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

Good morning, and thanks for joining us for Cisco's quarterly conference call covering the first quarter of fiscal year '24. I'm Sami Badri, and I've taken on the role of Cisco's new Head of Investor Relations. With me today are Chuck Robbins, who serves as our Chair and CEO, and Scott Herren, our CFO. Before coming to Cisco, I spent a decade covering the company on the sell-side, so joining the team is genuinely thrilling for me, and I'm eager to work with all of you in this new capacity. You should have received our earnings press release by now. Once this call concludes, a webcast with slides — which includes supplemental information — will be posted in the Investor Relations section of our website. A quick note: the way we report product and service revenue, along with customer markets, has been simplified. Beginning with this quarter, revenue is being reported across five categories: networking, security, collaboration, observability, and services. Customer markets, meanwhile, are being reported across three categories: enterprise, public sector, and service provider and cloud. Additionally, as we customarily do in Q1, certain reclassifications have been applied to prior period amounts so they conform to how the current period is presented. Income statements, complete GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements, and other financial information are all available in the Financial Information section of our Investor Relations website. During this call, we'll reference both GAAP and non-GAAP financial results. Product results will be discussed in terms of revenue, while geographic and customer results will be discussed in terms of product orders, unless otherwise noted. Every comparison we make today is on a year-over-year basis. What we discuss today includes forward-looking statements, among them the guidance we're giving for the second quarter and the full year of fiscal 2024. These are subject to risks and uncertainties described in detail in our documents filed with the SEC — in particular, the most recent report on forms 10-K, which identifies important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. Regarding guidance, please also refer to the slides and press release accompanying this call for further details. Unless Cisco makes an explicit public disclosure, we will not comment on our financial guidance during the quarter. I'll now hand things over to Chuck.

