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

Perfect. Why don't we go ahead and get started. I'm Aaron Rakers. I'm the IT hardware and semiconductor analyst for Wells Fargo. Extremely excited to have Mark Patterson here, the CFO of Cisco, company fresh off of results last week, a very good solid print. So first of all, Mark, thanks for joining us, it's really great.

Thanks, Aaron. I'm here with you and meet you in-person.

Yes, definitely, definitely better than the Zoom video, I think last week, I was in an airplane trying to do my call back with you guys. So...

Webex video, whatever.

I'm sorry. But Mark, again, I appreciate it. Maybe we'll start by just to level set. When we -- Cisco is a big company. That's clear. Broad-based portfolio. But how do you think about the biggest growth drivers for Cisco as we look out over the next 12, 24 months? And maybe we'll just double-click from there on some of those key themes that we're talking about.

Yes. So first off, I would just start with our recent quarter that we announced earnings, really strong earnings. But if you look at our order growth, if you look at it across geographies, across customer markets, if you look at technologies, everything grew. Really good balance, really good strength. So very broad-based. I would say you and I were chatting a little bit ago and I just started my 26th year with Cisco. And I would say that right now, we've probably got more opportunity ahead of us than I can remember in a long, long time, if not ever, to be honest. So I think the big things for us right now are AI networking and AI infrastructure starting up at hyperscale, going down into neoclouds, including sovereign and into the enterprise AI opportunity as well. This big campus refresh opportunity that we spent some time talking about with our earnings call and callbacks, et cetera, is really starting to happen for us now. And then cybersecurity, if you go back -- it was just about, I guess, it's been 20 months ago now that we closed the acquisition of Splunk. And so I think we really filled out that portfolio and see that as a big growth driver for us moving into the future.

Yes. That's great. So I'll start, right, where you started, AI. Let's talk about maybe, again, remind us of what you guys have done, $1.5 billion. I think we talked about $3 billion last week on the call, very strong order growth if my memory is right, $1.3 billion. But walk us through some of those numbers. And I think what I'm most interested in is to maybe appreciate how that's evolved, right? How it's deep and how it's maybe broadened and maybe touch on that from a perspective of the web scalers, right, but also what we're starting to see in maybe enterprise and sovereign as well as far as opportunities for Cisco?

Yes, sure. So I think how it's evolved is really key because if you go back 18 months ago, I think that folks really were not -- they were not sure what Cisco's role in AI. And as you go back to the beginning of our last fiscal year, we put a target out there of $1 billion that we said we'd take in orders. And I think the reason why we really did that was twofold. One is to really just show the criticality of the technology that we sell to the hyperscalers and building of the training models, et cetera. But the second was also just to show the magnitude and the size of the opportunity. Fast forward to the end of the fiscal year, we did just over double that target. So really good strength as we exited FY '25. I think this quarter may be an inflection point for us though. So we had a really strong start to this fiscal year, $1.3 billion, as you said, in terms of new orders that we receive just the top hyperscalers, so this doesn't include sovereign or the neocloud opportunities. $1.3 billion we said we would do by the end of the year, we gave 2 targets. We said order-wise, we would anticipate to do at least double what we did a year ago. So I think $4 billion plus anyway. And then we gave a revenue target too, because there were also a lot of questions last year about, okay, it's great you got these orders, but when they're cancelable, when they're going to turn into revenue? And so we recognized $1 million in revenue last fiscal. This year, we said we do over $3 billion. So I think, again, a lot of momentum as you dig underneath that, we can certainly talk more about kind of where some of the strength in, but we're really seeing good strength across each one of the web scalers at this point as well.

And I always -- the question always comes up. I mean you guys -- first, to just make sure the definitions everybody understands. It's back end, just web scalers is that number, right? To your point, it doesn't include enterprise. It doesn't include sovereign, but it also doesn't include any front-end opportunity that you might see?

Yes. And what the big differentiator is each one of the hyperscalers has marked it as an AI use case specifically for us. It starts to get a little bit blurry between back and front and connecting them back to the front, et cetera, but we really just follow exactly what our customers are telling us.

And then the other vector within that is optics systems within systems, Silicon only relative to full-on systems. Can you help maybe us appreciate those mix dynamics?

