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

We're good? Yes. All right. Hi, everybody. Thanks for coming. Tim Long, Barclays' IT hardware, com equipment analyst. Happy to have Cisco with us today. Mark Patterson, CFO, he's been with the company a very long time. So looking...

Yes. 26 years.

26. That's a lot. A lot of years, a lot of years. So I appreciate the time. I know it's a very busy day, a lot going on in the world here that we're living in.

So let's start off with kind of a few of the hotter topics. Obviously, we'll start with AI. You guys gave some pretty good numbers where you're kind of couching. You've been couching orders for a while, couching the revenues and the revenue move. So maybe if you could touch on a little bit on kind of the strength you're seeing in orders and revenues for AI-related optics, optical and optics and systems. If you could kind of talk about the traction of the products and how -- what's the breadth from a customer standpoint and a use case or a product standpoint, that would be helpful, to start.

Yes, we're seeing a lot of success. So if you just -- maybe if you just go back 15 months ago, we -- as we really entered our fiscal year '25, I think a lot of folks were unsure what is Cisco's role in this whole AI build-out. And so we put up a target for FY '25 for the first time for really two reasons. One is to really show the criticality of the technology that we have, that we supply the industry. And second, just the materiality overall to just give people a feel for kind of what that looks like. So we put a target of $1 billion up. We actually ended up doing more than double that in FY '25. And just over $2 billion for the year and recognized $1 billion in revenue just for the top hyperscalers. And so we'll talk, I'm sure, more about the neocloud, sovereign cloud opportunity, et cetera. But if you stick just with those top hyperscalers, you fast forward then to this year, we started this year in Q1, and we continue to see a lot of momentum. We -- in Q1, we actually had those top hyperscalers place orders with us for $1.3 billion in just Q1. So continued strength. And you can't put out a target without folks wanting you to put out another target. So we did that. And in Q1, we said we would do at least double what we did in terms of orders in FY '25. So somewhere north of $4 billion is what we see landing there and then triple in terms of revenue. So $1 billion a year ago and we said we'd do $3 billion in revenue, and we're off to a really good start.

Great. Maybe just looking at the pieces of it. On the system side, so obviously Silicon One is important here. So kind of what's the feedback? Is that the main reason you're winning? Or just a little on the system side, what's driven the success?

Yes. So if you look at what we're doing with the hyperscalers, a couple of things, so one is, if you go back to FY '25, beginning of the year was really a lot of optics that was sold in, about 2/3 of it was optics and 1/3 of it was systems. And the second half really played out like we said it would in terms of really flipping that ratio to 2/3 systems. We see that same kind of mix really probably continuing into FY '26. But if you go to -- I think, a big differentiator for us is the silicon. And our hyperscalers wanting silicon diversity but also they really like the power efficiency, the cost savings, some of the programmability of the chips as well. And so at times -- basically, what we said was, look, you can buy the chip, you can buy our software, you can buy the system, whatever you want to do. And in most cases, they're buying the whole system.

Okay. And yes, to follow-up on the systems part of it, a lot of talk lately, scale-up Ethernet, scale-across, whether it's optics or Ethernet or both, can you talk -- we don't have to get too technical here, but talk a little bit about kind of new use cases that are still emerging, which provide more opportunities for order growth in the switching part of the business?

