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

Thanks so much for joining us. So I'm sure everyone is familiar with Cisco to some extent. But maybe for those that aren't familiar with as much of the transition that's underneath the story and the migration to software and subscriptions maybe let's give a little bit perspective in background and we can walk through that.

Sure. So one of the things -- one of the key things that we've been working on at Cisco is moving to a far more recurring revenue model. And I think it tracks the pattern of the industry. It tracks -- as we look at the total addressable markets out for the next 5 years, there's growth in that 5% to 7% range when you accumulate across the markets we sell into. But if you go to the next click, the growth of the subscription model within that overall growth is about 15% to 17%. So it's a great opportunity for us to go where the market is to go with what our customers want to buy. And that's the process we've been on. So we -- at the last quarter, we're at about 43% of our revenues are recurring. And with that, we've built up an annualized recurring revenue and ARR of more than $22 billion. And remaining performance obligations, so RPO of about $30 billion, of which about $16 billion is current, meaning it will turn into revenue in the next 12 months. So we've made really nice progress on the transformation. As you look out towards fiscal '25, so we're at the end, this is our fourth quarter, our fiscal year ends at the end of July. So we're at the end of our fiscal '22 right now. If you look at the commitments that we've made or the target that we've put out for fiscal '25, we'll be 50% recurring revenue at that point. And I think there's room beyond that to continue to extend that.

Perfect. So maybe more near term in terms of the April quarter, we're coming off a bit of a mixed quarter with top line a bit below street expectations with flat year-on-year revenue growth, but you have to deliver in EPS. Can you maybe just review the impacts, everything that's going on from Russia, Ukraine, Belarus and maybe some of the component availability that were the main culprits of the shortfall?

Yes. Thanks for that, Jared. Because it was a quarter that had a couple of unexpected surprises that came up for us -- the 2 things hit us on the top line during our Q3 that we reported a couple of weeks ago. The first is, obviously, the war in Ukraine and in response to the war in Ukraine, we ceased operations in Russia and Belarus and in response to that. And in doing so, not only did we have obviously little bit of a headwind to revenue. So on an ongoing basis, Russia mostly drives around about 1% of our revenues. So obviously, we didn't get that. But then as we ceased operations, we also had some refunds to make for subscriptions that were in flight that we were no longer going to deliver on. We had receivables in Russia that we also had to write off. And so the impact on the top line, just for the decision we made in Russia was about $200 million of negative impact, and that was after we guided the dates are -- we announced earnings and gave guidance on February 17, and Russia began the invasion on the 24th. So there was no way to predict that. And the second is -- so given that our fiscal quarter is offset from the calendar quarter by a month, the shutdown in Shanghai, the complete shutdown in Shanghai had an impact to us that we really didn't see in the March month that we saw just in the April month, the last month of our fiscal quarter, where there were a fair amount of not so much -- we do have a final assembly and test plan in Shanghai, but we have about a dozen final assembly and test plans around the world and our supply chain team has gotten very nimble at being able to adjust and being able to say, okay, we've got an outbreak here. Let's take the component parts to another point. So it didn't have much of an effect. The Shanghai shutdown didn't have much of an effect on our final assembly and test. It did have an effect on our suppliers. And in particular, we have 2 fairly significant power supply providers that by their subcomponents from the Shanghai area. So when Shanghai went on total shutdown, they weren't able to get the components they needed to be able to produce the power supplies. And so we where we expected there to be supply chain challenges around semiconductors and around some of the areas that we've been chasing all year. The surprise was the issues that came up with the complete shutdown in Shanghai. And that hit us by about $300 million on the top line in that April quarter. And as you look at the guidance that we put out there, which is probably your next question.

Yes.

Let me go ahead and get ahead of that. If you look at the guidance we put out there, it really reflects our expectation that it's not going to get better or worse. But we don't expect things that particularly around the zero COVID policies in China and the complete lockdowns that happened there and a lot of the not just our suppliers but their suppliers, right? Our suppliers, suppliers are based there. We don't expect that to get better or worse during our Q4 in this quarter. That's what -- that's the assumption built in.

