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

Welcome, everybody. Before we get started, I'll read some research disclosures. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. For those who don't know me, I'm Meta Marshall. I lead up the networking coverage here at Morgan Stanley. We're delighted today to have Cisco and Jonathan Davidson, which I was saying always has a new title that's grander and grander, but now we have a EVP and GM of Cisco's networking business.

Great.

Perfect. So Cisco is coming off of a very strong quarter. You guided to double-digit growth for the year in light of macro headwinds understanding there's backlog release as part of that. But what is the biggest pain point for your enterprise customers today? And what is kind of causing that continued investment in Cisco?

There's a lot of different transitions that are happening. First of all, continued digitalization of our customers' businesses and the need to really change how they're interacting with their customers is driving significant transformation. If you look inside of a new factory for cars, I had a tour of one just a few weeks ago, and the amount of equipment every 10 feet to make sure that all of that equipment is network is critically important. Of course, security is top of mind for all of our customers and how security and networking are coming together to create a seamless experience for users and applications and things. There's so many fundamental areas where connectivity is just pervasive in all of our lives, and that's really driving a lot of that.

Okay. I mean your Analyst Day in 2021, you noted 5% to 7% growth CAGR which is above the traditional growth rate Cisco had seen. Is it just this connectivity that's causing the increasing of networking as a percentage of the IT budget or just what is causing that to be maybe less macro sensitive than in the past?

Well, I think if you look at the areas in which we play, it's really important to look at how all these businesses are continuing to transform. I mentioned the digitalization. But if you look at businesses that maybe people aren't aware that we're even in. For example, our cloud -- our connectivity management platform, what we acquired a company called Jasper 7 years ago. We are now the #1 connectivity platform with 60 service providers around the world. We have over 200 million mobile connected things. We're the #1 connected car player in the world. So connectivity is certainly there. But also as you look at how companies are either trying to incentivize people to come into the workplace instead of mandating it, how the workplace is being used is changing. Even in our corporate campus, we have taken certain buildings that used to house people and we've converted it so that you could go and have really large offsites. And so instead of going and having an offsite offside, you have an offsite onside, and we've actually blanketed it with more connectivity because you could have a room full of 100 people instead of a room full of 50 people. So we think that how you're using the connectivity changes, our Penn 1 building in New York, for example, has power over Ethernet-based lighting. You can save 50% on your cost by moving down that path. And so when you look at how all these things are tied together, including, of course, sustainability, especially in Western Europe. These are really driving a lot of additional needs, not to mention other tailwinds like the fact that governments around the world are putting tens of billions of dollars into infrastructure to drive connectivity into homes and the need for broadband everywhere to close that digital divide.

Got it. We thought and Mobile World Congress last week, like 80 million connected cars at this point kind of powered by Cisco. It's a big number. All right. So where do you see the greatest opportunities for Cisco to evolve the portfolio to kind of address these pain points? Is it more integrated security, more subscription sales, more analytics? Like what do customers need more of from you guys?

Yes. They did all of those things. What customers really want from Cisco is outcomes. They're really looking for us to help them transition from current state to future state. And there's a lot of areas in which we can help them do that. So if you have an on-premise data center and you need to move to the cloud, okay, well, how do I get connectivity to the cloud? How do I ensure security to the cloud? How do I connect from cloud to cloud? How do I know that my employees, when they're on-premise or when they're working from home, are having a great user experience? And this is where things like full stack observability come into play. And so helping you understand what's happening with the applications because most enterprises are digital now. Pizza companies are digital companies, how do we help them understand their user experience, whether that's their employees or their consumers and we're one of the few people on the planet that -- if not the only company on the planet that actually can help you understand your employees' experience and your customers' experience in real time across public cloud, private cloud, the Internet, we have more data points and more just straight analytics than anyone. But on top of all that, that sounds really complex what I just described it. They want it delivered to them in a simple way. And this is where we have been putting in, it's just a tremendous amount of effort is to unify the experience of Cisco so that it is simple for them to digest all of this technology.

