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

Hello, everyone, and welcome to the quarterly earnings call for Cisco's third quarter of fiscal 2021. I'm Marilyn Mora, and I lead Investor Relations. With me are Chuck Robbins, who serves as our Chairman and CEO, and Scott Herren, our CFO. You should have had a chance to review our earnings press release by this point. After this call concludes, a webcast with slides, which includes supplemental information, will be posted in the Investor Relations area of our website. You can also locate income statements, complete GAAP to non-GAAP reconciliation details, balance sheets, cash flow statements, and additional financial information within the Financial Information portion of our Investor Relations site. During this conference call, we'll refer to both GAAP and non-GAAP financial results, and unless otherwise noted, we'll talk about product results in terms of revenue, while geographic and customer results will be discussed in terms of product orders. Every comparison we make on this call will be year-over-year. Today's discussion includes forward-looking statements, among them the guidance we'll give for the fourth quarter of fiscal 2021. These statements carry risks and uncertainties, COVID-19 included, which we describe at length in our filings with the SEC — in particular, the latest reports on forms 10-K and 10-Q, where the significant risk factors that might lead actual results to differ materially from what those forward-looking statements contain are identified. Regarding guidance, please also review the slides and press release accompanying this call for more information. Cisco won't address its financial guidance mid-quarter unless that happens via an explicit public disclosure. I'll hand things over now to Chuck.