Yes. So we started with a lot higher concentration of optics versus the systems. We kind of finished the year -- our last fiscal year at a higher concentration of systems versus optics. I think you're going to see that ebb and flow a little bit. The first quarter that we did, the $1.3 billion of new orders is basically half and half between the 2. We've got a very compelling optics portfolio as well as all of the systems that we're selling them are Silicon One based. I think the big thing, too, that is really an important data point on sort of where we are with the web scalers is. What you do is you work with them to get designed in and into some use case, if you will, whether it's top of rack, leaf, spine, et cetera. And we said at our Investor Day, we had like 10 design wins in total about 1.5 years ago. But we continue to have a lot of success with the web scalers. The number is growing overall. But if you dig into that $1.3 billion of new orders that we got in Q1, you'll see that there were actually 4 different web scalers that showed more than 100% growth when you look at those Q1 orders versus a year ago. And the fact is also we had 4 different design wins in the quarter, which will pay off in the coming quarters and years. And those 4 were across 4 different web scalers. So it's not surprising. I think that as you get in, you start to have success, you get more roles, you get more opportunities -- and we're seeing that across the broader portfolio as well. It's not just the AI infrastructure piece. If you just look at in totality, what we're selling the web scalers. We had 2 web scalers that purchased over $1 billion a piece last year. And that's the whole portfolio, if you will, cloud space as well as infrastructure.

And then I think in the past, you've talked about -- you've had 5 wins at 6 of the top -- the 6 top web scalers, right? You just mentioned 4 new ones at 4. But overall, -- that's correct, right? It's 5 out of the top 6?

Yes. We did. But just to point out, so we do business with all 6 in terms of the total portfolio, but we've talked about 5 in terms of the AI infrastructure and systems space.

And how would you characterize in the switching piece of this, appreciating it ebbs and flows, Acacia comes in, optics are strong and vice versa. But the depth of your engagement in the networks, meaning I think in the past, when I've spoken with Sami and stuff, it's been more maybe top of rack. Has that gone deeper. Any color on that?

Yes. We haven't given the specifics of all the rules, but I would say it continues to evolve and the relationships are continuing to improve. More roles are coming online. We've got products that will address both the scale out and scale across technologies now. You've seen some announcements here recently on our P200 based systems that will be available in the spring, and the optics portfolio, obviously, the long-range coherent pluggables that we have. So I'd say a lot of momentum and sort of the role that we're playing is growing in importance and scale.

Yes. Maybe I'll -- well, before I go there, you mentioned scale out, scale across. What is Cisco's role in scale up? What is their view on that?

We -- so if you notice in our investor slides that Sami so nicely put together for us, you'll see kind of a road map, if you will of Silicon One, and there's 5 product families now actually across the scale-out as well as scale across and then there's 3 different enterprise/service provider product families that we're rolling out across our entire portfolio. But scale up, we basically just said, look, we're going to be a part of that. We've not said a lot publicly yet. So I'd just say stay tuned on that front.

Yes. And part of that is the standardization the ecosystem evolving if it's [indiscernible] or some of the other things, okay. Shifting -- keeping with AI, but maybe shifting to the other piece, the enterprise and sovereign piece. Cisco has been involved, again, in your orders, right? It doesn't include HUMAIN, G42. What are you seeing in sovereign? And then -- after that, I'll ask you the same question on enterprise.

So we just talked through a lot of stats around hyperscale. And we've got material numbers that we're talking about there. So we wanted to kind of bucket that, if you will on its own. The other area that is much more nascent, but growing, as you mentioned, it's kind of neocloud, including sovereign as well as the enterprise AI piece of it. And so we gave 2 data points. And just for now, kind of collecting all 3 of those in sort of 1 bucket, if you will. Pipeline is over $2 billion now. So really ramping there and the orders are starting to ramp as well, a couple of hundred million dollars in orders that we've taken collectively across that space. But what we said is HUMAIN and G42 and some of the sovereign builds, in fact, we just had an announcement out today with our investment in HUMAIN and the build-out that's going to begin there. We just -- what we said was, look, it's not really material to our guide this year. You'll see some ordering really start in the second half of this year, but I think the more material build outs, if you will begin in FY '27.