Thank you, Sami, and it's great to have you at Cisco. I trust everyone is doing well, and I appreciate your presence on this call. Fiscal 2024 got off to a strong beginning, marking the best first quarter in the company's history when it comes to both revenue and profitability. Revenue for Q1 landed at the top of the range we had guided. Earnings per share came in above the upper bound of our guidance, powered by robust gross margins and cost discipline, which produced significant operating leverage. Thanks to careful cost management and favorable effects from reshaping our business model, we achieved our best non-GAAP gross margin in more than 17 years along with a record non-GAAP operating margin; in Q1 we also gave back $2.8 billion through cash dividends and share buybacks, fulfilling the capital return promises we made to shareholders. As our business keeps shifting toward greater software and recurring revenue, driven by faster innovation, we stay dedicated to generating operating leverage and returns for shareholders. Now, on the demand side, following three quarters of remarkably robust product shipments, our customers have shifted their attention to installing and rolling out these unprecedented volumes of products. What was once a supply chain constraint has moved downstream, now resting on implementation by our customers and partners. Order lead times and backlog have mostly come back to typical levels. As shipments increased, the channel inventory we monitor at our distributors likewise fell steadily over this period. In short, customers are currently spending time to onboard and deploy these elevated product deliveries. Although the macroeconomic difficulties we've mentioned persist, we think this deployment stage is the main driver behind the decline in new orders; it showed up chiefly among our bigger enterprise, service provider, and cloud customers, and it was felt most acutely in October. According to our analysis, we view this stage as short-lived and estimate that roughly one to two additional quarters' worth of shipped orders are sitting with customers, yet to be deployed. This carries near-term implications for revenue and our guidance over the coming couple of quarters, which Scott will cover soon. That said, it doesn't alter our longer-term conviction; we anticipate product order growth rates will climb during the second half of the fiscal year. We also continue to feel highly confident about the fundamental strength of our business and the growth prospects ahead, given how essential our technologies are. On the whole, our win rates hold steady, cancellation and return rates are still under pre-pandemic figures, and we've picked up market share — all of which demonstrate the strength of our portfolio and how well it matches our customers' most urgent requirements. As we work to strengthen our capabilities in faster-growing segments, during the first quarter of fiscal '24, we revealed our plan to purchase Splunk. Bringing Cisco and Splunk together will form an end-to-end data platform that boosts our customers' digital resiliency through our complementary strengths in AI, security, and observability. Bringing Cisco and Splunk together also aligns squarely with what we're trying to accomplish strategically — pushing for stronger growth, deeper software offerings, and increased ARR. As one combined company, we'll offer trusted leadership in innovation, a very strong go-to-market operation, and a top-tier culture, all of which should help our customers reach their technology goals through inventive products and solutions. Now I'd like to talk about how we did this quarter. Like I said earlier, Q1 revenue came in strong, spread broadly across our product lineup and fueled by customer spending on generative AI, cloud, security, and full stack observability. Sure enough, when the calendar Q2 figures came out, we kept picking up share, posting yet another quarter of gains versus a year ago in three of our biggest networking markets: campus switching, wireless LAN, and SP routing. Over in webscale, AI momentum keeps building — three of the top four customers are deploying our hyperscale ethernet AI fabric. And we already can see a path to more than $1 billion in orders for AI infrastructure coming from major cloud providers during fiscal year '25. To push AI forward, we're collaborating with key GPU and storage partners on solutions that include ethernet technologies, GPU-enabled infrastructure, and reference architectures we've jointly tested and validated, with a commitment to open networking for AI. Taken together, we see a major opportunity for a wide range of innovations and compute GPU networking software and services supporting core and edge AI infrastructure. Per the 650 Group, the AI switching market should surpass $10 billion in 2027. Our scalable fabric for AI, combined with Cisco Silicon One's demonstrated power saving capabilities, leaves us well positioned to build out what AI clusters require, and we're intensely focused on coming out ahead here. Turning to Security, we're still delivering on our product roadmap and making our unified security platform stronger. Since our Cisco XDR solution launched this summer, we've built recovery into the response process, which lets security teams snapshot and restore business critical data the moment a ransomware attack appears. With our three new offers around XDR, Cisco Secure Access and Multicloud Defense, we now have more than $500 million in the pipeline spanning over 1,000 customers. We also rolled out our new Cisco security firewall solution during this quarter. We're competing actively in sales with all of these products and anticipate meaningful positive results in the quarters ahead; in our Collaboration portfolio, we just unveiled a set of genuinely game changing AI capabilities, covering the whole Webex suite plus new devices for reimagined workspaces at our WebexOne event. Before handing things to Scott, let me quickly recap three key takeaways. First, looking at where we stand today, the main demand problem is that customers need time to onboard and deploy heightened product deliveries. Although macroeconomic conditions did affect us, we view that as short-lived, since both our customers and partners keep saying our portfolio has never been in a better position, and we have kept gaining share in key markets. Next, our confidence in what lies ahead is strong, given the added AI infrastructure opportunity worth multiple billions of dollars, the growing importance of security and observability, and how exciting we find what Cisco and Splunk together can deliver for our customers. Finally, whatever the environment looks like, you can depend on us to stay disciplined. Our dedication to operating leverage, capital allocation, and expense management does not waver. I'll hand things over now to Scott, who will give you more detail on the quarter and our outlook.