Yes. So Silicon One can be used in really all the switching roles, if you will, just in terms of top of rack and leaf and spine, first of all. The Cisco 8000 is also used in routing use cases as well. When you think about kind of scale-up and scale-out and then scale-across, today, we're in largely scale-out, but also scale-across with our Optics portfolio that we have as well. We just introduced a new Silicon One chip, the P200, which will really be focused on the scale-across and a system that will go with that, that I believe is the 8223. Sami can always correct me if I'm wrong, but -- and those will be available in kind of the spring time frame. So the one that we have said, we will be looking to be a part of that's really probably more of an FY '27 and forward opportunity would be the scale-up opportunity as well as we'll look to get into that, too. But two things. We were talking about this a little bit earlier in some of the investor discussions that I've had. I think that as you look at the AI infrastructure play in hyperscale, two things that are of particular interest when you sort of evaluate our progress and how things are going, and you look at this $1.3 billion of incremental orders that we just took in our first quarter is, one, is this like all one webscaler? Is it one hyperscaler? Or you having actually success across others? And then two, I think it's some of these roles that you get designed into, they can place orders against for 3-plus years. And so I think understanding is there continued success? Or is it just buying off of sort of original design wins or use cases. And in both cases, if you take a look at just that $1.3 billion, just for example, we had four hyperscalers, not just one but four hyperscalers within that order set that grew more than 100% year-over-year. So if you just compare the orders that they placed on us in Q1 of FY '25 to Q1 of FY '26, you had four different hyperscalers growing over 100%. And then when you look at sort of design wins and use cases, again, it's continued momentum. If you look at, again, that $1.3 billion, we actually had four new design wins just in Q1 alone, and those are across four different webscalers. So all in all, I think it just shows that as in anything else, if you continue to have success, you continue to meet and exceed customer requirements, you begin to be designed into more and more use cases. And we're seeing a lot of momentum in not only their AI infrastructure, but also their traditional cloud spend too, that we're just getting to be a much better partner of all the hyperscalers.

Great. Great. And yes, just on -- just flipping to the Optics, Acacia mostly, side. It seems like that's experiencing really strong growth as well. Obviously, there's a lot of ports out there in need for transceivers and a lot of the technology. So similar positive trend, I would say, in the Optics side.

Yes, definitely, Tim. So I think as you look at it, we sell -- we supply optics to all of the top hyperscalers. And I think if Bill Gartner were here, who leads our Optics and Optical business, probably many of you may have met him in other investor settings, he would tell you our market share is probably 25% plus in the hyperscale space. And so really good success there. But we also sell optics into service providers, enterprises, there's almost 400 different service providers on a global basis that we sell optics into. And so we feel very good about where we are in that portfolio as well and the momentum that we're seeing.

Okay. Great. You mentioned neoclouds and enterprise. I think maybe we're up to three neoclouds that have been announced in the Middle East. I think -- two or three. Anyway...

[ I don't know ] how you count it.

Yes, maybe -- yes, some of them, I don't know who's who anymore, but maybe discuss kind of time lines that you're expecting for the sovereign business to ramp more meaningfully?

Yes. So this is a space we're really excited about and I think is going to be a significant opportunity for us going forward. What we've kind of said is that export licenses were required. There's a lot you need to do in sort of the early stages plus the early ordering is not going to be material to our revenue in FY '26. We'll start to see orders really coming online in the second half of our FY '26. But really, I think the ramp will really begin in FY '27, and I think it could run for quite a while. We talked a little bit about the pipeline and the momentum that we're seeing in that space and things continue to ramp there as well.

Okay. And enterprise is still very early phases. What do you think the dynamic will be there?

Yes. I think early days. So what we did was we said, we gave a whole bunch of data on hyperscale, and I talked a bit about that already. And then we said, look, as neocloud, sovereign cloud, enterprise AI get big enough, we'll begin to give you specific data on each of those. But for now, we kind of couple them together and said, look, as you look at neo, sovereign and enterprise together, we've had over $250 million in -- or over $200 million in orders. And we've got a pipeline that's ramping. Our pipeline now on a collective basis there is over $2.5 billion. And so I feel good. The enterprise is still moving pretty slowly. I think it's still fairly nascent, but everybody continues to believe that ultimately, that's going to be a massive opportunity for us.

Right. Okay. Great. Maybe shifting to a different topic. We'll talk about the campus a little bit. A lot of moving parts here. We'll start with -- I mean this came up a few times on the last earnings call when you talked about a -- whatever, 7% growth number and people did the math where you go from [ 1 to 3 ] on data center and you subtract it and so the rest of the business is guided to grow 4% or 5%. And obviously, there's other things in there, but campus will be a portion of that. So maybe talk about the campus growth in the context of you do have the end of lifing of products, you do -- end of support for products, so some of the installed base and then you obviously have a new platform as well. So a lot of moving parts in it. So curious how you think about the growth algorithm there? Because it's been a choppy few years. You had really good years and then kind of a correction -- inventory correction year and now it seems a little bit more back to normal, but I'd love your perspective on that.