Appreciate that, Marilyn. Good afternoon, everyone, and thank you for being here today. I trust all of you are remaining healthy and safe as vaccine rollouts begin to show results and economic activity keeps improving. First, I want to recognize our team members, customers and partners in India who are facing a terrible spike in COVID cases. Cisco is supplying essential resources through this difficult period, and all of you remain in our thoughts. Even though many of us are witnessing significant gains in recovery efforts, we have to stay vigilant and flexible as we navigate the continuing pandemic globally. Moving to the quarter, Q3 brought impressive momentum that leaves me feeling very optimistic about what lies ahead; we got back to growth, with revenue climbing 7%, powered by a better macro backdrop, the strongest product lineup in our company's history and excellent work by our teams; demand was broad-based across the business, led by our largest growth opportunities: hybrid work, digital transformation, cloud and continued strong adoption of our subscription-based offerings; we're also seeing early momentum as key technology cycles ramp, which are long-term growth drivers for us, including 5G, 400 gig and Edge. The coming stage of recovery and the future of work will depend heavily on our technology. Cisco's end-to-end portfolio will underpin next-generation infrastructure solutions along with cloud-enabled delivery models and innovation, enabling our customers to operate with far greater speed and agility. That will demand a major investment cycle and underscores the strength of our strategy while creating more opportunity to build a world that is more connected, inclusive and secure; we stay focused on speeding up innovation while making adoption of our offerings simpler through network-wide automation, analytics and flexible as-a-service consumption models, all intended to enhance our customers' network performance capabilities and security, which we believe will unlock enormous long-term opportunities for us. Our Q3 results only strengthen my confidence in what's ahead; these numbers show a return to a strong spending environment and an economic recovery that has picked up momentum thanks to vaccine rollouts and loosening restrictions. As the economy has gotten better, customers have boosted their investment across our portfolio to get ready for the upturn and return to office; in Q3, product orders grew 10%, the fastest growth rate since Q1 of fiscal 2012, reflecting solid improvement across every one of our customer segments and geographies. On the product revenue side, we saw 6% growth, led by strength across our portfolio including campus switching, routing, wireless, security, collaboration, and Webscale, as well as from our acquisition of Acacia, which closed during Q3. We keep aggressively shifting our business toward more recurring revenue streams, which we expect to grow over time as we expand our offerings. During the third quarter, software revenue came in at $3.8 billion, and 81% of that software revenue was sold through subscriptions, which is up from 76% in the prior quarter; in addition, we recorded yet another quarter of double-digit expansion in both deferred revenue and remaining performance obligations. Across the last six years, we've made considerable strides and today operate one of the industry's biggest software businesses, with an annual run-rate comfortably above $14 billion. Now let me turn to Infrastructure Platforms. Demand was robust across most of our portfolio, paced by our next-generation Enterprise Networking and Service Provider solutions, as organizations speed up modernization of their infrastructure. This modernized infrastructure brings greater performance and quicker data access, while delivering the finest user experience in an environment that keeps growing more distributed. Customers come to us seeking help in building the trusted workplace of tomorrow, with Wi-Fi access points, video endpoints, cameras and IoT sensors channeling data into DNA Center and DNA spaces. We're helping operations teams monitor workplace conditions remotely so they can return to the office safely; beyond that, we're working to deliver visibility outside corporate networks, something that matters more and more as our customers ramp up adoption of SaaS and cloud solutions for hybrid work. At Cisco Live, we introduced the industry's first enterprise-wide full stack observability offering, combining ThousandEyes cloud intelligence with our Catalyst switching portfolio and AppDynamics; this gives IT visibility along with actionable insights spanning external and internal networks, enabling a seamless digital experience for users; and since users are more distributed than at any point before, having the most efficient and secure connection to the cloud is essential. Thanks to our deep partnerships with Google, Amazon and Microsoft, native connectivity is possible from our SD-WAN fabric to each of those cloud offerings; using our technology, customers can cut deployment times and link branch offices to cloud workloads within minutes. In our Webscale business, we posted our sixth straight quarter of strong order growth, which rose more than 25% during the quarter, and more than 50% measured on a trailing 12-month basis. Our Webscale customers are beginning their 400 gig upgrade cycles and aggressively chasing long-haul build-outs, while our Carrier customers are investigating new architectures to capture the full potential of 5G. We're building the internet for the future by generating breakthrough innovation through our routing, optical and automation technologies, yielding substantial economic benefits. Not long ago, we introduced a new routed optical networking solution, bringing together our scalable, high-performance routers and Acacia's pluggable optics, which delivers considerable cost savings. Last week, we announced our intent to acquire Sedona Systems in order to extend our cross-work automation platform and build on these capabilities. We also broadened our Silicon One platform, moving it from a routing-focused solution into one that serves the Webscale switching market, offering 10 networking chips spanning 3.2 terabits to 25.6 terabits per second, which makes it the highest performance programmable routing and switching silicon available on the market. We recognize our customers increasingly want to consume Cisco's technology in new and more flexible ways. During Cisco Live, we introduced Cisco Plus, our new As a Service lineup, along with the initial offering, Cisco Plus Hybrid Cloud, which brings together our data center compute, networking and storage portfolio. Within Cisco Plus are our intentions to provide networking as a service, which will bring together networking, Security, and observability spanning Access, WAN and Cloud domains, so we can give our customers an unmatched experience. Now on Security, we delivered a record quarter, exceeding $875 million in revenue, rising 13% while we broadened our customer reach globally. The focus of our Security approach is on providing a straightforward and protected experience; we possess an unequaled capacity to offer end-to-end Security capabilities spanning users, devices, applications and data, on any network or any cloud; that's the main reason customers rely on us to assist them in proactively defending against and resolving threats. Indeed, top customers across every industry, which includes 100% of the Fortune 100, rely on Cisco Security solutions. These customers are increasingly adopting our Zero Trust and Secure Access Service Edge or SASE architectures, together with automation, authentication and analytics capabilities. Given today's distributed workforce, businesses need to rapidly roll out highly secure, trusted access to essential applications anywhere while avoiding any hit to performance. Clients such as Ford are relying on umbrella, our cloud-delivered Security platform, as they protect over 100,000 of their remote staff.

