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

Hello, everyone, and thanks for joining us for Cisco's conference call about earnings for the third quarter of fiscal 2023. I'm Marilyn Mora, and I lead Investor Relations. With me are Chuck Robbins, who serves as our Chair and CEO, and Scott Herren, our CFO. You ought to have already received our press release on earnings by this point. A webcast to match it, complete with slides and supplemental material, is going to be posted in the Investor Relations area of our site once this call ends. You can locate income statements, complete reconciliation data between GAAP and non-GAAP, the balance sheet, cash flow statements, plus additional financial details in the Financial Information portion of the Investor Relations website. During this call, we'll refer to financial results under both GAAP and non-GAAP, and unless we say otherwise, we'll talk about product results as revenue while geographic and customer results will be discussed as product orders. Every comparison we make today is on a year-over-year basis. What we discuss today will include forward-looking statements, among them the guidance we're giving for the fourth quarter and for the entire fiscal 2023 year. Those statements carry risks and uncertainties, which we describe at length in documents we've filed with the SEC — in particular, the latest reports on Forms 10-K and 10-Q, where significant risk factors are identified that might lead actual results to diverge materially from what those forward-looking statements suggest. Regarding guidance, please also look at the slides and the press release accompanying this call for more information. Cisco won't address its financial guidance at any point during the quarter unless that happens via an explicit public disclosure. I'll hand things over to Chuck now.