Yes, maybe I can give a few data points and perspective on some things. I think -- so first off, the numbers that you were talking about that some may or may not have done the math on, I think, was basically, if you back out hyperscale, what's the rest of the business growing. You have to keep in mind though that you probably also want to back out collaboration and services. Those are much lower growth businesses to get to sort of a true campus or enterprise type of networking growth, which would be a little bit higher than kind of what you were thinking. Networking overall, double-digit growth now for 5 quarters in a row. So we lapped double-digit growth, and I was watching it closely. We wanted to make sure that we didn't see as we now were comparing against a double-digit growth quarter a year ago, that we didn't fall off and we actually accelerated. And so overall, networking was up. This -- if you look at the overall business, two data points here. So total order growth was up 13%, but if you excluded the webscale business overall, it was up 9%. So we saw really good growth in enterprise, public sector and our more traditional kind of portfolio, if you will. This campus refresh opportunity, we are in the very, very early stages of. It's a multibillion-dollar opportunity, multiyear opportunity and not going to happen in a couple of quarters or even in the fiscal year, but over quite a bit of time as you look back at kind of different cycles that we've seen in the past. And I think there's just -- there's a lot of reasons for people to upgrade right now based on AI and security and a number of factors that we can certainly talk through. But you've got kind of two things happening. One is, I think our portfolio is in the best shape that it's been in a long time, if not ever, while I've been at Cisco. And then there's a lot happening around AI and security and aging-out of equipment that, as you stated, we have a significant installed base that's tens of billions of dollars that will come up as end of support here in the next year and the next 2 years. And so there's just a big opportunity and you've got the portfolio at the best place that it's been, and you've also got a lot of things happening around the enterprise and innovations that are happening that I think are going to drive them to upgrade as well.

Okay. Maybe a little bit on the competitive landscape here. Obviously, the #2 and 3 players got together. So that always causes disruption. So I'm curious, your take on how you view the competitive landscape as the dominant market share player?

It's always a very competitive space. I think that as HPE and Juniper come together, they have a lot of overlap in probably their best performing space, which is wireless. So that's causing, I think, a lot of confusion with customers and what's going to happen there. And we've certainly been able to, I think, capitalize on that. You also look at just -- HPE has a lot going on in terms of activist pressures and cost pressures. And I think that they're probably at a place that will strain the amount of money that they can spend on innovation at perhaps the time when the innovation, I think, is probably the most critical. So I think we'll do well there. Again, though it's a very competitive space, and we take them very seriously.

Okay. Great. Maybe if we -- you mentioned security, let's pivot there. I think it was viewed as a little bit of a disappointment last quarter. This move to cloud and some older platforms with the newer platforms doing really well. So there's always balancing act of these transitions, but it sounds like pretty confident that we'll exit the year at a much better growth dynamics. So maybe talk to us about kind of visibility and how we get past some of the pressures and turn it into a more steady growth dynamic now that you have Splunk on top of the core Cisco business.