Thanks, Chuck. Our Q1 performance was solid, and that came from the strategic steps we'd already put in place to ease supply chain pressures. During the quarter, we posted robust revenue growth along with a record non-GAAP operating margin. Revenue totaled $14.7 billion, an 8% increase versus a year ago, landing at the top of the range we had guided. Non-GAAP net income reached $4.5 billion, climbing 28%. Non-GAAP EPS came to $1.11, rising 29% and beating the upper end of our guidance. Digging further into Q1 revenue, product revenue overall was $11.1 billion, gaining 9%, while service revenue totaled $3.5 billion, rising 4%. Networking, which remains our biggest product category, fueled the gain with 10% growth. Inside networking, switching powered that growth, with campus and datacenter each rising by double digits thanks to demand for our Catalyst 9000 and Nexus 9000 offerings. A drop in wireless partly offset this. Security rose 4%, lifted by our Zero Trust plus threat intelligence, detection and response offerings. Collaboration grew 3%, helped by gains in Calling and Contact Center, partly offset by a decline in Meetings. Observability climbed 21%, powered by growth throughout the portfolio, which included double-digit increases in ThousandEyes and AppDynamics. We keep advancing our shift toward offerings built on more recurring revenue; ARR performed well at $24.5 billion, rising 5%, with product ARR up 10%. Software revenue overall was $4.4 billion, an increase of 13%, and software subscription revenue also rose 13%. Subscription-based software made up 85% of our software revenue. Subscription revenue overall grew 10%, reaching $6.5 billion, equal to 44% of Cisco's total revenue — a gain of 1 percentage point from a year earlier. RPO stood at $34.8 billion, up 12% versus a year ago. Product RPO grew 14% and service RPO grew 11%; altogether, short-term RPO rose 8% to $17.6 billion. Turning to product orders by geographic segment, compared with a year ago, product orders overall fell 20%, with the Americas down 19%, EMEA down 13% and APJC down 38%; among our customer markets, Service Provider & Cloud fell 38%, Enterprise fell 26%, and Public Sector rose slightly at 2%. Non-GAAP gross margin overall landed at 67.1%, up 410 basis points from a year ago and 110 basis points above the top end of our guidance. Product gross margin was 66.5%, up 550 basis points. That gain came mainly from productivity improvements, along with lower freight, logistics, and component costs. Favorable mix and positive pricing also added to the year-over-year improvement. Services non-GAAP gross margin was 69%, up slightly. Non-GAAP operating margin reached 36.6%, up 480 basis points and above the top end of our guidance. This stronger leverage came from both our robust non-GAAP gross margin and continued disciplined cost management. Moving to the balance sheet, we closed Q1 with total cash, cash equivalents, and investments of $23.5 billion. During the quarter, our operating cash flow came in at $2.4 billion, a 40% decline driven mainly by the $2.8 billion tax payment tied to earlier quarters, connected to IRS tax relief stemming from the California floods. In this quarter, we gave back $2.8 billion to shareholders, made up of $1.6 billion in quarterly cash dividends and $1.3 billion in share repurchases. In line with how we allocate capital, we're dedicated to boosting shareholder returns via stronger operating leverage, sustaining a larger volume of annual share repurchases, and raising our dividend. We keep investing both organically and inorganically in our innovation pipeline. In Q1, we revealed our plan to acquire Splunk, which should close by the end of the third quarter of calendar year 2024, pending regulatory approvals and customary closing conditions, including approval from Splunk shareholders. Also in Q1, we completed several acquisitions, each highly complementary to our internal R&D, consistent with our strategy of reinforcing our position in cloud, security, observability and AI through targeted strategic M&A. In summary, we turned in a solid quarter, marked by topline growth and greater operating leverage that produced stronger than anticipated earnings per share. We're still making headway in shifting our business model toward more recurring revenue. We stay committed to disciplined expense management while not losing sight of the strategic investments needed to innovate and seize growth opportunities. Now for our financial guidance: as Chuck explained, the bottleneck we used to see in the supply chain has moved downstream to implementation by our customers and partners. Most supply chain constraints are now behind us, and both shipment lead times and backlog have mostly come back to normal levels. Q1 product orders fell 20%, since our largest customers are working through elevated levels of product shipments from prior quarters as we fulfilled orders from our historically high backlog levels. As Chuck noted, we think there's one quarter to two quarters worth of shipped orders waiting for implementation by our customers. Our revenue guidance assumes one quarter to two quarters of lower revenue, followed by a return to more typical sequential growth rates. So for Q2, we expect revenue between $12.6 billion and $12.8 billion. We anticipate non-GAAP gross margin between 65% and 66%. Non-GAAP operating margin should land between 31.5% and 32.5%, and non-GAAP earnings per share should range from $0.82 to $0.84. For fiscal year 2024, our guidance is updated as follows. We expect revenue between $53.8 billion and $55 billion. Non-GAAP earnings per share should fall between $3.87 and $3.93. In both our Q2 and full year guidance, we assume a non-GAAP effective tax rate of 19%. I want to thank our teams for their focus and execution this quarter. Our confidence in the business's strength hasn't wavered, nor has our belief in our capacity to seize the major growth opportunities that lie ahead. At this point I'll hand things back over to Sami so that we can begin the Q&A.

Thanks, Scott. Michelle, let's go ahead and queue-up for questions. Tal, you there?

Yeah, my apologies. I had myself muted. You should be able to hear me now. What sort of assumption do you have regarding how growth will behave seasonally once the coming quarter wraps up? Do your assumptions have us returning to a typical seasonal pattern? Or are you anticipating a seasonality that differs from what we saw in earlier years?