Thanks, Marilyn — good to be with everyone, and I hope you're all doing well. We put up another solid quarter, and I'm extremely proud of the work our teams have delivered. During Q3, we hit all-time highs for revenue, non-GAAP income, non-GAAP EPS, and operating cash flow. On top of that, we kept executing well against our strategy, generating healthy ARR growth that reached close to $24 billion while subscription and software revenues grew at a double-digit clip. Given how well Q3 went, we're lifting our fiscal 2023 guidance for both revenue and earnings per share once again — Scott will walk through those details in a few minutes. Turning to fiscal year 2024, we anticipate modest top-line growth, despite a difficult comparison against the double-digit expansion we saw in fiscal year 2023. Before I walk through Q3 results, though, I want to cover three important areas that should fuel our growth over the long term. Number one: we're happy with how our shift toward subscriptions and recurring revenue keeps paying off; software revenues rose 18% in Q3, and we're carrying $32 billion in remaining performance obligations. We anticipate that this momentum will pick up speed. Number two: security remains a massive opportunity for us. As I've said before, we've overhauled our approach, brought in a top-tier team, and elevated this to a company-wide priority. In the quarters ahead, you'll see fresh innovations here that build on our strong Cisco Security Cloud strategy — including at Cisco Live next month. Given how quickly we're progressing, we feel good about what's ahead of us in this rapidly expanding market. Number three: generative AI and cloud. Here at Cisco, predictive AI is already deeply embedded throughout our portfolio; beyond that, our foundational networking technology already supports several of the leading AI models operated by hyperscalers globally. We've also moved fast to bring generative AI capabilities into our own offerings, and you'll learn more about that over the next few weeks and beyond, beginning at Cisco Live. Now, let me turn to our quarterly performance. As I said, in Q3 we posted our highest quarterly revenue and non-GAAP earnings per share ever, coming in above the top end of our guidance range. Margins were healthy, and non-GAAP net income set a new record, which speaks to our strong operating discipline. Together, these drove record operating cash flow in Q3. As anticipated, the steps we took to ease supply constraints kept delivering results. Pricing gains from the measures we implemented last year helped counter inflationary pressure. Our tight cost management let us keep expanding gross margins while still prioritizing the strategic investments that fuel long-term growth. When it comes to customer demand, several forces are shaping it — forces we think are affecting the whole industry. First, because we're shipping more product, customers and partners frequently need to absorb those shipments before they put in new orders. Next, because product lead times have dropped significantly, there's much less of a reason for our customers to place large advance orders. And then there's the macroeconomic picture. That said, when we talk with customers — including the conversations we had earlier this month at our most recent Global Customer Advisory Board event — they're still putting money into the key technologies that sit at the heart of their strategies. As we've said before, since demand for our technology during the pandemic was unprecedented, we think sequential order rates tell us far more than year-over-year rates do. As in the previous two quarters, our sequentials in Q3 were broadly in line with historical ranges, landing one point below the historical range. On top of that, order cancellation rates are still significantly under historical levels, which shows how strong our backlog and portfolio are. On the backlog side, we still anticipate finishing the fiscal year with product backlog at roughly twice what we normally carry. Let me go a little deeper on a few of our newest innovations. When it comes to our web scale customers, they're in the middle of consuming and deploying the major technology investments they made previously. A tremendous growth opportunity still exists across every one of these customers, made possible by our hardware, software, silicon, and systems portfolio; we're already seeing early design wins in AI infrastructure, and we keep seeing additional wins and competitive displacements, which drives continued share gain in this space. Within our networking business, our focus stays on creating solutions that deliver a better return on investment and greater sustainability. Back in March, we brought 800G capability to our Cisco 8000 platform, using the industry's first 28.8 terabit line card, powered by Cisco Silicon One ASICs and pluggable optics. Compared with 400G solutions, this new platform can provide as much as 68% power savings and 83% space savings, which helps lower operational costs and carbon emissions, while also allowing networks to densify in support of use cases like AI ML and IoT. Customer feedback on this keeps being positive, and we're excited about the opportunity. To round out our own innovations, during Q3 we completed the acquisition of Valtix, which fits our security cloud vision of delivering protection across multi-cloud environments with a seamless experience. We also announced that we intend to acquire two companies, which will further expand our capabilities in cloud, security, and full-stack observability. Before I wrap up, I want to say once more how enormously proud I am that, for the third year running, we were ranked number one in the U.S; on Fortune Magazine's 100 Best Companies to Work For. In 14 other countries around the world, we were also named the number one great place to work, which speaks to Cisco's standing as a premier destination for top talent worldwide. To sum up, our record results showed our ability to navigate uncertainty. Our performance is still solid and demonstrates the strength of our strategy along with the benefits of the investments we've made over the last several years. Tight operations and top-notch execution are fueling all-time-high profits, cash generation, and value returned to shareholders. Looking ahead to Q4 and fiscal year 2024, I want to offer a handful of thoughts. As I said before, at this point we anticipate a slight uptick in revenue for fiscal year 2024, building on the robust results we delivered in fiscal year 2023. You should also expect us to expand earnings per share faster than revenue in Q4 fiscal year 2023 and the entirety of fiscal year 2024, which mirrors better gross margins and disciplined cost control. Finally, we anticipate keeping up share repurchases at the elevated pace witnessed across the past two quarters. My thanks go out to our teams for their dedication and delivery, plus our customers and partners for the confidence they've shown in us. With cloud, AI, and security continuing to grow, Cisco's deep-rooted leadership in networking along with the scope of what we offer leaves me confident in our capacity to seize the many chances that lie ahead. I'll hand things over now to Scott.