Perfect so to recap about $500 million of total top line impact in the April quarter, between supply chain constraints as well as Russia and Belarus.

That's correct.

And can you maybe just talk a little bit about market share shifts in the context of these shortages? From your perspective, do share shifts happen that quickly to the extent that you -- you're in a shortage scenario when you can't deliver because of mission-critical component like a power supply. Does that yields any kind of market share shifts on a quarter-by-quarter basis?

Yes. So we're not seeing that. And part of the reason we're not seeing that is all of us buy from a very similar set of suppliers, maybe not the exact same. So there could be one supplier that's different here or there. But I think the biggest constraint that everyone in the market has been dealing with has really been around ASICs and merchant semiconductors, right, coming from a couple of well-known companies. And I think as -- because the demand for that is so broad. And in fact, when you look at some of the merchant chips that we buy, not only are we competing with our peers in the networking business, we're competing with, for example, automobile manufacturers who are trying to get that same capacity. And so there's a lot of competition for the similar parts and really at its core for the same manufacturing capacity that's coming out of those foundries. And so I don't think this is fueling any kind of a market share shift by itself.

On the call, you were -- you seem pretty confident that it was not a demand-related issue. Obviously, it's -- it's quite turbulent out there from a macro standpoint, just looking at the markets. You still feel confident that's the case in terms of look on the assertion that it's not a demand issue. And then maybe as a second part of that, can you just -- I think you gave us some granularity on the call in terms of just the number of mission-critical components that were impacted. So maybe just talk about what you're doing to go ahead and mitigate the situation.

Okay. Let me hit the demand question first, and then we can come back to the component supply question. On the demand, of course, I'm not going to comment on the current quarter. So I'll go back to what we said on our Q3 call. And we added -- demand outstripped our capacity to produce again during the third quarter. So we added well over $1 billion more to our backlog. So transactions, customers placed orders on us -- our backlog actually grew from -- we had announced it at $14 billion to north of $15 billion during the quarter. So we're still seeing solid demand. The issues that are showing up in the top line are much completely besides the write-downs that we had in Russia, completely tied to the supply chain scenario. And I think to put a finer point on that, and we've talked about this a bit on our call, the best leading indicator we have, we're being very vigilant, by the way, in watching for demand slowdown. And the best leading indicator that we have, if you look at our customer segmentation is our smallest customers. right? They're the most sensitive to a slowdown. They slow down ahead of the rest of the business, and they pick up ahead of the rest of the business. And for us, that's a segment we call commercial. So our commercial and small business in the last quarter still grew 19%. Demand grew 19% in the last quarter. So if you go back to when the pandemic set in, the first place we saw a decline was in commercial and small and then the rest of the business obviously followed several quarters ago as we came back out of the pandemic, commercial and small came out first. And so it's the best leading indicator we've got. We're constantly watching this. I will say, by the way, before we end the demand topic or at least this question. It's going to be harder to look at the year-on-year growth rates and discern what's happening in demand, right? Because if you remember, coming back out of the pandemic, our Q3 more than a year ago, grew 10%, and we just put another 10% on top of that in the quarter we announced our Q4 grew 31%. Demand grew 31%. So compares for the next 3 quarters are all north of 30% growth rate, which is -- so I think the better way to think about demand growth that we'll see in the fourth quarter is not year-on-year because of comparing to a year that had really 2 things happening, a catch up of demand for products that needed to get done that weren't done during the pandemic and then some people responding to our longer lead times. As our component lead times have gone up, our production lead times have gone up. And our customers see those lead times and they order in advance of when they would have otherwise ordered. It's the confluence of those 2 things that grew those 3 consecutive 30% growth rate. So the year-on-year growth rates are going to be skewed.

We really need to look at 2 years or 3 years stack exactly.

Yes. Yes, you probably have to go back and compare -- so that you can capture seasonality to the same quarter back in our fiscal '19.

And on the supply front, on the complete 150 critical components that you mentioned.

