point this quarter unless that happens via an explicit public disclosure. Chuck, I'll hand things over to you now.

Thank you, Marilyn. Before we begin, I'd like to share my gratitude and appreciation for every frontline worker out there battling this pandemic daily to keep so many people safe. I also want to offer my sympathies to those who have lost their lives, and to the families that have felt the deepest pain from what this tragic situation has brought upon us today. This really is unlike anything any of us have gone through before. As you might expect, our focus has been on assisting our employees, customers, partners and communities. Right now, 95% of our global workforce is working from home, and that shift went seamlessly for us because we already had a flexible work policy in place. We also build the technologies that let organizations remain connected, secure and productive; for that 5% who need to be in the office to perform their roles, our attention is squarely on their health and safety, and we're taking every precaution required. Throughout this crisis, a great many of our customers and partners have been under tremendous pressure as they confront cash flow challenges. That's why we rolled out a range of free offers and trials for our Webex and security technologies as they moved entire workforces to remote setups at dramatic speed. Beyond that, we announced $2.5 billion in financing through a new Business Resiliency Program with Cisco Capital to provide financial flexibility and help sustain their business continuity; this will give customers and partners access to the technology they need right now, allow them to invest for recovery and defer most payments until early 2021. This pandemic is bringing to light so many inequities that were already there and making these problems worse. I'm proud to say Cisco has committed nearly $300 million so far to back both global and local pandemic response efforts, including technology and financial support for non-profits, first responders and governments; we're also donating personal protective equipment to hospital workers, among it N-95 masks and face shields, 3D printed by Cisco volunteers across the world. I'm incredibly proud of our teams, who have stayed relentlessly focused on these efforts and keep finding ways to innovate so we can help those who need it most. I especially want to recognize our IT, Webex, security and supply chain teams, together with our partners and suppliers, who have worked around the clock to make sure we're doing everything possible to keep organizations everywhere up and running and to give back to our communities. Thank you; now let me turn to our third quarter performance. Despite the difficult environment we're all operating in, we delivered a solid quarter and financial performance amid the greatest financial crisis of our lifetime. While we aren't immune to the effects of the global pandemic, we believe our underlying business fundamentals and financial position remain strong. When we look at the quarter, it very much mirrored the journey of the pandemic. During March, we actually exceeded what we had planned for, since organizations were concentrating on making their IT setups more resilient. Then, once April arrived, we started noticing a deceleration throughout our operations, because nations everywhere had gone into lockdown. Although certain areas of our portfolio took a harder hit than others, we feel that our position as a leader when it comes to products, innovation and operations is still strong. Given how much ambiguity exists right now, we feel our part has never mattered more and our duty has never been larger, since a large portion of the globe depends on Cisco's technology — from networking to collaboration to security — to remain connected, protected and efficient. Now more than ever, organizations need to concentrate on resilience and agility, and those that had already put money into digital tools could handle this transition with less friction. Although we can't forecast the timing, one conviction we hold is that appetite for our offerings will be robust once we come out of this period. We feel the evolution of our own business model, via our move toward greater software and subscription-based products, is delivering returns. We witnessed ongoing robust uptake of our SaaS-based products, and subscription now accounts for 74% of our software, compared with 65% 12 months earlier. We also feel we stay well positioned for the long haul to support our clients and generate distinctive value tied to cloud, 5G, Wi-Fi 6 and 400 gig. Our business model, varied portfolio and capacity to keep putting money into key growth priorities provide us a solid base for building even stronger client relationships. As we get ready for what lies ahead, we'll work closely alongside our clients to update their infrastructure, protect their remote workers and their data via our creative solutions that will act as the basis for their digital organizations. Now, I'll move on to how our business segments performed, beginning with infrastructure platforms; with the globe essentially shifting online overnight, the strain on networks has never been higher, with users seeking secure connectivity, dependable performance and consistent experiences. This has resulted in our clients assessing how to grow their capacity swiftly, how to best safeguard their teams and how to keep their data protected, all while keeping their operations efficient. It's also pushing enterprise IT to quickly set up, roll out and provision mobile offices or mobile healthcare clinics. What I've witnessed IT teams accomplish globally, and what they've enabled, is truly remarkable. Our approach and value proposition are unambiguous. We are fueling the world's capacity to remain connected, efficient and protected, while automating a great deal of these abilities. Our intent-based networking architecture was designed for circumstances such as these. For sectors like healthcare, public services, financial services and service providers in particular, having network infrastructure deeply tied to security is absolutely essential. In Q3 we introduced new cloud-based COVID-19 bundles for teleworker, mobile healthcare and pop-up branch use cases via our partners and service providers. When it comes to customers upgrading the networks they rely on, adoption stayed robust for our subscription offering, Catalyst 9000, since organizations want to rapidly expand remote access so workers stay protected and operations keep going. Our approach for secure cloud scale SD-WAN keeps moving forward as we put money into new ideas and alliances that assist enterprises in speeding up multi-cloud plans. To illustrate, we're now linking up with Umbrella, our secure Internet gateway, so clients can pair top-tier cloud protection however they prefer with the SD-WAN offering that leads the market. Through ties with web scale players such as AWS, Azure, and the Google Cloud deal we just announced, a genuinely multi-cloud network fabric becomes possible. With bandwidth needs and SaaS app usage climbing, we're helping clients link branch locations safely and hook into various cloud providers, which delivers steady app performance plus a dependable user experience. Now turning to security, something that sits at the core of all our efforts. During Q3, growth came in solid, showing rising appetite for our strong offerings that protect against the swift expansion of remote employees and the devices they use. As the biggest enterprise security firm globally, our position is unmatched when it comes to protecting clients no matter where their work happens. No one else offers a portfolio as thorough and integrated, spanning end to end, covering the network, cloud, applications, and endpoints.