Yeah, Tal, that's an excellent question. Like I mentioned in — well, we discussed somewhere between 1 quarter and 2 quarters of essentially inventory, meaning product that has shipped and sits with our customers, though installation hasn't happened yet. My expectation is that the biggest effect lands in Q2 as well as Q3. That said, if you examine order growth, what we observe is order growth coming back during the latter half of the year, on both a sequential basis and a year-on-year basis as we move through it.

So when it comes to recognizing revenue, my question was about the quarter-over-quarter pattern from 2Q into 3Q. Should we anticipate that 3Q will come in below the usual seasonal trend? Or should we expect it to match how prior seasons have gone? Or could it even rise on a sequential basis?

No, as far as revenue goes, Tal, we don't provide guidance on bookings, but where revenue is concerned, I do expect an increase from Q2 to Q3 on a sequential basis.

Tal, thanks.

Sami, over to you.

Tal, we appreciate it.

Michelle, let's take the next one.

Thanks a lot. Perhaps a question about whether the kinds of investments are shifting — maybe free — the orders you have observed, and when they might return a couple of quarters from now. I'm simply attempting to understand whether a lot of the orders we've witnessed during the last year were catch-up spending, such as campus and data center? And will the investment areas shift once things come back, or is this genuinely just inventory digestion, with the investment categories and the way customers prioritize investments staying unchanged? Thanks.

Yes, Meta, I appreciate the question. I believe your second point is likely nearest to reality. We aren't expecting much of a change. That said, given the gains we've made in our portfolio and security, we ought to see security speed up. Naturally, we'll keep bringing you up to date on the AI opportunity ahead. Our view is that it will remain a driver across the coming 2 years. But overall, once we move past this, I think things will appear more typical.

Meta Marshall speaking first, saying thanks.

Then Sami Badri thanked Meta and moved things along by inviting Michelle to pose the next question.

Amit Daryanani jumped in, thanking them for taking his question. He directed a point at Chuck, noting that people will likely have trouble grasping why he holds such strong belief that what's happening amounts to a temporary pause tied to implementation, rather than a broader softening driven by macro-level demand. So Amit said he'd really appreciate hearing anything Chuck could share on that, and what makes him so certain this reflects a one-to-two quarter implementation situation instead of companies' appetite weakening. He added that any insight along those lines would be useful, and then said he also wanted to get clarification on the spot. You mentioned a billion dollars of AI orders, which is double what was reported previously — is that right? Thanks.