Out of 41,000, right. So the point is it's less than 1% of the products. And so we like most in the industry, are sitting on a growing backlog and a growing inventory position, right? Where we're buying the other 99% of the products so that as those critical components free up, we can square the sets to use the phrase that our supply chain team uses, produce the products and get them out the door. And so that's -- so it's a manageable number that we're off chasing. I would say our supply chain team is doing a terrific job on that. And both being creative in the way they're going after things. We are qualifying second sources and third sources in some cases, for component parts that are particularly problematic. And the importance of that, of course, is you don't just go get an equivalent part, you have to go through the full qualification process so quality doesn't suffer. So we're doing that. We're actually redesigning products, in many cases, existing products that are shipping today, not the next-generation existing products to design around problematic components where we can. We've entered in long-term purchase agreements. You can see our inventory and advance purchase agreements are north of $12 billion at the end of the last quarter. So the team is doing everything we can and then obviously, leveraging our position as a significant buyer for most of them. What's been interesting as we've worked through this, is I think all those things have worked fairly well. We're now also as -- just use the supply chain example, the problem we were having was not with our power supply vendor, it was with their vendors. So we're having those 3-way meetings with our suppliers and with their suppliers and helping them get supply, helping them qualify second source components, et cetera. And obviously, looking at the brokerage market, brokerage market hasn't been that great during the pandemic because no one's releasing product into the broker channel.

So maybe building on that last point, is there any impact from a gross margin standpoint when you look at procuring some of these incremental sort of, call it, second sources or having to buy on the third or buy in the aftermarket. I know one of your competitors have had gross margin issues in terms of having to pay up for components and that really impacted the bill of materials. How are you sort of thinking about that?

Yes. We have seen an impact to our gross margin. So gross margins in the last quarter were well ahead of our expectations but down year-on-year by about 80 basis points. And it's really -- it's what you just said, Jared. It's the increasing cost of components and the expedite fees and going to brokers, et cetera. It's also logistics costs. I don't know about you. I flew here. Air transportation right now is not a lot of fun in that. And a lot of the things that get shipped, especially these high-value components, travel in the belly space on commercial airlines, right. Belly space has been very difficult to come by. So our logistics costs have gone up quite a bit. So you can't use ocean, particularly for high-value components. You can't use ocean right now. many times that we've seen that picture of all the container ships anchored off in offshore. And then -- and there's a shortage of truckers. So logistics cost has also been a hit. Those are the things factored into the guidance that we gave on gross margin. What we've been doing, and we saw some of the benefit of it in the last quarter and our Q3 results is increasing prices just to offset our increased cost. So not trying to be opportunistic about this, but our costs are going up. We've increased pricing to try to reflect that. We've had 2 price increases in the last 12 months. But it takes time. From the time you announce the price increase until it shows up in the revenue stream, we sell a lot through the channel. So first thing we do is we notify the channel, given 30 days notification for a price increase. There's a...

Is that your device making the sound?

There's a -- we honored in their quotes for another 30 days. Then those new prices start to get reflected in purchase orders. Those purchase orders go into the backlog and as they come out of the backlog and get fulfilled, that's when we see the benefit of the price increases. So we just saw at the tail end of the third quarter that we announced, some of the benefit of the first price increase we put in place which was exactly when we said we thought we would see it toward the end of the third quarter. So we're trying -- simply trying to offset the increased cost in both components and logistics that we're seeing from the supply chain right now with our price increases.

And just as a reminder, if anyone has any questions, raise your hand or you can just use the device and it will pop up here.

Can you please follow up or maybe elaborate on these different components on the supply side? How do you think this is going to pan out over the next, I don't know, 12 -- 6 to 12 months? I mean is there any light at the end of the tunnel? Or is this the new normal for you? Like how do you see this kind of -- do you see any signs of improvement?

I think that's the question that everyone would love, including me. The answer to is when does this all begin to clear up. I don't think it clears up in a step function. In other words, I don't think we're going to have a quarter where we're $3 billion above expectations because I think the 2 things are going to have to happen. Supply and demand get back into balance, which they've been significantly out of balance, beginning at the bottom of the supply chain all the way up to final assembly. That's going to take time. That's not going to happen in a quantum step. And the second is the logistics issues have to get resolved. And that's also going to take time. It's going to take time for air travel to normalize. It's going to take time for the shortage of truck drivers to normalize once you get to your components to where they need to be. And then ultimately to get back on to ocean freight. So I think both of these are just going to take time to work their way out, and they'll work their way out, I think, in a more gradual fashion.