Like I said before, we gave out longer complimentary licenses for essential security tools built to safeguard people working from home, such as Cisco Umbrella, Duo's Zero Trust Security, Cisco AnyConnect's top-tier secure network access, and endpoint protection via our AMP technology. In addition, we're helping clients along their multi-cloud path by letting them protect direct internet access, cloud app usage, and roaming users; we're merely 2 quarters into our secure Internet gateway shift and already we're witnessing robust uptake from both current and fresh customers. Leveraging the money we put into innovation partnerships and acquisitions, we also rolled out SecureX; that's the broadest cloud-based security platform in the industry, linking the full scope of our portfolio and our customer's security infrastructure through unified visibility, automation, and streamlined security spanning applications, the network endpoints, and the cloud. Now onto applications. Remote working and collaboration instruments have turned into a vital connection for companies and their employees to remain in touch and productive, with security and privacy mattering more than ever. Our portfolios sit at the heart of our customer strategy for enabling teams and boosting productivity, since 95% of the Fortune 500 rely on our collaboration portfolio today; we adopt a security first stance toward remote working and deliver extremely secure cloud-based collaboration solutions featuring integrated end-to end-encryption, all while safeguarding our customer's privacy. Over the quarter, we put resources into scaling our platform at a speed without parallel to provide a highly secure, consistent experience and guarantee business continuity for our clients. Right now we're operating our Webex platform at triple the capacity compared to what we ran in February to handle the sharp rise in usage growth; we had well over 500 million meeting participants, producing 25 billion meeting minutes in April, which is more than three times the volume in February. We additionally brought in numerous new prospects via complimentary Webex trials that we expect to turn into revenue later on. With applications central to every company and the spike in need for monitoring tools delivering real time business insights and refining user experiences in multi-cloud settings, AppDynamics keeps delivering solid results, especially in this climate. As I finish up, I simply want to restate how thankful I am to have our teams, our resources, and our operational resiliency throughout this period. I also want to praise the heroic work of IT organizations and teams worldwide who've needed to digitize their operations and back remote workforces at a speed and scale never seen before; this crisis has underscored the value of having highly resilient, globally scalable infrastructure technologies to keep the world running and this is what we build. We're offering an innovative solutions that assist our customer support business continuity, drive productivity and ensure a highly secure work environment. We think we'll come out of this crisis in a stronger place than we went in. Thanks to a faster innovation cycle, a refreshed portfolio, and meaningful headway on moving toward more software and subscriptions, we're better positioned right now than we were during earlier periods of uncertainty. That confidence gets an extra boost from our solid balance sheet, which lets us put money into the future, and from our track record of getting things done whatever conditions we face. On top of that, I think our amazing culture has grown even stronger lately, and I take real pride in everything our teams have accomplished. I have no doubt that Cisco is resilient and that we're built to last, no matter what lies ahead. Kelly. I'll pass it to you now.