So more Meraki-like experience, across the portfolio.

Right. It's -- we have different feelings about that. But the -- if you want to make it the Merakification of the large part of our portfolio, we started talking about this last June at Cisco Live, where we were taking our existing very large on-premise portfolio and enabling the monitoring of that portfolio, which the adoption has been great for that. And then expanding that into management of that portfolio as well, to really create a seamless path for that huge, huge installed base so that they can start to step into cloud. And obviously, we've got Meraki. Meraki is a very large business. So if you want to go all in on cloud, you can do that today.

Yes. Okay. Got it. So you just spoke a little bit about kind of the outcomes that people want. Well, really, the outcome for enterprises is that we're moving towards a hybrid future. And so is there a better way of helping them manage these environments either, I mean, I guess, better security or at-home connectivity? Or just what does the hybrid environment require that is more Cisco intensive?

Yes. So there's a few things. One, I think it's important to call out that there are different hybrid environments that exist. There -- especially if you look at governments around the world, especially in the U.S., you need to make sure that you are certified, you're FedRAMP, your stock to compliant, all those types of things. And this is where we put a tremendous amount of effort in that. In fact, just last week, our SD-WAN portfolio was spread around moderate certified. So we continue to invest. So if you need to have a cloud experience, but you're in the government, you can go and use our -- the #1 SD-WAN technology out in the market today. So we're really excited to that and we're going to continue to do that. When you start thinking about what's happening in the cloud. Of course, there are private data centers that are going to exist forever, right? The mantra of private data centers going away with a few years ago, you heard that. The pendulum from a marketing message swings both ways, but it usually settles right in the middle from reality. And we're continuing to see how we can help customers migrate to the cloud. But really, it's about how we can help them really understand what workloads make sense on-premise, what workloads make sense in the cloud? And then how do you have seamless policy and connectivity and security between all of those. So if I'm a user, and I want to get access to an application that you shouldn't have to log in 2 different times if it's in the cloud versus if it's on-premise. And this is where our security approach of enabling that consistent policy from the campus, from the data center, from the public cloud, is so important because that drives simplicity and enables the customers to just worry about the outcome instead of having to worry about the swivel-chair management having to -- have my user instance in multiple places.

I mean you can provide the outcome, but where do you think customers are on that? You've mentioned the pendulum swings on what investors think or what the market thinks. But like where are companies on thinking about what that hybrid footprint looks like, do you think?

Well, we have a few different ways of segmenting out the customer base. From an internal perspective, I don't walk up to customers and ask them this. But we say, look, there are customers that are Cloud Averse. And I'll give you a simple example. Cloud Averse customer could be a DoD, right? Basically, where do you want your management orchestration for your infrastructure to exist. And it's probably good for all of us that the DoD wants that firewall from the Internet. And then you've got the smaller enterprises who are all in on Cloud First. So you've got Cloud Averse, you've got Cloud First and then you've got Cloud Hybrid type customers. And this is not only how they want to manage and orchestrate their infrastructure, but how they view, where should their workloads reside as well. And we have products, and that's the beauty of this. We have products that can help our customers and it doesn't matter whether they're Cloud First, Cloud Averse or Cloud Hybrid. We have a very broad portfolio that enables you to be on that entire spectrum.

But for maybe ignoring Cloud First and ignoring on-premise first, I guess, we're in this period of cloud rationalization, we're in this period where maybe people are reevaluating what hybrid means to their organization. I guess I'm just -- you guys, you may not ask them where you are in your hybrid journey. But just you're having a lot of customer conversations. So I guess I'm just looking to see if there's any way to kind of determine where people are and figuring out what hybrid means to them maybe post this kind of digestion period?