Yeah. Amit, I appreciate it. So bear with me, and I'll walk through a handful of figures and some background on why we see this as an inventory matter resting with our customers. To start, across the past 90 days, both our customers and our sales teams have told us plainly that this is the problem — especially our big enterprises and our large service providers. We'd already discussed it regarding the service providers, but it moved into the enterprise segment substantially. Also, during our Partner Summit last week, several of our biggest partners brought up this exact topic on their own right at the start of conversations with me. Honestly, I already knew customers had raised it and that our sales teams had discussed it too, so hearing it was genuinely unexpected. The fact that it came up so repeatedly at that Partner Summit gives you a subjective sense of things. Beyond that, we ran some analysis, and I'd highlight three points. First, in some sections of our business, we're able to track how long it takes from when a product ships until it links up with the cloud — Meraki, for example. What we've found is a lag of one to two quarters compared with what used to happen historically after these products shipped, in terms of how quickly they'd be turned on and join the Meraki cloud. That's the first thing. Second, from an orders standpoint, we had a really robust quarter in federal — U.S. federal. So we dug into the reason a major customer such as the U.S. government, the Department of Defense, wouldn't face the same problem. So what's actually going on is they've got specific provisions written into their agreements granting them most-favored-nation treatment whenever shipment decisions get made, and especially when it comes to the Department of Defense, they're at the front of the line while the supply chain was in crisis. As a result, they never experienced a huge surge — instead products moved to them in a very consistent stream, which is why the numbers on their orders appear pretty typical. The third thing I'd mention is that Transactional Advanced Services — basically, implementation services — jumped considerably in Q1, rising almost 20%, and for Q2 we're projecting something in the neighborhood of double digits once again. So customers clearly want us to step in and help them get this completed. I'll offer one last anecdotal piece of evidence, and after that I'll get into the AI topic. A major partner told us they will have hired, quite literally, 200 people within the past 90 days, entirely dedicated to deploying technology for their clients. There are simply so many lessons we've picked up across those last 90 days. Obviously, this caught us off guard. Still, I'd say we feel quite good at this moment. Let me explain why I don't believe it's macro — honestly, it would have been simpler for me to label it macro. However, as we've said before, the traditional service provider space has been difficult, and it stays difficult. We've mentioned the stretched-out sales cycle, and that hasn't changed. We've mentioned how sometimes additional approvals are required, which is fairly typical, and that also hasn't changed. Even so, we saw no material deterioration during the quarter. So all of that — and apologies for the lengthy response, I just wanted to be complete — all of that genuinely pushed us toward this conclusion: that what we're facing is a consumption problem among our customers. I'll stop there, and then I'll address your AI question. What we provided previously was orders to date. We've booked orders exceeding $500 million. That's for infrastructure supporting AI networks, AI GPUs within the cloud players. And then — I'll expand on that a bit more shortly. The figures we shared today are forward-looking. Say, in fiscal year '25, which is when, as we stated, we expect the broad ethernet build-out to happen underneath GPUs. We have already observed — we can see a path to $1 billion plus in orders that our teams feel confident we will secure and/or where we're already designed in. So that's essentially a forward-looking order set we've pinpointed for fiscal '25, alright. I should also note that ethernet fabric is now deployed underneath GPUs at three out of the four major U.S. Hyperscalers. On top of that, we're working very closely alongside AMD, Intel and NVIDIA on solutions, and that includes reference architectures we jointly test and validate for GPU-enabled infrastructure built on ethernet technology. And just this week — actually yesterday — Jensen from NVIDIA stopped by along with four of his executives — four or five of them — and they spent 90 minutes with my executive team and me. We think there's a major chance to create integrated offerings that combine what our technology does with what theirs does, and then bring those to enterprise customers. As a result, we're starting to observe enterprise use cases changing, and in that situation, we feel teaming up with NVIDIA—pairing our foundational tech with our strong route to market—will prove to be a successful mix. That's another thing we're actively developing, so plenty is happening right now in the AI area.

Okay, thanks, Amit. Michelle, let's take the next question.

Thanks for asking. I'd like to know if you might be open to breaking down the networking segment a bit, specifically around the trends. What I'm really after is understanding what's performing better, what's performing worse, and my hunch is datacenter helped us quite a bit while campus may be somewhat softer and declining. And hopefully as you move to the new segmentation, you could give us a bit more detail within networking? Thank you.

Hey, Simon, thanks for that. The larger variance we're seeing — I mean, at this moment, clearly the demand signal is somewhat difficult given how much inventory is sitting out in the field and the fact that we've normalized lead times now; we expected that to occur at some point in the first half. It has now occurred. Our lead times have returned to where they stood pre-pandemic; and our backlog has shipped. The supply chain team has done a fantastic job getting product out the door. That's essentially what shifted the bottleneck from our level down to our customers' level. But as you begin to unpack within networking, we aren't seeing at this point a massive difference between, say, datacenter or campus networking. What we are seeing, though, is somewhat more field-based inventory on wireless access points. That's been a little slower than what we've observed. It's simply due to how much product has been shipped out compared with what we've seen in the rest of the networking.

Simon Leopold here, thanks a lot.

Sami Badri speaking, okay, thanks Simon.

Chuck Robbins responding, yes, appreciate it, Simon.

Okay. Michelle, let's take the next one.

Hi, thank you. Good afternoon to everybody. My question is about the pace at which you're repurchasing shares. The stock clearly might take a hit here; we've been discussing roughly $5 billion of buybacks for this year. I realize a portion of that halts dilution. If you're confident about a pickup in the second half, could you potentially be more aggressive next quarter? And given the current dynamics with the Splunk deal coming, how are you viewing share repo this year? Thanks.

Yes, Ben, as we stated regarding the Splunk transaction, it will sit outside of transactional costs. From the first year onward, it will be cash flow positive. So the Splunk deal is not, in any way, affecting our capital return, whether via the dividend or via — via share buybacks. We expect to keep up that elevated and consistently elevated pace of share buybacks, and to keep delivering increases in our dividend. We also will, obviously, examine the opportunity — the chance to act opportunistically on the share buyback. I won't make a commitment to that right now, but that's something we will obviously take a look at.

Okay, thanks, Ben.

Thanks.