During this quarter, Lyft chose Cisco to bolster security safeguards for every one of its users who access their applications. Through implementation of our duo portfolio, Lyft could deliver robust access controls, since they safeguard users' confidential personal and financial details while cutting their overall ownership expenses by over 50%. With close to $6 billion spent annually on R&D, what Cisco invests in both Security and the Network keeps driving momentum throughout our portfolio, marked by 23 straight quarters of double-digit umbrella cloud Security expansion, almost 7,000 clients utilizing our cloud native SecureX platform and solid platform growth via Security enterprise agreements; we keep broadening our leadership through fresh innovations, such as passwordless authentication, data loss prevention, observability, cloud-based malware detection and improvements to SecureX. We're additionally enhancing our organic innovation with assets that allow stronger security efficacy. Our plan to purchase Kenna Security will merge their risk-based vulnerability management platform with SecureX's threat management abilities to prioritize and more efficiently handle overall risk. Finally, let me discuss Applications. Our collaboration business keeps doing well; we achieved a record quarter in WebEx, as we carry out our approach to drive the future of hybrid work. During the past six months, we've introduced over 400 new features and devices into our WebEx portfolio. We're delivering seamless experiences via our desk camera and desk hub solutions while broadening the WebEx suite of devices, such as digital signage, touchless calls, room capacity alerts and environmental sensors to assist in enabling a safe return to the office. Wellbeing is foremost in so many people's minds today as we confront a new way of working. That's why we introduced People Insights to assist individuals in monitoring and managing their wellbeing. These fresh features, devices and capabilities paired with Cloud Calling and Cloud Contact Center give our customers the most thorough and inclusive hybrid work platform. Last week, we revealed our plan to purchase Socio Labs. By merging Slido and Socio Labs into our WebEx platform, we'll likewise be capable of offering the most thorough internal and external event management solution available in the market; in summary, we enjoyed a very good quarter. I'm extremely proud of the ongoing success of the business transformation our teams are propelling. As I noted before, we're witnessing the strongest demand in close to a decade. We're likewise encountering comparable component shortage supply problems as our competitors. The positive aspect, and this is shown in our guidance, is that we're confident we'll resolve this since we've already established revised arrangements with multiple key suppliers. We think these steps will let us optimize our access to essential components, such as semiconductors, and look after our customers by meeting their demand as swiftly as feasible. Our strategy and dedication to leading with trust, innovation and choice, together with our ongoing focus and discipline, are setting us up nicely for growth and profitability. When we move faster on innovation for the people we serve and the partners we work with, backing our employees, the places we live, and the environment becomes essential. Fortune and Great Place to Work just gave Cisco the top spot as the Number One Best Place to Work in the United States, and that makes me extremely proud. It means a great deal to receive this, since it reflects both the outstanding efforts of our teams and the strength of the culture we've built. Then, on the steps we're taking for the environment: the Cisco Foundation shared last month that it will provide $100 million across 10 years for nonprofit grants and impact investing aimed at climate solutions. In the U.S. we've reached 100% renewable energy already, along with many nations throughout Europe, and this marks yet another meaningful move ahead. From our sharp emphasis on generating the strongest outcomes for customers, partners, and employees to our dedication to creating change in communities everywhere, Cisco stays true to our purpose of powering an inclusive future for all. Looking forward, I feel quite optimistic, and I have confidence in what our team can accomplish. Scott, over to you.