Thanks, Chuck. I'll begin by walking through how we performed financially this quarter, and then I'll cover what we expect for Q4. Our Q3 numbers overall show solid execution, with robust margins and non-GAAP EPS growth despite a highly difficult backdrop. COVID-19 certainly affected both our business operations and our financial performance during this period, particularly within the supply chain, where we encountered manufacturing difficulties and shortages of components. Revenue came in at $12 billion, a decline of 8%. Our non-GAAP operating margin rate reached 34.9%, an increase of 2.7 points. Non-GAAP net income totaled $3.4 billion, which is 2% lower than the same quarter a year ago, while non-GAAP EPS came to $0.79, a rise of 1%. Let me give you a bit more color on revenue for Q3. Product revenue overall fell 12%, landing at $8.6 billion. Infrastructure platforms dropped 15%. That's the segment hit hardest by the supply chain difficulties. Switching revenue fell in both Campus and Data Center. We did record robust growth as the Cat 9K continued its ramp. Routing was lower among both service providers and enterprises. Data Center revenue fell because of ongoing market contraction that weighed on our servers as well as our HyperFlex offerings. Wireless was down on the whole, though we did see momentum in the Wi-Fi 6 ramp and healthy expansion at Meraki. Applications decreased 5%, pulled down by lower Unified Communications and TP end points. Conferencing did grow, since uptake was strong amid COVID-19 conditions; we also posted strong double-digit gains in AppDynamics and IoT software. Security rose 6%, performing well in unified threat management, identity and access and advanced threat. Our cloud security portfolio did well, with strong double-digit growth and continuing momentum from our Duo and Umbrella offerings. Service revenue climbed 5%, powered by software and solutions support. We keep transforming the business, providing more software and generating more subscriptions. Software subscriptions made up 34% of total software revenue, a gain of 9 points versus a year ago; when it comes to orders in Q3, total product orders decreased 5%. April brought a slowdown during the quarter, as the effects of the COVID-19 environment persisted. Turning to geographies, the Americas came in flat, EMEA fell 4% and APJC dropped 22%. Emerging markets overall were down 21%, and BRICS plus Mexico declined 29%. Among customer segments, public sector rose 1%, enterprise fell 4%, commercial dropped 11% and service provider was down 3%. Remaining performance obligations, or RPO, stood at $25.5 billion at the close of Q3, an 11% increase. The product-related portion rose 25%. On non-GAAP profitability, gross margin for Q3 totaled 66.6%, up 2 points. Product gross margin was 65.8%, up 2.1 point, and service gross margin reached 68.9%, up 1.6 points from a year earlier. The product gross margin improvement came from productivity, with ongoing memory cost savings and favorable mix, partly offset by pricing; on the bottom line under GAAP, Q3 net income was $2.8 billion and EPS was $0.65. We closed out the third quarter with total cash, cash equivalents and investments amounting to $28.6 billion. Operating cash flow came in at $4.2 billion, which represents a 2% decline compared to the same period last year. Our balance sheet is extremely solid, we generate healthy free cash flow, and we can access capital markets quickly. In a difficult environment, that combination is a genuine competitive advantage. Nothing has changed regarding our dedication to the capital allocation program, and through returning at least 80% of our free cash flow each year, we intend to keep delivering long-term value to shareholders. During Q3, we gave back $2.5 billion to shareholders — that figure consisted of $1 billion in share repurchases plus $1.5 billion paid out as our quarterly dividend. To wrap up, we performed well, posting strong margins and non-GAAP EPS growth despite a very tough environment. The returns are showing up from the investments we are making in innovation and in pushing the shift toward more software and subscriptions, which drives long-term growth and shareholder value. Let me restate our guidance for the fourth quarter of fiscal '20. As with the forward-looking information Marilyn mentioned earlier, we expect revenue to fall somewhere between minus 8.5% and minus 11.5% versus the prior year. We anticipate the non-GAAP gross margin rate will land in the range of 64% to 65%, the non-GAAP operating margin rate should come in between 31.5% and 32.5%, and the non-GAAP tax provision rate is expected to be 20%. Non-GAAP earnings per share should fall in the range of $0.72 to $0.74. At this point I'll hand things back to Marilyn so we can begin the Q&A. That's a minimum of 50% of our free cash flow annually.