Right, right. So first, I just want to make sure in terms of similar, so I'm going to describe the 2 different things. One, if we say customers want to have a hybrid cloud environment, that's for their workloads. If customers are looking at how they want to orchestrate and manage that and they're in a hybrid management orchestration perspective from the networking infrastructure, the beauty of this, I'll give you one really large customer in the U.S. where for their very large campus locations, they're on-prem, they're comfortable with that. For all of their massive amounts of thousands of retail locations, it's Cloud First, but they want to have a console capability so that they can manage both in parallel. In fact, the -- for their remote operators, they give them the Cloud First log in, and they can go and turn a port on and off and it's -- but it's a seamless experience for the central team that manages the whole thing. And this is something that we're giving them today and they're using today. So we see it's not just this customer only wants it this way. It's like what's the use case? What problem are you trying to solve and how can we help you go and do that? And that seamless automation and management experience, which only we can deliver is really resonating with both very large and very small customers.

Got it. A big conversation we have with investors is just around the campus portfolio. You guys have been dominant here. It's one of your most profitable markets. But there's a lot of people at this conference who have spoken about kind of attempts to chip away kind of your position there and so what steps can you takes to kind of defend some of the positioning that you have here?

Yes. So I think there's a few things. One, I always welcome competition. Competition keeps us on our toes. I think that's a great thing. And what we've seen is that we need to be more clear about what innovation we have inside of our portfolio. And so I'm certainly we see marketing messages from our competitors and what we think usually is like we've had the capability for 2 years, and they're announcing it and people are getting excited. We need to do a better job of explaining the capabilities that we have in our existing portfolio that's been out and available to our customers. So that's kind of one. We need to do a better job of messaging that. And you're going to see more and more of how we're able to use AI and ML. This isn't new for us. This is something we've had for years. We've been shipping for years. The other thing that we've seen is that our competitors like to go and compare, especially on the on-premise side, something that is on-premise where the customer may not have upgraded for 3 or 4 years, although we do -- we push the code to our on-premise capabilities, and we say, "Hey, you need to upgrade, just click this button and magic will happen, and you'll get the upgrade", but there are some customers who haven't clicked the button and that's their decision. And then we have competitors who compare what they have right now to our on-premises offering from 3, 4 years ago. And so what we do when we get into those sales scenarios is we say, "Hey, that's not apples-to-apples. Let us show you what we have right now that you've been missing out on, you already have rights to. " So we need to do a better job of making sure our customers are moving to the latest and greatest. And also, we've been -- or I have been surprised at how rapidly people are willing to accept cloud management. And I'm not talking about small commercial customers. I'm talking about large customers. And I'd say, go back 10 years, it's kind of like how fast the banks were willing to move their workloads to the cloud. It went from we're never doing it to -- it's one of our top priorities over a period of 2 years, like 10, 8 years ago, and it feels like we're in that same kind of space. And the good news is we have the largest cloud networking portfolio from a networking infrastructure perspective than anyone on the planet.

All right. So some self-affirmation, some good marketing, and we can -- will go a long way. I don't think that there's any -- there's headlines all the time about campus footprint shrinking, less office space, even you guys have rationalized some of your office space. And so are there enough kind of opportunities to expand products into this market to keep it as attractive as it's been?