Thank you, Chuck. During the previous quarter, I laid out 4 main priorities that guide how we shape our financial approach: pursuing growth that is profitable, maintaining a steady and disciplined emphasis on managing finances and running operations efficiently, establishing a long-range roadmap to optimize value creation via strategic transformation, and reviewing investments, whether organic or inorganic. During Q3, we advanced on each of these areas and continue to develop our financial framework around these essential pillars, which gives us a solid base for improved financial results and for generating long-term value for those who hold our shares. Let's now move on to what we achieved. I'll begin by summarizing the financial outcomes for the quarter, then follow with the outlook for Q4. As Chuck mentioned, Q3 proved to be a robust quarter throughout the company. Our execution was solid, featuring robust product bookings and healthy expansion in revenue, net income, and earnings per share. Overall revenue climbed to $12.8 billion, a rise of 7% compared with the same period last year, surpassing the upper limit of the range we had guided for the quarter. We observed widespread vigor across every product category and region. We likewise witnessed ongoing improvement in our operations, and accumulating momentum showed up as sequential revenue expansion of 7%. Our non-GAAP operating margin came in at 33.6%. Non-GAAP net income reached $3.5 billion, an increase of 4%, while non-GAAP earnings per share stood at $0.83, rising 5% versus the prior year, landing above the top end of the EPS range we had projected. Let me now offer further specifics regarding our Q3 revenue. Revenue from products totaled $9.1 billion, marking a 6% gain. Service revenue came to $3.7 billion, an 8% increase. Infrastructure Platforms recovered well, posting a 6% rise in revenues. Inside that category, Switching Revenue grew overall, with campus growth propelled by robust double-digit expansion of our Catalyst 9K products. Routing achieved strong double-digit growth, fueled by momentum in the Service Provider market. Wireless delivered substantial growth, powered by the ongoing ramp of our Wi-Fi 6 products and by strength in Meraki. Data Center revenue fell, mainly because of servers amid ongoing contraction in that market. Applications rose 5%. We keep seeing double-digit growth in WebEx, thanks to our product innovations and the value we deliver for remote work; we recorded growth in Unified Communications, IoT software, and AppDynamics, which was partly offset by a drop in TelePresence endpoints. Security climbed 13%, with gains throughout the whole portfolio. Our Cloud Security portfolio turned in a solid performance, achieving strong double-digit growth along with sustained momentum for our Duo and Umbrella offerings. Thus we kept reshaping our business, providing more software solutions and generating expansion in subscriptions and recurring revenue. Software revenue amounted to $3.8 billion, and subscriptions represented 81% of total software revenue, an increase of 7 points from a year earlier. As we keep growing our software subscriptions, we are producing greater amounts of recurring revenues. In fact, most of our overall revenue growth this quarter originated from recurring revenue streams. Moreover, the strength of our portfolio and our shift toward more software and services is fueling expansion in remaining performance obligations, or RPO. At the close of Q3, RPOs totaled $28.1 billion, up 10%. Remaining performance obligations rose 15% for Product and 7% for Service. Acquisitions of Acacia and IMImobile, both of which closed in the quarter, contributed a positive 90 basis points to revenue growth during that period. Keep in mind that our Q3 revenue guide did not include these acquisitions. Order momentum was solid in Q3, with total product orders increasing 10%. By geography, the Americas rose 6%, EMEA gained 10%, and APJC climbed 31%. Total Emerging Markets increased 13%, while the BRICs plus Mexico were up 31%. Within our Customer segments, Service Provider grew 17%, Commercial grew 16%, and Public Sector grew 11%. Enterprise was flat, a meaningful improvement versus last quarter. Non-GAAP total gross margin landed at the high end of our guidance range, at 66%, a decline of 60 basis points year-over-year. Product gross margin reached 64.9%, down 90 basis points, while service gross margin was 68.7%, down 20 basis points. The product gross margin decline stemmed largely from ongoing costs tied to supply chain challenges, offset by favorable product mix that includes some software benefit. Price erosion was fairly moderate and consistent with our historical range. Regarding the supply chain, we keep managing through the constraints observed across the industry and keep incurring additional costs. We are working alongside our key suppliers, using our volume purchasing and making supply commitments as we tackle the supply chain challenges that we expect to persist. As mentioned on our last call, the quarter contained an extra week. In line with our guidance for the quarter, the benefit to total revenue was roughly 3 points of growth. The total impact on our cost of sales and operating expenses was about $150 million. Operating cash flow came to $3.9 billion, down 8%, due to the timing of payments and restructuring costs. We expect operating cash flow to normalize for the full fiscal year. We finished Q3 with total cash, cash equivalents and investments of $23.6 billion, a sequential decline of $7 billion, driven by $5.5 billion in payments for acquisitions, along with 3 billion in repayments of our long-term debt. From a capital allocation standpoint, we returned $2.1 billion to shareholders during the quarter. That consisted of $1.6 billion for our quarterly dividend and $510 million of share repurchases. Year-to-date, we returned $6.7 billion to shareholders, representing 64% of our free cash flow, and we have $8.7 billion in capacity remaining under our current share repurchase program authorization. We continue to invest organically and inorganically in our innovation pipeline. During Q3 we closed three acquisitions, Acacia Communications, IMImobile, and Dashbase. After the quarter ended, we also successfully closed on our acquisition of Slido on May 4. These investments align with our strategy of complementing our internal innovation in R&D with targeted M&A to allow us to further strengthen and differentiate our market position in our growth areas. In review, our third quarter was excellent. We carried out our plans effectively, achieving robust revenue expansion and profits; the money we're putting into innovation is paying off, and we keep moving toward greater reliance on software and subscriptions, which produces growth and builds value for shareholders. So now, let's discuss what we're projecting for Q4 of fiscal '21. As Marilyn mentioned before, this outlook carries the same forward-looking statements disclaimer. Here's what we expect financially next quarter: year-over-year revenue growth should land somewhere between 6% and 8%, which again shows the solid demand in the market. We're looking at non-GAAP gross margin landing between 64% and 65%, which mirrors the rising supply chain expenses we're absorbing to keep shipments going to our customers. For non-GAAP operating margin, the anticipated figure falls between 32% and 33%, while the non-GAAP tax rate should come in at 19%. We project non-GAAP earnings per share somewhere between $0.81 and $0.83. Also, we're pleased to share that a virtual Cisco Financial Analyst Day is scheduled for Wednesday, September 15, 2021; details about the event will be posted in the next few weeks, and we can't wait to tell you more then. At this point I'll hand things over to Marilyn again so we can begin the Q&A.