Thanks, Chuck. We turned in a record-setting quarter, one that came in above what we had projected on both the top line and the bottom line. That performance came from disciplined execution, ongoing transformation of the business, and the steps we've taken across the past several quarters to lessen supply constraints. For the quarter, we posted our highest ever figures for revenue, non-GAAP income, non-GAAP earnings per share, and operating cash flow. Revenue totaled $14.6 billion, which is 14% higher than a year earlier. Non-GAAP net income came to $4.1 billion, while non-GAAP earnings per share reached $1, a 15% increase. Digging deeper into Q3 revenue, product revenue overall was $11.1 billion, rising 17%, and service revenue came in at $3.5 billion, rising 3%. Inside product revenue, Secure, Agile Networks — our biggest business — performed very well, climbing 29%. Switching revenue posted strong double-digit growth, with both campus and data center switching contributing, thanks to our Catalyst 9000, Meraki, and Nexus 9000 offerings. Growth in enterprise routing came mostly from our Catalyst 8000 series routers, SD-WAN, and IoT routing. Wireless likewise saw very strong double-digit growth, fueled by our Wi-Fi 6 products and Meraki wireless offerings. Internet for the Future rose 5%, lifted by growth in our core routing products, among them very strong growth for our Cisco 8000 offering; web scale also grew by double digits. Collaboration fell 13%, pulled down by declines in Collaboration devices and meetings, though growth in calling and contact center partly offset that. End-to-end security rose 2%, lifted by our unified threat management and zero trust offerings. Optimized Application Experiences rose 12%, lifted by growth throughout the portfolio, among it double-digit growth for ThousandEyes; we keep making headway on our transformation metrics as we move the business toward offerings built more on recurring revenue, powered by greater amounts of software and subscriptions. Our ARR of $23.8 billion put in a solid showing, rising 6%, with product ARR growth of 10%. Software revenue overall was $4.3 billion, an 18% increase, while software subscription revenue rose 17%. Subscription-based software made up 82% of software revenues. Our product backlog still holds an elevated level of software orders. Subscription revenue overall was $6.1 billion, an 11% increase. RPO stood at $32.1 billion, up 6%, as product RPO rose 9% and service RPO rose 4%. Short-term RPO overall climbed to $16.9 billion. Product orders overall fell 23%, because of the three factors Chuck mentioned earlier. The aging of our backlog has gotten much better, and cancellation rates remain very low, which speaks to the quality of orders we've booked previously and how essential our product portfolio is. Non-GAAP gross margin overall landed at 65.2%, above the top of our guidance range and 10 basis points lower than a year earlier. Product gross margin was 64.5%, 240 basis points higher sequentially and 40 basis points higher than a year earlier. That year-over-year gain came mainly from positive pricing and a favorable product mix. Higher component and other costs partly offset it. Services gross margin was 67.3%, 160 basis points lower than a year earlier. Our non-GAAP operating margin landed at 33.9%, which was the top end of the guidance range we provided — that's a decline of 80 basis points compared to the same period last year, and an increase of 140 basis points from the prior quarter. When it comes to backlog, both our hardware and software offerings are still well above where they've historically been. Thanks to supply conditions getting better along with our disciplined approach, we managed to speed up deliveries against older backlog to satisfy what customers needed, and that brought backlog numbers down on both a sequential and year-over-year basis. Our expectation remains that we'll finish the year with product backlog at approximately two times the typical level. As a quick note, backlog doesn't get counted within the $32 billion figure for our remaining performance obligations. Together, the substantial product backlog and RPO give us excellent line of sight into our top line as fiscal year 2024 gets closer. Moving over to the balance sheet — we closed out Q3 with $23.3 billion in total cash equivalents and investments. Operating cash flow for the quarter hit a record $5.2 billion, which is a 43% increase year-over-year, mostly because of robust collections and the fact that our Q3 federal tax payment got deferred thanks to IRS tax relief tied to the California floods from earlier this year. That deferral of the federal tax payment contributed roughly 20 points of positive growth year-over-year to Q3 operating cash flow; this latest IRS relief pushed back the deadlines for our remaining current year federal income tax payments into Q1 of fiscal 2024. Consistent with our disciplined approach to capital allocation and our dedication to returning capital, we gave back $2.9 billion to shareholders over the quarter — that breaks down as $1.6 billion in quarterly cash dividends plus $1.3 billion in share repurchases. At quarter's end, we had $12.2 billion left in stock purchase authorization. So far this year, we've returned $7.7 billion in total through cash dividends and share repurchases. That underscores how confident we are in the strength and steadiness of our ongoing cash flows. We keep investing both organically and inorganically in our innovation pipeline. In Q3, we announced and completed our acquisition of Valtix, which makes our security portfolio even stronger; this move aligns with our approach of pairing internal R&D innovation with targeted strategic M&A. To wrap up, it was a solid quarter with record top-line growth, non-GAAP profitability, and cash flow; we're continuing to advance our business model shift toward more recurring revenue while making strategic innovation investments to take advantage of our major growth opportunities. Now let's move to guidance. For fiscal Q4, we're guiding to revenue growth in the range of 14%-16%. We expect non-GAAP gross margin in the range of 64.5%-65.5%. Non-GAAP operating margin should come in between 34%-35%. Non-GAAP earnings per share is projected to be in the range of $1.05-$1.07. As Chuck noted, we're once again increasing our fiscal year guidance for fiscal 2023, as follows. We're expecting revenue growth in the range of 10%-10.5% year-on-year. Non-GAAP earnings per share should land between $3.80-$3.82. For both the fourth quarter and the entire year, our guidance assumes a 19% non-GAAP effective tax rate. The ranges we've provided for guidance show considerable visibility, which comes from a solid backlog, ARR, RPO, and better supply availability. As Chuck said before, at this point we anticipate modest revenue growth in fiscal 2024, building on what was a strong fiscal 2023 for us. You should also expect earnings per share to grow faster than revenue in Q4 and across fiscal 2024, which reflects gross margins that are improving along with disciplined expense management. Finally, we anticipate keeping up stock buybacks at that elevated pace witnessed during the past two quarters. I'll hand things back to Marilyn now so we can begin the Q&A.