Okay. One of the things that I thought is interesting and very unique to the Cisco story around AI is the relationship with NVIDIA. And that's deepening I think, and you're going to correct me if I'm wrong, it has a lot to do with the enterprise adoption, this idea of bringing agenetic AI into enterprises, the network piece of the equation. Today, it's been complex. So can we talk about the NVIDIA relationship, how that differentiates Cisco? When do you maybe see that becoming an incremental driver to the story?

Yes. I think the partnership with NVIDIA is all about trying to make it as simple as possible for enterprises to deploy AI and to really accelerate that opportunity. And so you've seen 2 products from us there's a switch that we built based on Silicon One that is part of the reference architecture of Spectrum-X, and that is now available. There's also another switch that we just announced this past quarter that is going to be Spectrum-X silicon and have our software and we'll build the system. And that will be available in the spring. So again, I think well received by customers, working very well with NVIDIA, probably start to see things ramp kind of in the back half of this year. And then I think FY '27 would be a much larger opportunity for us.

Maybe shifting over to another big topic because you brought up at the beginning of the conversation, the campus upgrade opportunity, right? I mean, we talked on the call back last week about end of life, end of support the opportunity that you see. I think the company has been very pragmatic and like this isn't an inflection. It's going to be a multi-year upgrade cycle. Can you dive a little bit deeper on that, what's driving the campus upgrade cycle? How big is that opportunity? Anything you could share with that?

Yes. So as you mentioned, I think this is a -- it's a multiyear, multibillion-dollar opportunity, it's not going to hit in a quarter or a couple of quarters or anything like that. I think that you've got -- in the campus, our customers are basically saying, look, we've got equipment that's aging out, it's become a security risk for us. We need to deploy AI applications and use cases, and we need to upgrade our network posture, our security posture, the threats that are coming out of these days are more sophisticated than ever. And they really want -- I think that the fact that we've said we're going to really embed security deep into the fabric of the network is an appealing thing for them. So you've got kind of return to office as well, and there's a number of reasons why our customers are looking to upgrade and at the same time, we had our biggest customer event in June, where we announced pretty much across the board refresh to our campus switches, which are smart switches, which incorporate AI as well as security. You can run security as well as networking processes over those. We've got secure branch routers and we've got new firewalls we've announced with new products in the data center, a new IoT products, new Wi-Fi. So pretty much across the portfolio, you've got a real refresh and probably the biggest innovation payload that we've announced in a long, long time in connection with a lot of drivers on why companies are looking to actually upgrade their networks as well.

And those drivers would be WiFi 7. You've got a large installed base that comes in to the support as well over the next...

We do -- yes, we've got tens of billions of dollars of sort of pre even Pre-Cat9K that are still installed, which again pose a security risk to our customers. I think the AI build-outs are big. If you look at agentic AI and the traffic flows that we expect associated with that, it's going to be -- it's going to put a strain on the network that we've never seen before. So again, Sami put together a slide that we showed in our investor deck that basically shows you the -- as you add agents and they're working 24/7, and their agents are working and collaborating with other agents, it's as if the number of employees on your campus or your branch are significantly more than you've had before double or even 3x depending on the workloads and work that the -- and tasks that the agents are doing. And so that's going to put a strain on the networks, and it's going to also require a lot more security to be built into the networks as well.

By the way, you brought up the Sami slide deck several times -- there's a lot of detail in that, hasn't looked through it. There's good stuff in there. The competitive dynamics in campus, right? I think everybody has talked a lot about campus upgrade cycle. You had one of your competitors recently get acquired, that create dislocation. You've got another competitor that cease campus is a large incremental opportunity for them to go after some. I'm curious of how you would describe the competitive landscape you're seeing for this opportunity?

Yes, it's always been a competitive market for us, certainly. I think if you just look at the orders, though, 13% on a global basis. If you excluded web scale from that, we've still grown 9%. So really strong growth. We feel good competitively there. We talked also about this campus refresh and how we believe it's underway. So if you look at our campus networking, which includes enterprise routing, campus switching and wireless, all of those technologies grew in the quarter quite nicely, but they all accelerated in terms of their growth in Q1 versus Q4. And then if you dig into it also the move to the new platforms in each of those we go back and we look at prior launches and how quickly our customers actually moving to the new platform, and it's happening faster than prior launch in all 3 of those wireless routing and switching. So real good strength, and we think that the order growth kind of tells the story for us.