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

Sure, thanks for taking the question, everyone. I'd like to begin, I suppose, with the margin guidance — that's what the largest number of people have been asking me about — and, Scott, I caught what you said regarding the effect of higher costs. Could you perhaps shed a bit more light on just how lasting those effects will be, and also speak to the OpEx line? Those expenses appear elevated as well, I'd guess for a few of the same underlying causes, but what I really want to know is whether these cost pressures and the type of margins you're guiding for can hold up as we move ahead. Thanks.

Sure. Thanks, Rod. If I begin with gross margin, what's behind the impact you're seeing in the Q4 guide on gross margin is essentially supply chain. There are a few pieces to that. The first is unit cost. As a matter of fact, an announcement came out today from Gartner — we hold the top supply chain team worldwide, 2 years running. That group has done a terrific job staying ahead of the problems that the whole industry is facing; even so, we've secured both supply and pricing with a number of the critical component providers we work with moving forward. That's what's reflected in the margin guide, and as far as I can tell, the supply chain challenges will remain with us at minimum through the close of this calendar year. On the OpEx side, things are somewhat different. Looking at the — let me say right up front, before you even ask, that we remain fully on track with the savings tied to the restructuring we told you about earlier this year, earlier this fiscal year; at that point we stated that a portion would be reinvested into growing the business as a whole, and that is exactly what you're seeing now. So if you examine the year-on-year growth in OpEx, what's behind it is the integration of the acquisitions that closed during the quarter, a modest headwind from FX as the dollar has weakened, and then the larger commissions resulting from the robust strength of the top line. Commissions have risen and been reset under variable comp plans. That's the cause, and regarding sustainability, to address your point, my expectation is that a number of these supply chain problems will stay with us through the close of the calendar year, the first half of our fiscal year.

Yeah. Hi Rod, Chuck here. I'd like to give a bit more context on that. Once it became clear that these incremental costs were coming, we needed to make certain calls, and I believe it's fair to say we view them as temporary. How long they'll persist is still uncertain, but given that, and given how much momentum the business is showing at the moment, we chose to keep putting money into the business to fuel the growth we're experiencing; and when you look at how that growth is distributed across all the businesses, the regional mix is even, it's even across the technology areas. It's even across segments. Then, consider that alongside some of these truly major trends that are happening and that we're at the early stage of, such as the 400 gig transition, such as what we're achieving in Webscale, the Service Provider 5G build-out, the hybrid work and return to office, we discussed Wi-Fi 6 driving campus switching, which is now unfolding, and the Security business posted a record quarter at a moment when nearly every customer is indicating they'll increase their spending on cybersecurity over the coming 12 months. So, we felt it was wise to keep investing to satisfy the demand and absorb some near-term pain, and then we expect to come out the other side of it.