Appreciate that, Kelly. Michelle, let's move forward and get the line ready so folks can ask their questions. And just like I do each quarter, a quick note: please limit yourself to a single question. That way there's room for everyone else. Michelle?

I can't decide if I should bring up the infrastructure decline, so I'll just go with that. Chuck and Kelly, perhaps the two of you could say something about pricing as a courtesy, plus the other factors behind that strong gross margin result. But on the infrastructure question, here's a thought: since so many organizations moved to working from home, and that's probably going to stick around to some extent, what do you expect when it comes to the upside from remote work — meaning the demand for your solutions, or for strong connectivity — and then the possible downside, which is having fewer employees inside the four walls of the enterprise? What does that do to campus switching and wireless LAN? Any perspective you can offer would be welcome.

Yeah. Paul, I appreciate the question, and the way you're framing it is exactly right. When we look at our customers working remotely, there are obviously collaboration tools I've talked about, and clearly more security has to be put in place. Then there's the matter of when they come back to the office — how many of them come back, and what that means for the infrastructure that supports their campus environments — that's definitely something we'll be monitoring. I'll say this: I've spoken with plenty of customers who aren't at the center of this crisis and who came to realize during the pandemic that they're carrying a fair amount of technical debt, and that a lot of their equipment is aged; so we all understand the timeframe. But many of them have told me this will be — this is a wakeup call, and it will actually give us air cover to talk with our senior leadership team about upgrading and building out a more robust, modernized infrastructure; so again, different customers will be able to do that at different paces depending on how they're impacted and what their capital situation is. But that's our thinking as we go forward, and let's see how it plays out. Kelly, do you want to say anything about the pricing thing?

Yeah.

Yes.

Okay, Paul, regarding pricing — we had another quarter of solid margins. That said, there are some things at play here. We still got a lift this quarter since we'd stockpiled memory while prices were lower, and that helped us quite a bit, as you'll notice in the VCP. However, pricing did soften somewhat. So to answer your question, Paul: on a year-over-year basis, the gross margin rate on product was hit by minus 1.9 points from pricing, and that's a touch worse than the year-over-year figure we saw last quarter — and it will certainly be the case for the quarters coming up, including the ones before that too. Still, all in all, productivity was very, very strong, once again thanks to memory and cost reductions, plus a favorable software mix.

So would you perhaps like to discuss how the revenue figure for infrastructure platforms relates to the supply chain?

Right. As I mentioned during the prepared remarks, essentially most — possibly even every one — of the supply chain issues we faced, with components and factories both being affected, occurred over on the infrastructure platform side, so that definitely accounted for a very substantial portion of that revenue.

Thanks. That's helpful. Chuck, could you draw a comparison between the current situation and what happened 10 years ago during the financial crisis, as well as 20 years ago with the bubble?