Thanks, Scott. Michelle, let's go ahead and tee up the queue for questions.

Hello, and thank you for taking my question. Perhaps I could begin by asking for some clarity regarding orders. Chuck, I believe I heard you mention that orders came in 1 point under seasonal norms on a sequential basis, but could you confirm whether they rose or fell when compared quarter over quarter? I'm not certain whether you provided a year-over-year figure, though perhaps more broadly, when considering your guidance for the coming year, what assumption regarding orders is baked into that? I have one more question after this. Thanks.

Thank you, Samik. As I mentioned during my opening remarks, three elements are truly impacting demand. To begin with, since we are delivering more from our backlog, our customers are working through what they had previously purchased. Next, because our lead times are shrinking — and on a weighted basis those lead times have dropped 40% across the past two quarters — customers no longer really need to place orders far ahead of time the way they previously did. And then, obviously, there are the macroeconomic conditions. Regarding sequentials, as I've stated, the year-over-year figures are simply too difficult to predict, so what we've said is that the key signal we watch to determine whether momentum in the business is shifting comes down to whether sequentials stay in line. Just as I noted during the prior two quarters, and again this quarter, the sequentials we're seeing sit at or a bit under the bottom of our historical ranges. I wouldn't describe it as robust, yet it remains inside the range or marginally beneath it. Looking ahead to Q4, we in fact anticipate sequentials matching what history has shown us. Based on what's visible to us today, our perspective is that we can still achieve positive growth in fiscal year 2024, even following the strong growth year we just had. Let me add one more thing. Rewinding to September of 2021, when our analyst conference took place, we set out long-term top line growth of 5%-7% alongside long-term EPS growth of 5%-7%. By the close of fiscal 2024, according to what we see today, we will land within that range on a CAGR basis from a revenue standpoint, and we will sit above that range from an EPS standpoint across that same stretch of time.

Okay, understood. All right. For my follow-up, I think I wanted to kind of address that cost discipline you mentioned and EPS increasing at a quicker pace than revenue. Is that kind of a shift in philosophy from the analyst day, since I think at the analyst day, you were discussing kind of constrained operating leverage and earnings rising more in line with revenue? It appears that beyond the gross margin, you're considering being somewhat more rigorous and reducing expenses somewhat, maybe confirm if that's kind of how we should be reading that? Thank you.