Alright, sounds good, thank you very much, I appreciate that.

Thank you, Rod.

Appreciate that, Rod. Can we take the next one?

Hello, and thanks for the opportunity to ask. Chuck, I suppose this partly picks up where Rod left off. The general macro view seems to be that we're heading into a stretch of elevated inflation, and you're picking up signs of it in the supply chain plus in other areas too. Could you walk us through what benchmarks the company is using while managing that? And specifically, how do you weigh that against the lift that could come from certain customers accelerating purchases or bringing demand forward simply to lock in product from you?

Yes, those are a couple of excellent questions. First, what's clear to us is this: should we determine that any of these higher costs, or the inflation you just referenced, will persist longer, then we'll consider strategic price moves in the places where it's necessary. That effort is already in motion. Some calls have already been made on our end, so that's the path we'll take; as you're aware, the situation shifts quite a bit. Then, regarding the pull-ahead, we've gotten that question before. Though quantifying it accurately is basically not possible, it stands to reason that when a customer faces longer lead times, they'll likely submit orders earlier than otherwise. That's simply logical; even so, we also track proxies we'd watch for to show this becoming a real problem, such as order cancellations if someone orders across several channels and then drops the order once one channel delivers. That isn't happening. You'd expect more of this pull-ahead among Enterprise and clearly Commercial and Small Business, whereas you likely wouldn't see much there, and those units were sizable growth drivers for us during the quarter just ended. So nothing jumps out as an obvious warning sign, even though we'd definitely acknowledge that some degree of early ordering is likely taking place.

Okay, thank you.

Thanks, Chuck. Next question?

Thanks a lot, I appreciate that. What's your sense of where buyers stand when it comes to planning a return to the workplace? Could it be that bigger accounts are ahead of the smaller ones, or is it the other way around? Also, what are you observing regarding spending among the sectors that got hit hard a year ago? Thanks.

That's a good one. To start with, I'd say the opposite holds true. We're noticing Small Businesses along with Commercial clients are progressing somewhat more quickly, even though Enterprise gained momentum in Asia and Europe, and our team has run a thorough analysis. The U.S. got better, and we'd anticipate that in the coming quarter and then the following fiscal year, U.S. Enterprise will truly improve substantially compared with where things stand now; and regarding industries, we were conducting that review in the U.S. and we've genuinely observed double-digit growth across hospitality, healthcare, and retail; we've even watched the cruise lines place sizable orders as they get ready to set sail again. So we believe that's clearly an indicator that recovery is underway. Another point I'd call out is that when our clients consider hybrid work and contemplate coming back to the office, we've discussed how widespread Wi-Fi 6 has become — we kept seeing Wi-Fi remain strong. And we noted that once that starts, we expect an upgrade of campus switching to follow, and from a demand standpoint the CAT 9K has posted four quarters of rising growth in double digits over the recent quarters, so that's materialized too; so overall, I'd say things are unfolding the way we anticipated, and maybe even faster.

Great, thank you.

Thanks, Meta. Next question, please?

Hey there. Two things I want to ask — one ties in, the other doesn't. The first one concerns how things are priced out there. We're noticing costs going up everywhere. There are shortages of components. Does that have any effect on what you charge for what you sell? Also, do you have any intention, or have you already made changes to your prices because of this? That's my first item. For my second, I'm attempting to grasp the year-over-year patterns when you factor in how simple the comparisons are against genuine expansion. I realize it's tough to state, and tough to measure, but could you at minimum describe in a qualitative way the reality that, when you post 7% growth and we strip out what the acquisition brought, and so on, how much of this comes from conditions genuinely getting better, per what you're saying, as opposed to merely simple comparisons, given that the prior year was so soft owing to COVID? Thank you.