That's perfect. Moving again, Silicon One maybe should have been tethered to the AI, but I think it's broader than that, right? It's definitely -- we're still early earlier, maybe we're moving towards the middle innings of what the strategy is around Silicon One. But maybe just unpack that strategy, talk a little bit about Silicon One, how important it is for the company? How does that differentiate Cisco and where is it going?

So Silicon One is I would say, one of our most strategic assets that we have at the company. It is the reason, I think, are the biggest reason that the hyperscalers are looking at our technology. All the systems that we sell into that space are Silicon One space. They really like the technological advantages that it gives us the power savings, the cost savings overall. And it gives them diversity in terms of silicon as well, which I think all the hyperscalers are looking for. As you then kind of -- and I would just also add to that, basically, when you sell them a hyperscaler, there's 2 fundamentally -- 2 areas that really differentiate you in terms of delivering value and what they really care about. And I was going to stop short of calling it a critical control point. But it's basically what they're really buying, right? One is the silicon, the other is the software. And so companies that don't have the silicon and more and more being asked to deliver open system kind of software are really not able to add a whole lot of value in the hyperscale space. So we feel good about that. As you look at the whole portfolio then, we're -- as I mentioned earlier, we've got 5 different product families around Silicon One now that go across enterprise and public sector and service provider business by -- we've said by FY '29, all of our high-powered systems will be Silicon One base. And that gives us really 2 things -- if you think about it, one, I think more and more important today is just controlling your own destiny and your own supply chain, and it gives us much more control there. And then the second thing is we don't have the margin stacking in terms of buying somebody else's silicon. And so I think over time, it will be a tailwind for us in the gross margin area as well.

And so the gross margin tailwind, the pace of innovation, I think this is one thing I asked Chuck about last week is -- you mentioned it's a critical asset within the company. How do you think about investing into that business and keeping with...

Martin, who runs our -- Martin Lund, runs our silicon business. He's like he's first in line every time somebody asked for money and as a CFO, everybody is always asking for money and it's usually no No, no, no, no. Martin, here you are. And so there's a lot that we need to invest in there. As I mentioned earlier, we're having a lot more success with different web scalers and different design wins and to keep that going and to have different sort of tracks, if you will, and some bespoke silicon for different players and different use cases. We're going to need to continue to invest there, and this is exactly what we're doing. So a lot of what I'm actually trying to do is kind of extract productivity and efficiency relative to AI and really get the company moving to adopt AI in a much bigger way so that you've got savings across all functions that we can then move into what matters most to make sense?

Before we go to the model a little bit because I would be remiss if I didn't ask the CFO about some model inputs. But the security business has kind of been a topical area these last couple of quarters? Can you talk about that for a second? What are you seeing as far as there fundamental changes going on given the recent performance that we saw last week, it seemed to be a key discussion point. So maybe give you opportunity to unpack that a little bit?

Yes. So what we've said is we believe this is a double-digit opportunity, kind of mid to even high teens for us over time. The big thing during this quarter, which we actually saw a decline of 2% revenue growth -- I say growth but revenue decline in the quarter, is really just the move, which is a very good thing, but the move of our customers to more of the cloud offers relative to Splunk versus the on-prem the rev rec and accounting centers basically say, if you delivered on-prem, you recognize revenue in the quarter and cloud is ratable over the life of the contract. Now having said that, so there's a bit of a dip temporarily. It's pure timing. The health of the business is strong. If you look at product RPO, you look at product ARR, both growing double digits for Splunk. Over time, we actually find that the cloud offers are stickier. Customers are able to adopt the technology and new features a lot faster, and we'll recognize more revenue over time which is a really good thing. But it's a bit of a headwind earlier on in some of the growth rates. The other areas of the portfolio. So there's kind of 3 big things, if you will, if you look at our security portfolio, one, Splunk, which I just talked about. The other 2 are -- we've got sort of a basket of new and refreshed technologies, really good customer adoption there with the new offers around AI defense, secure access, Hyper Shield and others. We've got now 3,000 customers, new customers across that part of our portfolio. It's only about 1/3 of the total weighting though, of our total security portfolio, but it's growing quite nicely. It grew faster in Q1 than it did in Q4. So again, good signs in terms of where we're moving there. And then we've got a basket of kind of more, hate these more, but more legacy or sort of prior generation products. Those are declining at a slower rate. And so we're moving people to the new portfolio as quickly as we can. But those decline in a lower rate, the new refresh grew faster. So both really good there and then Splunk was really just a timing difference for us.