Honestly, comparing this to the bubble doesn't really work, since we were right at the center of that one, so it felt very different. With this situation, we're more like secondary collateral damage, I'd say. The key distinction here, though, is the wide-ranging difficulties that this has created — that it has brought to customers everywhere. And — but we're all aware that what the Fed has done, what Congress has done with stimulus, and the dedication to speeding up the economy or trying to slow down the economic deceleration is definitely on a scale we've never witnessed. So I believe that, just like everyone else, it depends on testing being available, therapeutics being available, and obviously at some point a vaccine — I really think the one thing that stands out to me about this situation is that it hit us so fast and so uniformly across the globe that I genuinely believe customers are now pausing and asking themselves, what should I do to strengthen my infrastructure and to get my business better prepared for the next time something like this occurs.

All right. Appreciate it, Chuck. Can we take the following question?

Thank you. It's good to know everyone is fine, including all the employees. We appreciate the effort put in there. So I wanted to ask about applications — with the momentum behind Webex and AppDynamics, I found it a bit unexpected that it declined compared to the same period last year. Chuck, could you shed a bit more light and help us grasp the respective revenue sizes of Webex and AppDynamics against the unified IP, which is obviously shrinking and, as a result, masking those businesses? I'm attempting to figure out how near we are to a floor in the shrinking businesses, at which point the growing businesses could at last be visible within the total product category?

Yes, Ittai, I believe — allow me to offer some context, and after that, Kelly can share a few metrics. Still, I think that if you examine the applications business and collaboration across the past 2 years, they've done fairly well. When you consider what occurred with Webex this time, what I can say is that getting customers operational was our top priority, and so we truly have 3 groups of opportunity from customers that, as I mentioned during my prepared remarks, we think will turn into revenue down the road. So we have enterprise customers, a lot of whom already held licenses, who require additional licenses and have gone past their usage, and we'll return and collaborate with them to sort that out later. Yet again, getting them operational and simply letting them stay productive was our priority. The next one is that we had quite a few new customers — enterprise customers, commercial customers — who seized the chance to use Webex and rolled it out for the first time through the 90-day free trial programs we introduced; and then a 3rd group existed, which is more the individual free accounts that customers would register for on the internet. I'd say those first 2 groups make up most of what we consider the revenue opportunity ahead, though that's something we'll find out later and it truly wasn't captured in the quarter we just reported. So Kelly, would you like to add anything?

Okay, so what I'd say is, to help you get a sense of the scale — the relative scale of these different pieces — you know, of applications, monitoring and analytics: the AppD business, like I mentioned, is expanding at a double-digit rate, extremely robust, really solid, but as a share of the total applications, it's still pretty modest, and the IoT software side is the same story. So then it really comes down to collab — traditional collab — and when I split that apart, unified communications makes up the largest piece of total collab, and that's exactly where the pressure is showing up, the same pressure we've been seeing in the endpoints. So that's going to stick around for some time as that plays out. Obviously we're working to shift that with some of what the teams are developing there, but that's a substantial portion that I'd guess keeps declining for a while; though once again, conferencing is performing well and, as Chuck mentioned, the revenue — this is revenue we're discussing. When I look at demand and at the adoption, the considerable adoption we saw, the promotions we ran this past quarter, simply applying our usual assumption about what converts from free to paid, that's going to give us a nice tailwind across the coming few quarters.

Understood. And just so I'm clear, when you mention endpoints, it's mainly IP we're talking about — is that how we should be looking at it?

Yes, that's exactly how to look at it; that's the primary factor.

Okay. Good luck. Thanks.

Thanks, Ittai.

Let's take the next question, please.