Sure, Tal, that's wonderful. I'll address the first item, I'll address the two of them, and afterward Scott is able to chime in. Regarding how we price things, like I mentioned moments back, I believe we've reached some choices regarding particular offerings where we're going to raise prices, and we are examining the remainder of our lineup very carefully, depending on where expenses exist that we think will persist. Even so, at present we're leaning strongly toward looking after our clientele and attempting to maximize our capacity to get things to them at this moment, since we believe that strengthens our ties and boosts our standing in the future with these buyers; thus that's our current approach. As for the year-over-year patterns, what I'd highlight is that the genuine element I consider meaningful is the demand side of what we've witnessed, and — since you're correct. You can run some calculations that arrive at the Q3 revenue figure, yet I think that given what we observe and the demand we observe, we genuinely think this is definitely a marketplace that's improving for us, and I think the effort we've put in across the past year — we shifted our approach 12 months back according to what we anticipated would occur after the pandemic. The teams have been working incredibly diligently, and it's wonderful to watch clients adopting the solutions we're putting out there; thus we sense that it can last.

Sure, Tal. I believe the way you should frame that year-over-year figure is against the backdrop of the progress we've been making. At this point we've logged 4 to 5 straight quarters where the sequential numbers have gotten better, and honestly, the gains are broad. Every geography shows it, and every product line shows it too. So improvement keeps coming, and that clearly sets us up well as we look toward Q4 and beyond. Another point we've raised is how strong demand has been, and you can see that in the revenue we reported for Q3. What wasn't visible to you is that we've also accumulated a solid backlog by now. So as we head into Q4, we not only have a very large share of recurring revenue that we know will flow into the top line during Q4, we also hold a meaningful backlog right now, of orders still to be filled, and we have full visibility into what's in the pipeline. So we genuinely feel good about the sequential direction we're seeing throughout the business.

Yeah, Tal, I believe that's a genuinely solid observation Scott brings up. We're up against a revenue headwind tied to the supply chain, so setting aside those supply chain issues, our revenue guidance would have come in higher, and that likely could have carried through to better EPS too. So what we're working through at the moment is a pretty complicated situation. Even so, despite all of that, I haven't felt this good about the business, our momentum, and where we stand in a long time.

Great, thank you.

Next question, please?

Thanks, a few things I'd like to ask. Chuck, I want to revisit the demand picture once more. What I'm attempting to figure out is how much of the current activity consists of work postponed because of COVID that's now being delivered, and how much is future initiatives being pulled forward. Essentially, I'm trying to picture what a typical demand level looks like for you after the COVID distortion — which hurt last year and is helping today — fades. Perhaps you could walk us through that. Then for Scott, regarding the revenue growth outlook for the coming quarter, could you identify the specific contribution from the acquisitions? What would that growth outlook be excluding Acacia, IMI, Dashbase, and Slido, the deals you recently completed?

Sure, Ittai, thank you. I'll do my best to address your question, though giving a truly definitive answer is tough, I believe. A few dynamics are at play, in my view. I'm quite confident some projects were paused by customers and are now being sped up as visibility into the returns has improved. That is surely occurring. I also believe the second factor you mentioned is occurring. Every customer, in my view, is focused on upgrading their infrastructure, since nobody wants to be surprised by the following crisis, and everybody has come to appreciate what technology can do over this period. So there's a component of greater spending we'll observe throughout all technology segments, plus of course cybersecurity, and so on. Yet another point that matters greatly, I believe, is that we've spent a long time investing in many of these major market shifts that are now beginning to take off. As you'll recall, Ittai, five years back we weren't participating in the Webscale arena; we simply weren't. And today, that represented close to 25% of our Service Provider business once more this quarter, and it continues to expand strongly. It rose by more than 25% this quarter, compared with a quarter one year earlier that itself had growth above 70%, so it's still picking up speed. Beyond that, 5G is beginning to unfold in the manner all of us have anticipated. There's the shift back to the office and hybrid work involving Wi-Fi 6, along with the campus refresh projects we've discussed. And there's the cybersecurity worry, which is only made worse by everything reported in the media about the ongoing attacks, all at a moment when we posted record revenues. So I think each of these elements is contributing, and that's why we feel fairly confident about our current position.