Did you -- historically, was ocean freight the predominant -- is that what you used predominantly or it's always been a mix across...

It's always been a mix. I wouldn't say it was predominant, but it's been very difficult to use Ocean over the last, say, 6 to 9 months.

And just to recap in terms of the benefits of the price increase, I mean it was first instituted in August of last year. And are you seeing into the July quarter, you're seeing some of that benefit now roll through?

We are. It was -- so the first one, there was a small one that was just a normal adjustment for currency in August. We did another one at the end of last calendar year. So we're seeing the benefit of the first price increase right now. That is -- I think we'll continue to see that through the fourth quarter and forward. And that is built into our expectations on gross margins for Q4.

Got it. But we should consider gross margin neutral from the standpoint of it effectively just offsetting costs.

That's exactly been our goal.

Maybe let's touch on -- you touched on this a little bit in some segments of the market, but in terms of product order growth, was obviously tracking incredibly strong at greater than 30% for multiple quarters in a row. And I think you touched on a little bit of this where customers were likely ordering an advanced demand due to longer lead times. So we decelerated from up 30 to up 8 in the most recent quarter. Maybe just walk through how to sort of think about that. To what extent is the up 30 just really not that indicative of business conditions because of that? And what really do you think was attributable to that pretty significant deceleration.

Yes. I'd love to think that at $50-plus billion a year in revenue, we could continue to grow 30% on a steady-state basis. But I don't think anyone had that built into their models and just tell me if I'm wrong. So I think the -- when you look at the third quarter that we just announced, 8% product growth, but buried within that. So as we took the write-offs and ceased our operations in Russia, we also had bookings that hadn't been fulfilled, and we debooked those, right? So if you normalize for that, it was 10% product order growth in the third quarter. So the real demand was more like a 10% growth. And that compares back to Q3, which was the first quarter coming out of the pandemic on the prior year that we began to see growth. So it's 10% growth on a 10% growth in the prior year. So again, feeling good about that level of demand. I think in the next 3 quarters, as I said, the math is just going to make it difficult. If you just look at one year growth rates, the math is going to make that quite difficult. The better compare is going to be to go back and look at kind of pre-pandemic. But you didn't have this. For those 3 consecutive quarters of 30-plus-percent order growth, there were 2 effects in there. There was a catch-up of things that didn't get done and then there were people ordering in response to our longer lead times. And so it's going to be -- we're not seeing a demand slowdown at this point, but it's going to be difficult, I think, to just look at the year-on-year growth rates and discern that.

And is the -- when you think about the metrics that you utilize internally, is the product backlog a better indicator of the demand as opposed to the order growth?

It's actually 2 things. It is the product backlog. The product backlog stands at north of $15 billion at this point of just product, not services. Within that, by the way, is $2.4 billion of backlog on software. And you go -- how can you have a backlog, there's no supply chain issue. Well, there is, right? Because a lot of our software is attached to hardware both in the security business and in our Meraki and our core networking businesses. So there's $2.4 billion of that north of $15 billion, that's just software base that's sitting there. take that and add it to the number that I gave you earlier, so our remaining performance obligations, or RPO, right, which is the sum of committed but unbilled orders plus deferred revenue. You add those 2 together, that's remaining performance obligations. We have $30 billion of RPO at this point. So -- and you can add these 2 together. None of what's in the backlog is in our RPO. So we've transacted more than $45 billion in sales that are in hand, either in backlog or an RPO that haven't yet showed up in our revenue stream. So actually feeling quite confident in that position.

And I think just to clarify, you said, I think earlier, $16 billion of that $30 billion is current from an RPO standpoint?

Correct. Meaning it will turn into revenue in the next 12 months.