I think when you -- the conversations that we're having with our customers are very different than they were. And for those of you who've been around for a while. If you remember, when we move campus switching to Power-over-Ethernet, all of the ports became Power-over-Ethernet even though only the phones and then eventually the APs were power-over-Ethernet. Well, we see that there is a densification happening inside of that remaining office space. And also, it's a full spectrum. There are certainly companies that mandate that you come into the office. I think you might have had one of the speakers earlier this week who came in, and he's one of the people who like to mandate people come into the office every day. But there are companies who are on that end of the spectrum. And then there are companies that the other side of the spectrum like, hey, come in when you need to do things where you need to collaborate face-to-face. The power of drawing on a whiteboard is real. And we're an innovation company. And so from an engineering perspective, our engineers, we heavily encourage them to come in anywhere between 2x to 4x a week. In some teams we have people that -- we've encouraged them to come in more than 4 days a week and that's more on the hardware side, because innovation and hardware requires you to really be in person. But it's really for team kickoffs for brainstorming, for solving really intense problems. All of that comes down to we see that there's a way that the campus network is being used differently. And I'll give you an example of spaces. If you were to go into our San Francisco office, just down the street here, what you would see when you walk in is a very large WebEx screen. They will have a 3D model of the floor plan of the building, they will tell you which conference rooms are available just by glancing at it. They will tell you the temperature of every room, the humidity of every room, you can book a conference room right when you walk into the building, tells you how many people are on that floor, and it gives you a view of what's happening. And so I sit out in the open in that building, and I can see people come in, they look at it, they book, it's heavily used. And so how we're using office space is fundamentally changing. And the whole point here is we've got cloud-based technology like Spaces, like Meraki that give you the visibility in analytics and spaces is one of our fastest-growing SaaS applications where we're integrated with over 100 different partners that have sensors, not just Cisco sensors, but sensors that are connecting into it where we can give you that broad visibility of what's happening inside of our infrastructure, the WebEx screens are sensors. They can count the number of people in the room and report that out too, so you can see whether rooms are utilized or not utilized, which is great for facilities teams, which we're seeing more and more has moved underneath the HR function. So you think about your people and you think about your spaces, cohesively and together. And those are the kinds of conversations that we need to have with our customers. It's not just about how many PoE ports do you want anymore. It's kind of experience do you want to drive and we're primely positioned for how to do that, not to mention, of course, all the great technology around we've got the best APs in the planet. WiFi-6E is great. The automation orchestration is phenomenal common policy in insurance, all those other things are great, but the conversations are uniquely capable with Cisco.

You then need to book of room by temperature, it blows my mind as a person who's always cold. All right. So maybe moving on to the cloud portfolio. You guys have made inroads with these customers over the past few years. Some of that was with the acquisition of Acacia. But just where have you found the greatest needs that you guys have been more uniquely able to address?

I think this really started 7.5 years ago when Chuck became CEO, he made infrastructure a top priority. He enabled the acquisition of Leaba, the silicon company out of Israel. And that team is the best silicon team I've ever worked with, and I've been doing this for a really long time. The -- it started there, but it really went to us going and engaging with the hyperscalers and the web accounts, understanding what they needed from us and then we had to build the products that they need from the silicon up. And we have continued to gain share. Chuck and Scott talk about it a lot in the earnings call. So you've heard over the last many quarters that we continue to see great growth in that area. And so it has been where we first penetrated was mostly in the wide area network. But we are in the data center proper across several of these hyperscalers. We are definitely taking share. I know there's -- everybody says they're taking share. But fundamentally, we are very excited not only about what we've achieved so far, but what is additionally is possible because we're the only company out there that can sell silicon to the hyperscalers. We can sell systems with no software. We can go and sell fully integrated systems and if they need any other type of assistance. So if they want to put our software on there, they can do that. We have embraced this disaggregated approach. There's no one else who has all of those things to offer, and that really resonates be able to have one common piece of silicon that they can buy multiple different ways and have a common operational framework from their top-of-rack switch through the data center, through the wide area because operations is painful at scale. And having each different box inside the infrastructure acts the same way is really important. Big silicon competitors, they have 3 different switching silicon portfolios to get there. And the largest hyperscalers are moving towards open OS is either one they run themselves or Sonic. We have our own Sonic distribution. We are all in on enabling Sonic. And so from my competitors who don't sell silicon, don't have they have long-term differentiation. I'm concerned for what that's going to mean for them.

I mean the topic of the conference has been AI. And we tried -- we put out a note last week that looked at the AI opportunity for networking, I guess just as clearly, cloud customers have been at the forefront of this. But just as you look at kind of what the data center or networking needs are for these AI workloads. Are you -- what can Cisco do to kind of help address or take advantage of that opportunity?