Now, Ittai, regarding what you asked next — how the acquisitions affected things — as we mentioned during the opening remarks, in Q3 they contributed roughly 90 basis points of growth, and that had not been included in our Q3 guide. Both deals closed within that quarter, so when we look forward to Q4, of the revenue growth figure we've provided, around 1.5 points comes from the acquisitions, with Acacia accounting for the majority of that.

There are a couple of additional points I wanted to raise on that specific question, Ittai, if that's alright. First, in Q4 we're looking at a revenue headwind stemming from the supply chain problem. Like I mentioned before, absent those supply chain difficulties, our revenue guidance would have been higher, and that ties to what Scott said regarding the backlog we're carrying into the quarter. Second, regarding the business transformation we've spent the past 5 or 6 years working on — if we look back at the first quarter when I became CEO and compare it with the quarter we're about to enter, the recurring revenue we're drawing off the balance sheet, which we have visibility into today and which will form part of Q4 revenue, has grown 64% over that period. So our visibility is much greater now, and it really demonstrates that the entire reason behind pushing this business model transformation — a big, complex change to achieve — has significantly helped us in being able to actually deliver the revenue we're discussing for next quarter. Thus, the advantages we believed the business model would provide — I think this quarter is likely the one where we're experiencing that favorable effect more than in any other quarter.

That's great, thanks. Appreciate it.

Thanks, Ittai.

Thank you, Ittai. Could we take the following question now?

I appreciate that. Thanks.

Simon? It seems we've lost your line.

We lost you, Simon.

Are you there, Simon?

Great, thanks for letting me ask. There are two things I'd like to cover. First, regarding your guidance and that 150 basis point decline in gross margin, I'm wondering whether you'd say supply chain challenges account for all of it, or if other factors are also contributing. That's the first one. Second, I was really hoping you could break down the Service Provider growth, since it picked up quite a bit — walking through what you're seeing in the traditional Service Provider side versus the Webscale business, and where that faster growth is coming from, would be really useful. Thank you.

Scott, do you want to handle the gross margin?

Absolutely, I’ll take that one. The reason behind it is the supply chain, and it shows up in a few different forms. Because of the effort we’ve put in to keep shipments moving for our customers, some components carry higher unit prices and higher unit costs, and that’s included. On top of that, there are larger expedite charges, again so we can secure the components and send the product back out through the door, plus a modest rise in freight. So all of it is genuinely connected to the supply chain.

Also, Amit, regarding how the Service Provider side expanded, I appreciate that you brought it up, since I ought to have highlighted it. Every one of the sub-segments within Service Provider posted growth in the double digits — that includes Cable, Carrier, and Webscale. As a result, the three were quite evenly balanced, and no single segment is driving the results, which is an additional factor behind our optimism. What we observed on the demand side held steady across each of our customers, held steady across geographies, and held steady across the product portfolio, yet within the ESP space it reached double digits across each of those segments.

Shall we take the following question?

My apologies for that. Is my voice coming through at this point?

Yes, we're able to hear you.

My AirPods suddenly quit on me, so I apologize for that. I was hoping you might be able to help connect the dots on the gross margin headwinds tied to the supply chain, since we recognize several factors are at play. It isn't only the chip shortages — there's also air freight, plus perhaps adding extra hours and paying overtime when deliveries slip because of those shortages. So if there were a way to bridge the components, that would help us grasp how the recovery could take shape. Thanks.

Yes, Simon. When your AirPods failed, Amit was thinking along the same lines and posed precisely the same question; therefore my response will be identical. Basically, two or three elements are behind this, and every one of them relates to supply chain. Unit costs have risen, which stems from the efforts our supply chain team has made to secure supply, so that we can get customers the gear they need from us. They also all have major transformation efforts going on inside their organizations to back the new hybrid work environment, so we're pushing as hard as we can to ensure we can get product to them. But unit costs are a bit higher, and that's semis, that's memory, and it's certain other smaller commodities across the board. The second factor is higher freight costs, and as those climb, clearly gross margin takes a hit. And last, expedite fees as we bring product in the door. So, it all connects to different elements of supply chain.