Yeah, Samik, over the past two years, we've in fact expanded EPS at a quicker rate than revenue. As we look toward Q4 and past that, it's fairly evident that given the gross margin growth and given our cost management that we're putting into place, we can continue to support the investment areas we must support while actually producing greater EPS growth rates than revenue, which is what many of our investors have requested. We think that's very achievable for us to accomplish at this point. Scott, do you have any thoughts on that?

No, I believe you've hit the main ones; we've kept putting money into growth, yet also, as you've witnessed over the past two years, you've watched us pull this off, expanding the bottom line more quickly than the top line in fiscal 2022 and at the midpoint of our guide for fiscal 2023. Looking forward, you know, it's a, it's a moment to be cautious; we see that occurring once more in fiscal 2024.

Yeah. Thank you.

Mm-hmm.

Thanks. Let's take the next question.

Appreciate you taking my question. Early in May, Cisco rolled out something called the Capital Business Acceleration Program, which sits within Cisco Capital — we haven't discussed this much on recent calls. What I'm hoping for is a bit more clarity on the strategy behind it, the thinking, and why this program was put in place. Thank you.

Appreciate that, Simon. What you're pointing to is a move we've made before. Really it just comes down to rates climbing to 5%, buyers who need access to technology so they can keep pushing their own plans forward, and us simply deploying our balance sheet a little more. There's nothing more to it than that.

No real effect on your financial model, I assume, then?

Nope. Neither from a profitability standpoint, nor regarding the effect it will have over the long term.

Great. Thank you very much.

Mm-hmm. Thanks.

Appreciate that, Simon. Let's take the next question.

Excellent. Thank you all for fielding this. This might lean more qualitative, and perhaps it builds on what Simon raised — could you share a bit more detail about conditions you observed, say, during March and then into April, and what the current macro picture looks like from where you sit? Based on what we hear from partners and others across the industry, it certainly seems March came in somewhat weaker than expected, and April brought no pickup. I'd really value your take on that. Let me squeeze in my follow-up as well. If I roughly apply what you said regarding the three-year plan, it would seem to suggest revenue growth in the coming year somewhere around 2%-3%, with EPS near 5%. Is that roughly the message you're conveying, on a rough calculation basis, for next year considering the macro headwinds? Thanks.

Apologies, David, but would you mind going over the latter portion again — those figures you mentioned? I missed hearing them.

Right, so if I just run a quick rough calculation on that 5%-7% target for three years, what that suggests is revenue growth in the coming year somewhere around 2%-3%, and EPS perhaps in the 5%-6% range. Is that roughly the message you're putting out, just so we can get a feel for your thinking on the macro? Thanks.

Okay, David. Appreciate the questions. Let me address the linearity we experienced during the quarter; from where we sat, it was actually quite favorable on the orders front. Although it's obvious we're sitting at the bottom edge of historical ranges when looked at sequentially, we didn't witness any worsening as the quarter progressed from start to finish. Honestly, our linearity came in a bit stronger than what's typical for us. April landed roughly where we'd expected, perhaps even marginally above the first two months. That specific result didn't materialize. Once again, you know, the thing we're watching for is a shift in the momentum underneath. I'm not claiming momentum is strong. I'm merely saying a shift is what we want to see, and the surest way to confirm that is to genuinely determine whether the sequentials keep unfolding as they should. Right now, we observe them unfolding quite steadily and kind of at the bottom edge of the range or just under it. Scott, would you like to handle the FY 2024 figure?

Right, absolutely. Regarding that calculation you're working through, David, my sense is you're roughly correct. Obviously, what I would say is I don't want to be overly specific about fiscal 2024 at this point, given that this is only our Q3 call. Keep in mind that represents growth in fiscal 2024 on top of the midpoint of our fiscal 2023 guidance, which was 10.2% growth for fiscal 2023. The most recent occasion we achieved double-digit revenue growth across an entire year was 2012, during the recovery from the global financial crisis. This year is quite strong, and we anticipate a modest amount of growth layered on top of it.

Great. Helpful, guys. Thanks a lot.

Thank you.

Excellent. Appreciate it, David. Let's take the next one.