So that timing difference on Splunk. I mean it probably surprised you obviously, some of the Street, I think where maybe you punt the question, but where do you think that, that kind of normalizing? Is that a couple of quarters from now? Is it further out than that?

Yes. I think -- so it's a really good question. I think that first off, we want to meet customers where they are. And so as opposed to some of the competitors we have in that space, we'll offer it on-prem, where others don't have that. And that can be a competitive advantage for us. We'll continue to do that. But at the same time, I do think more are going to lean into the cloud offer and the fact that they can much more easier adapt the new features or adopt the new features and technology which again is a good thing for us. But I think you're going to start to see more of a move probably towards cloud over time, and that will be good for us overtime.

And I think to be clear on that, that's factored into the guidance, right? You got the guidance for that...

That was the big thing. I think that we wanted to really take the risk out of -- and be really clear that we don't need security to materially improve from where it is today in order to meet our updated guidance. We raised our guidance for the year $1.1 billion. And I just wanted to be very clear that like we're not counting on some big recovery there. We know it's going to take time. We have a lot of faith actually in the things that we're doing in that business, and I mentioned kind of the really good data points that we're seeing across the portfolio that should say that our growth will be improving steadily. And I think as you get into FY '27 and hopefully sooner, but it's -- the guy is not dependent on it, I think you'll start to see the double-digit growth.

And you mentioned data points. I mean can you talk about the cross-sell and call it, portfolio go-to-market leverage that you've seen with Splunk at this point?

Yes. So a couple of things. I think as you look at new logos for Splunk, and that was a big focus for us is, okay, look, between the 2 companies and the joint go-to-market, we can really drive a lot more new logos. We had 250 new logos in the quarter. We think we're on track to get to 1,000 plus for the year. So feel good about that. We've also done -- in the quarter, we did, and this was a move to cloud for us. I believe it was from on-prem to cloud, Sami, you can correct me if I'm wrong, but second largest order that we've ever taken in Splunk's history was a good -- is kind of joint go-to-market that we did and move them to cloud. And so really pleased there. We also did our largest Splunk deal ever in the last couple of quarters as well as a joint company. So we think the momentum is good there. It's just -- like I said, it's just going to take a little time.

Yes. Perfect. In the minutes I've got left, I think, again, I have to ask a CFO about the model and stuff like that. So -- there is a lot of discussion right now, as you would imagine, on components, supply dynamics, memory, cost. Can you walk us through what you're seeing? And is this causing pressures on the margin or any of the kind of headline the demand dynamics of your business that you've seen?

Yes. So certainly on everybody's mind. And also wanted to be really clear what we're seeing and what's kind of in the guide. So we are seeing, obviously, the same as everybody else in terms of memory price increases. We're also seeing some strain in DRAM and in particular, DDR4 and some in the DD5 space as well. We've factored that into the updated guide that we gave the Street. And so feel good about that. There'll certainly be things that we got to work through. We got a world-class supply chain team that will do everything that they can to get as much supply as possible. But we've factored in any risk there. I also think that some others have talked about some lead times and risk on the silicon side because we use Silicon One and control a lot of our own supply chain there earlier. Like I mentioned, we're not seeing quite as much impact there, I guess, as maybe some others. And then on the pricing, I think everybody always asked, "Hey, what about memory pricing? What about hyperscale, what about optic? How are you dealing with this? Is it lower margin?" And if you just look at what we're focused on and the guide we gave very similar gross margins Q4 to Q1 this year and then a similar guide Q1 to Q2 in terms of gross margin. Q4 for the year, we don't guide gross margin. But if you just look at operating leverage and the profitability of the company, bottom line is growing faster than top line and Q4, Q1, Q2 guide and then also for the full year for FY '26.

And I guess this kind of encompasses that same question a little bit that the tariff impacts, the mitigation efforts, how are you managing the pricing strategy? Have you implemented some price increases? Are you not? Because I think to your point, I mean, one of the things that's pretty remarkable about Cisco is the margin profile is very, very consistent, right, from a gross margin down to the op margin line?