So on the -- I would say there's 2 things on AI, specific infrastructure. The hyperscalers have an extremely large AI networks, and they're only going to get bigger. And they have unique requirements for how the traffic flows through those AI networks. And we've been working closely with them for years to do modeling, to understand how our silicon needs to change, to understand how our software needs to change, to make sure the traffic is flowing across those AI networks exactly the way they need to. So we are in a great position because they're working with us and collaborating with us. So we know which kind of products and to me, that's the most precious thing. They stop working with you, you don't know what to build. And if you don't build the right thing, they're not going to buy it. So they continue and they have been working with us. So we have the intellectual property to change our silicon, to change our software, to change our systems to enable these very large AI networks. We're uniquely positioned in that space. And we see that there's definite continued upside for how large those networks are going to be. That knowledge can be taken into the enterprises. We have a lot of enterprise-type accounts who are going and building their companies around AI, who have similar types of requirements, not necessarily the same size and scale, but this is an area where you're going to hear more from us over time about how we're taking our intellectual property and moving that into AI-based networks for companies that are focused on. Now, if your company is doing a little bit of AI, go use a public cloud. But if you're basing your company around AI, that means you've got large amounts of AI, it's actually more cost effective to do it on-premise, and we want to make sure that we're able to help them. And that we've already been doing that for years as customers who have been building their AI networks on top of our products for a long time, but there's more opportunity there.

Got it. Maybe moving on to the service provider portfolio. These guys have always been maybe laggards and architectural changes, but this kind of Acacia routing portfolio has gained a lot of traction. Just can you maybe contextualize for people like what that opportunity is? And why it's so kind of transformational for carriers?

Yes. So 2 things. One, the traditional optical model has been, I'm going to sell you a hardware shelf, pretty much no margin is being made. And then I'm going to sell you transponders that slide into them. And those transponders are where I make on my profit or if you're in the optical only business, as the traditional razor, razor blade model. But what if I would be able to take that transponder and put it in a pluggable? So you don't have to buy that shelf anymore. So if you don't buy the shelf, there's no lock-in anymore because if I buy a transponder on one side from vendor A, I have to buy the transponder on the other side from vendor A. So we're breaking 2 models with Acacia and the ZR Optics. One is you don't have to buy the shelf anymore. That's number one. Number two, ZR is a standard. So you can get a ZR pluggable transponder from me. You can get it from another vendor, and they will work with each other. So finally, optical has options and open interfaces and that's the first part of it. The second part is what you called out is just routed optical network architecture. If you go back to the '90s, all of the Internet ran over TDM networks. Now TDM runs over IP networks. We're moving to the point with the cost per bit of silicon for routing, where -- and this is a really important point, the cost per bit for routing is so low that you actually makes more sense to put optical on top of the routing. So I know it kind of makes your head explode, but being able to put that and we had a shipping today, being able to go and put wavelengths over IP is real, it's available, and we think that that's the future. From a cost perspective, it makes sense anywhere between 30% and 50% savings.

Got it. Maybe just last question for you. Subscription software has become a bigger part of Cisco, but there's room to go. And so just where are we on kind of more products being available by subscription, more EOAs like kind of where do you think Cisco is and where do you think customers are on kind of accepting that transition?

So it's a great question. So across the board, if you look at the traditional infrastructure business, when we first started migrating towards, hey, the majority of my engineers have always been software, even though -- even on the hardware side of the business, but we're not charging for the value of the soft that's being created. So we started having different conversations with our customers 6-plus years ago. We migrated the model where instead of saying we're going to charge you $2 out of every 100 for software. We're going to target to $40 out of every 100 for software. And about half of that is going to be renewable. You're going to have to -- it's term-based license. You have to renew it at 1, 2, 3, 5 years, whatever you decide to buy and after the first part. So that is happening. Back to the cloud conversation, we have, when you look at all of our unified cloud experiences, the potential for knowing that you have a platform is when other companies are building their software platforms on top of your software platform. We have over 200 software companies who are building their companies on top of our unified software cloud experience. This is across Meraki, Spaces and things of that nature. All of that is driving subscription. All of that is driving software. Of course, thousand eyes full stack with durability with AppD and of course, collaboration and security. All of those are critically important, but these new consumption models are important as well.

Got it. Well, with that, we're out of time. So Jonathan, thank you so much for being here today.

Thank you, Meta. Appreciate it.