Hey there, everyone. Thanks a lot. So I suppose what I'd like to explore with you is the growth expectation for this year. What I'm wondering about is your perspective on how much of that growth is attributable to price, and how much is attributable to backlog consumption. What would you say are the more significant factors behind that growth this year? Thanks.

Sure, I suppose the place I'd begin is that the most significant factor behind the growth for this year is the enormous quantity of demand from our customers that has been sitting in backlog while we've been working our way through some of the supply issues. If you're asking what's behind the growth, that's it. It's demand from end users. When you begin to peel back to the mechanics of how that came together, much of it is our capacity to, on the basis of a great deal of hard work, really, from the engineering team as well as the supply chain team, unblock some of the component supply problems that we've been dealing with. That has enabled us to work through a portion of the backlog; we haven't finished. Supply constraints remain. We believe we finish the year, exactly as we told you last quarter, we finish the year with approximately twice what our typical backlog would be, but we've made significant progress on that front. Price has been favorable for us. As we mentioned earlier, as we work our way through the backlog, a greater number of the orders we took prior to those pricing moves we made last year have now been delivered. We are seeing it. When we publish our Q, you'll see this, roughly a point of benefit from price.

Great. Thank you very much.

Mm-hmm.

Let's go ahead and move to the next question, Michelle.

Okay, thank you. I wanted to ask whether you might describe the patterns you are observing among enterprise commercial service providers. You mentioned that some digestion is occurring on the web scale side, but I hoped to gain a sense of whether different trends are showing up across those categories of customers. Then, perhaps as a second question, it is clear that your customers have been pursuing cloud optimization work and considering architectures for the long term. Are there any shifts you can identify among customers in terms of the results, or in the ways Cisco could assist customers more effectively along that path? Thank you.

Okay, thanks, Meta. Regarding how each segment is behaving — consider the three elements I mentioned earlier. First, buyers must work through the inventory we've been delivering to them. Second, now that our delivery windows have shortened dramatically, there's no need for them to place orders so far ahead of time. When you look at which buyers enjoy the clearest visibility and have placed the most orders in advance, those tend to be big enterprises along with service providers and web-scale players. Looking at it by segment, the main problem we're encountering among service providers — and incidentally, 41% of the total year-over-year drop stemmed from SP routing, a category representing under 20% of our total revenue — is that this area punched above its weight in driving our overall year-over-year decrease. On the enterprise side, I'd note that big enterprises face the very same challenges and are responding the same way. They're working through the gear they bought, and they don't have to book orders so far out. We're also observing what you've been hearing from other companies: sales cycles have stretched out. We're seeing more approvals needed, you know. Broadly speaking, we do obtain those approvals, but they're coming through a bit more slowly. Turning to technology trends and where our buyers are placing emphasis — the encouraging part for us is that essentially every buyer worldwide has five main priorities that happen to line up with what we offer. First, they're redesigning their architecture for a multi-cloud environment. They're working out how to handle hybrid work. They're overhauling their whole application approach and redesigning those applications. They're reconstructing their cybersecurity presence given how distributed everything they do has become, and they're concentrating on sustainability. Our technology applies across each of those crucial areas, and we're putting in tremendous effort with every one of our buyers in each of those domains. Then there's the last item I believe is top of mind for everyone: artificial intelligence, or generative AI. Within the web-scale arena, across the coming 5 years, the total market opportunity for AI infrastructure is projected to reach $8.5 billion by 2027, expanding at roughly 40% CAGR from its prior level. As I mentioned during my opening remarks, we're already deployed as the networking infrastructure behind several of these early AI models that web scalers are operating. Think back to where we stood when the web-scale build out began 10 years ago — I've noted on these calls repeatedly that we weren't ready and ended up left out. This time around, when it comes to this AI infrastructure from a networking standpoint, my belief is that we're positioned better than anyone else. Our teams have done excellent work bringing us to this point, and we view it as an enormous opportunity.