Yes, the team does a great job on driving productivity improvements and doing what they can to manage the logistics and components and everything that's involved in it. And moving things from different countries to have the best strategy in terms of where we source products, where we build them, et cetera. On the tariff front, we've just said it's not a material number to -- there's certainly obviously an impact to gross margins, but it's not been a material drag on us. We did have a component price increase or I should say, rather a price increase relative to our global price list that we put in place at the beginning of the quarter was not specific to tariffs whatsoever, but really just kind of general cost of components, logistics, et cetera, that we were seeing. And so that, I think, has really helped us and navigate some of this.

That's perfect. Government exposure, maybe we talked about that. I think it's been a little bit of a factor in getting going back to Splunk? Obviously, coming off of a shutdown. I think in the past, you've been very adamant like you are overweighted towards the good pieces, if you will, within the spend bucket of the federal government?

Yes. The defense and intelligence pieces for us are, gosh, are almost 80% of our public sector business now, so with U.S. Fed, in particular, versus civilian so less exposure to some of the areas that are seeing real heavy cuts. Q1 is our biggest quarter relative to just the seasonality and how the Fed business falls throughout the year. We saw mid- to upper single-digit growth there, just as the teams had called actually in Q1. So pretty pleased with how they executed there. If you look at public sector for us on a global basis, it's actually been really strong outside of the U.S. So held up here nicely in Q1, and we think it will continue to do so for the rest of the year. You got to remember, we've got much easier comparison. So in terms of growth, we think somewhere in the mid -- even upper single digits is probably a good number. But then if you look at outside the U.S. in Q1, orders were up double digits. And a lot of focus on defense. And certainly, technology is becoming a bigger and bigger part of the spend of the defense budgets around the globe, particularly in Europe, you're seeing a lot of spend there. So that's been a big tailwind for us there.

So in the 2.5 minutes, I've got 2 questions left. One is the obligatory capital return. How do you think about that? You've integrated Splunk, We talked through that -- but how are you thinking about capital return versus maybe Cisco has been very acquisitive over its history, right? How do you think about balancing those 2?

So we've always said no change to this. #1 priority is just to fund the business and the opportunities that we have in front of us. Two is really to support the dividend, and we'll continue to do that. And we've also continued to increase that annually, and we'll continue to support the dividend. The third area is really on buybacks in order to give people and a better ability to plan. We've said you can count on $1 billion in terms of the run rate each quarter. And we're going to be opportunistic over and above that. Certainly, this past quarter, we bought back about $2 billion worth of stock at an average price of about $68. And so we felt like this was a good time to kind of lean in there. But you'll see us continue to do that.

Perfect. The final thing, I'm going to put an open-ended question out there. I mean when you and Sami, you're talking with investors and we think about the moving parts of the Cisco story, I'd love to just give you an opportunity to talk like what are the 2 or 3 things that you feel investors maybe either don't understand, maybe don't appreciate enough that you would leave us to kind of think about coming out of this?

So maybe a couple of things. I think -- the first thing is we all see all the news on all the circular funding, and so I'll hit on that a little bit. But you hear about the LLM, you hear about the GPUs and different companies that are making the GPUs and now TPUs and XPUs and you hear about all the power requirements, everything. One thing you probably don't hear enough about is networking. It doesn't matter whose GPU or XPU it is, you got to have networking. It doesn't matter whose LLM it is. There's networking. And so I think that the relevance of the network and the criticality of the network is significantly escalated in hyperscale and now into the enterprise as well. I think also that there's a lot of concern here, in particular in the last few days with kind of is there an AI bubble on what's going to happen here and the numbers that are being thrown around, if you just, sort of, Lisa Su was on CNBC last week, you talked about the TAM for GPUs by 2030 being trillion. The numbers may be off of that by some order of magnitude, just if you're one that says, hey, there's a bit of a bubble here, I don't see that completely coming to the numbers that people are talking about today. But that trillion dollars, I mean, somewhere between 10% and 20% of that is typically the networking spend that would be associated with that. So even if that were to come off, by an order of magnitude, there's a ton of opportunity for us, in particular. So I think that's probably a couple of things that maybe aren't quite as well understood.

Perfect. Mark, thank you so much. appreciate it.

Appreciate it. Thanks.

That's great. Okay.