We're seeing corporate scale back hiring plans pretty aggressively as we adjust to the reality of a slowing economy. I think last I counted, late last week, it was 25 very well-known companies just in the tech sector alone have cut back or have frozen hiring completely. How does Cisco responding to the current environment from a hiring perspective?

It's a time to be prudent. I think it's a time for everyone to be prudent as you look ahead. And we're doing the same. We're inspecting every opening as we look at it. And at the same time, ensuring that we're staying invested in our highest priority topic. So security continues to be an extremely high priority item for us, and I think it's a great opportunity ahead. So we're continuing to invest in the areas that are highest priority, but being very prudent overall in headcount growth. I think it's a time that us at Cisco, and I think all of my peers are doing the same thing or looking at this and just feel like it's a good time to be prudent.

To the extent that we end up going into a recession, like many are predicting, and we'll see what the Fed obviously does this week. Do you think Cisco is better positioned versus prior recessions, just given the mix to subscriptions and software? Maybe just help give us some more context of the transformation that we've been talking about and how resilient the business model can be?

Obviously, no one wants a recession. I think the more we talk about it, we can sort of talk ourselves [indiscernible] as well. And certainly, I don't want to contribute to that. Having said that, though, I do feel like just based on what we just talked about, Jared, with the $30 billion of RPO, which $16 billion is current, a little more than $16 billion is current and a $15 billion backlog. I do feel like we're fairly well positioned in terms of demand back to -- we've transacted more than $45 billion of sales that haven't yet showed up in our P&L.

So we're getting a question here, which is actually my next question. You've been very disciplined and prudent from an M&A strategy perspective over the last years. And clearly, software valuations, in particular, haven't come in considerably. So when you think about capital allocation, how do we think about M&A in the current environment? In 2022, software M&A activity last I checked was about $140 billion, obviously, inclusive of the recent VMware transaction. Would Cisco be willing to do large-scale M&A to the extent there was the right strategic fit, just given, obviously, your strong balance sheet and the ability to take on leverage, et cetera? Or is it better use of capital, just buying back stock at this point?

Yes. To me, it's not an either/or. But if you stack rank our cap allocation policy, this is not a change, by the way, but I'll just -- I'll restate what our cap allocation policy has always been. It is, first and foremost, to support the growth of the business, organically and inorganically. And so that continues to be our top priority. The dividend is incredibly important and is nonnegotiable. So we'll continue, obviously, within our cap allocation policy to support the dividend. Beyond that, it's to offset the dilution of our equity plans, our annual equity grants with share buybacks and beyond that with excess cash to return to shareholders. And so year-to-date, you see we have returned a significant amount, more than $15 billion to shareholders year-to-date through the combination of our dividend payments and our share buybacks. But we'll continue to look, first and foremost, at driving growth with M&A. And so I think part of your question is there's also scale on M&A. And we are constantly evaluating targets in the market. I'd say our Corp Dev team is part of my team. At any given time, we've got a dozen more or more things that we're looking at, things that we're inspecting and it's first -- the first filter, of course, is it map to our core strategies. Is it a really strategic fit in the areas that we see significant growth ahead. Beyond the second very quickly is from a cultural standpoint, we think there's a cultural fit because we've got a -- Cisco has been awarded again the best places to work in the United States and in several countries around the world, #1 and best places to work. Culture is important to us. And so we evaluate that very quickly. And then right behind that, to me, is the revenue model of the target. Does it map to our strategy of building a more recurring revenue model as we look into the future. And so those things are all -- there's -- as you'd expect, there's a number of filters that go into that, but those are the ones that are toward the top of the list. What we don't do is filter out based on, hey, it's above a certain clip level. We'll continue to look at that. But I'm not sure the revaluation that's happened, the repricing in the equity markets, both public, by the way, and private, has really sunk in on companies yet. I think in many cases, they still believe -- this is a bit of an anomaly. And my real value is the value that it was 6 months ago or 9 months ago. And so I think it's going to take some time for that the reset that you talked about, it's not -- that by itself doesn't necessarily create a shopping opportunity.