Yeah, hi folks, thanks for taking it. I suppose I have — there are two things I want to ask. First, on order volumes, I was hoping you could set side by side the fact that the US is, somewhat surprisingly, flat after having been down 8% in the prior quarter, along with the deceleration in commercial orders, and dig into where the regional impact is coming from. Is APAC mostly what's behind that, or was the US also soft? Then my second one concerns the $2.5 billion financing plan you announced. I'm not sure, Kelly — maybe you can walk us through the cash flow impact. Is it affecting cash flow in the current quarter, and how should we expect it to unwind back into cash flow over the next several quarters? Thanks.

Kelly, let me give a little context on the Americas and commercial side, and then you can provide some figures and speak to the financials — the programs. So Rod, regarding the Americas, we saw a result that was clearly better than what Asia and Europe showed, and honestly, if you consider the timing of when the pandemic struck, it's clear Asia was affected first. We observed that the downturn became more steady. In the Americas and the US, what stood out was clearly a pickup in Webex and security, since more customers were carrying out their continuity plans. We additionally saw momentum among service providers as they expanded capacity. That meant gains in cable, along with gains in the webscale segment. And since we haven't discussed webscale for some time, I'll add a remark about it. For a long time, we described that effort as a marathon, and we kept putting money into innovation plus our ties with those customers. Now we've posted strong expansion in that marketplace segment for a second straight quarter, and honestly, that's the first sign that all those years of grinding away and rebuilding our position there are paying off. I feel a lot of pride in what our teams have accomplished. It's been a standout over the past two quarters; when it comes to commercial, consider this — commercial or mid-sized enterprises, along with small and medium businesses, have taken a disproportionate hit from this pandemic. Therefore, it makes sense that this particular operation will take a somewhat bigger knock than the rest, and Kelly, do you want to share anything further on that front, and after that, walk us through the financial initiative?

Right, and I’ll add one more point on the US — just to build on that — switching also rose and was solid in America and the U.S., the Americas too. On the commercial side, the picture is comparable: every geography declined, yet the smallest drop came in the Americas, then EMEA, and by far the largest portion of the decline occurred in APJC. That ties directly to the geographic pattern you see when you step back and look at how orders moved overall. As for capital — the Business Resiliency Program — we only introduced it at the end of April, roughly 1 or 2 weeks before the quarter closed, so nothing affected that during the quarter. In Q4, I’d characterize it as a modest amount — we have a pipeline we’re working through. From the early signals in that pipeline, there’s substantial interest from smaller commercial customers that haven’t really used financing, such as many healthcare systems, smaller healthcare systems, and many small colleges, so a pipeline exists there. We’ll begin to see that convert in Q4. From a cash flow standpoint, I don’t anticipate a large impact. Some impact will show up in Q4 and a bit more in Q1, but after that they return to normal payments in the January months. So we’ll keep an eye on it, and hopefully it helps those customers that haven’t taken advantage of that before, but there’s no impact this quarter and I think it will be a small impact in Q4.

Okay. Thank you.

Yeah.

Excellent. Let's take the following question.

Hello, many thanks. You mentioned that routing declined across both SP and enterprise, yet you also noted strong momentum with webscale clients across two straight quarters, and considering some of the major pivots you've made toward work from home, plus the fact that you introduced new offerings back in December of 2019, how have products such as the Series 8000 fared throughout this whole transition? Are you observing an acceleration, or quicker uptake of that product, or has uptake been somewhat slower than what you anticipated, and perhaps a broader status update on the product?

Yeah, appreciate it. I suppose the positive aspect is that the wins we've had in the webscale arena over the past two quarters haven't yet felt any effect from the 8000; so it remains in trials with many customers — they take quite lengthy evaluation windows prior to deployment. That said, I can tell you it's performing extremely well in those trials. We hold a lot of optimism regarding what our teams have developed; we feel confident about it. Our service provider segment grew by mid-single digits, along with orders in the Americas during Q3, which clearly points to the capacity expansions some of them are undertaking, in addition to that webscale activity. So time will tell, though at present we're quite optimistic and feel good regarding where our platform stands. And additional iterations of that platform are on the way. We've only just revealed the initial pair of members within the family.

Excellent, thank you so much.