Point being that bid-ask spreads can still remain incredibly wide until the target adjust to the new reality of the current economic environment.

Willing buyer and willing seller, right? And so you have to have both of those to make a transaction work.

But it does sound like that size is not necessarily -- a larger transaction is not out of the realm to the extent that it fits all the criteria that you talked about.

I would say it doesn't -- it's not something that I would just say no above a certain size. We absolutely aren't going to consider it. But when a company gets to that scale, it takes years. It doesn't happen overnight. And so to get to that scale, they've been in business for quite some time. And the thing you have to evaluate then at that scale and at that price is the technology still current? Are we now looking at someone who's actually scaled nicely but is sitting on a technology base that's 5, 8, 10 years old, which brings with it a significant amount of added costs. So scale by itself doesn't discount a transaction, but it's hard to make those transactions work in some cases, when you look at the technology, the tech debt that's built into some of those companies.

At the Jefferies Software 2 weeks ago in San Francisco, the Microsoft Chief Marketing Officer, got on stage and talked about security as the most exciting opportunity for the company over the next 2 years. How are you thinking about the security vertical in particular as it relates to Cisco's product portfolio and growth strategy?

Security is an enormous opportunity. It's an enormous opportunity for us. It's an enormous opportunity in the market overall, and it's a growing opportunity. I think we're extremely well positioned given the strength that we have and the breadth of our networking product line, I think we're extremely well positioned from a security point. And one of the things that the guy that leads our security business, Jeetu Patel at RSA last week at the RSA conference talked about the security strategy of -- a lot of security companies are very point product focused, right? I've got -- I'm going to be the best-of-breed at one particular point product. And frankly, for a while, we played that same game in trying to view point product. And I think the way to play to our strength better is to have much more of a security platform. There still will be a best-of-breed products that need to snap into that, but to be able to better leverage the insight that we have from both our networking business and the breadth of our security portfolio. Through a common security platform that then allows you access to what's happening to do the correlation, to do some of the pattern recognition, machine learning, you can put on top of that ultimately leading to autonomous action, right? I mean I think that's the real opportunity for us. So we see security as not just a significant opportunity but a market that is -- it's incredibly important to us at Cisco and one that we continue to invest in pretty heavily.

Can you maybe just touch on quickly the silicon strategy that you've been pursuing internally and how that differentiates you versus your competitors?

Yes. it's -- so Silicon One is our silicon strategy, and it's -- this has been a development process that's been 5 to 7 years in the making. And frankly, it's one of the keys to the great success we've been having with the hyperscalers. We've talked on several of our earnings calls about the growth we've been having in that higher selling to the -- actually, I guess, I shouldn't mention the names, but the giant public cloud companies. Silicon One has been critical to that strategy. It not only fits in there, but it fits in -- ultimately will fit in across the Catalyst product line and across all of our networking products. It's going to take time to -- that will be as the next generations come out, but we'll continue to build that in. But our Silicon One product is not only our product line. It's not only critical from a high-performance standpoint. It's also extremely low energy. And so a lot of the things that you see, a lot of the wins that we get through the products that are incorporating Silicon One are really driven by not just faster bandwidth and faster speed. It's in a much smaller footprint and with significantly less power consumption. And I think as every company like Cisco has, has made commitments around sustainability and around getting to net-zero, that power consumption metric has become critically important as a buying criteria. So the Silicon One strategy is one that's been years in the making. We're really beginning to see the fruit of it now, and we'll continue to see the benefit of that over the next-generation of products that we send out.

Last question. You've been at Cisco for about 1.5 years now. What have been the biggest surprises from your perspective?

I think one of the things that surprised me, and I think may surprise everyone in the room is the size of our software business. I mean we are one of the top, certainly 1 of the top 10. You can do the math on a trailing 12-month basis, north of $15 billion of software revenue. We -- I don't think anyone thinks of Cisco as one of the biggest software companies in the world, and yet we are. And that is a critical -- it's a fundamental part of our growth in recurring revenue. I see we're out of time, so I'll stop there.

Perfect. Scott, thank you so much. Appreciate it.

Thank you.

Thank you.