Yes. I think, so if you just kind of zoom out, the three biggest opportunities we have, I think, for sort of outsized growth, if you will, one is in the AI infrastructure space. We talked about that, doing very, very well. The second is really in this campus refresh. Again, it's off to a very good start, seeing really good results there and acceleration. And then the third is really around cybersecurity, including our Splunk business. And what we said is we feel good about our security business, but it's going to take us longer to get to double-digit growth than we had originally planned for. And there's a couple of factors there, and I can certainly talk more about that. I think that we do see -- first and foremost, we do see getting to double-digit growth. We're committed to getting there as soon as possible. But at the same time, we wanted to sort of derisk our guide, if you will. And we raised our full year by $1.1 billion after Q1. And we let investors know that our raised guide is not dependent upon any sort of significant or material increase to the performance and security. Now having said that, so as you look at security, there's really like, I'd say, kind of three buckets you've got to really look at for us. One is the new and refreshed products, which is about 2/3 of our portfolio at this point and growing quite nicely, and we're pleased with. We've got 3,000 new customers on four of our new products that have been launched in the last, say, 18 months. And so there's a lot of traction there. The second area, though, is our prior generation or I'd say legacy, but I've said it. So the prior-generation products and kind of the drag that that's having on the overall growth within security. And that's still -- it's getting to be a smaller portion of the portfolio, which is good, but it's still got a pretty significant drag on the overall growth rates. And then the third bucket is what I would say is Splunk and it has always been a good double-digit growth performer for us and we're very excited about that acquisition that we've made and the opportunity there. What we saw, though, in the quarter was a timing difference. And what I mean by that is customers are leaning in more to our cloud offers, which is good actually for us. But when you look at the rev rec behind that, the on-prem stuff that we do in Splunk is recognized 100% as soon as you deliver the product. So 100% of the revenue within the given quarter, the cloud business is ratable over the life of the contract. And so again, I want to stress that it's actually better for us as a company because there's a lot more stickiness in the cloud products. The customers adopt new technologies and new features that we deliver. And over time, we actually recognize more revenue. The net revenue over time is actually higher. But it means that there's a little bit of a timing difference and there'll be more revenue in later quarters. So those are kind of the three factors that came into, all told, a lower-performing security business. But again, if you kind of go back to what I've said across all three, I think we feel really good about getting to double digits. It's just going to take a little bit more time for us.

Yes. So being 2/3 with the newer product helps. So the prior generation ones are getting smaller and smaller and then it just takes time for the SaaS revenue recognition to catch up with the product...

Yes. And if you look at -- like if you look at our next-gen firewall, our secure firewall business actually was up in the mid-teens. And so I think in key spaces, we're doing quite well. We've got two new firewalls that will come out that will be very competitive in both the ultra-low end and the ultra-high end, which is two very competitive spaces, and those come out in our Q2 here. So think in December, we begin to release that product and that will help us as well.

Okay. And maybe just touch a little bit on observability. That's the other bucket that's supposed to be ultimately mid-teens-type growth. What kind of dynamics are you seeing there? And how should we think about that growth curve?

Yes, we actually had -- we had very good growth in observability in the quarter. It's still a pretty -- it's a pretty small number, which is why we sort of lumped in security and observability. And we've even had discussions about would you lump those in completely in terms of financial reporting, and we've decided not to do that for various reasons. But I think that we had a good quarter. Our observability, as you look at our unique ability to really look at the endpoint, the application, the network, the data center, the industrial floor and really have observability in and outside of owned assets and unowned assets, we have some pretty unique capabilities there, and we feel pretty good about it.

Okay. Great. Maybe one on the verticals, obviously, a lot of focus over the last 6 months on federal government. I know it's not a huge portion of Cisco business. But if you could just share your thoughts on kind of the roller coaster of DOGE and then shutdown and all this other stuff and then no DOGE. I think it's high single digits or something like that. So maybe just give us your sense of when do we get back to kind of a normal dynamic because it does feel like underpinning whatever might have happened in the last 6 months, there's a lot of desire for the federal government to modernize its technology stack.

Totally. Yes, there's a few things in public sector that I'd just called out. I think -- so first of all, on a global basis, it actually performed really well for us, double-digit growth. Outside the U.S., it's performing much better. You're seeing a lot of emphasis on defense, in particular, in Europe, for example. And a lot of that defense spending is going into cybersecurity and modernizing their networks and technology, et cetera. And so we feel real good there. The U.S. Fed is -- they are a very large customer of ours. We saw a big dip a year ago. Basically, what we said as we went into this year is we weren't expecting any kind of massive recovery there, but we saw stabilization and we called for kind of mid-single-digit growth is what the teams were calling for. And we were at or above that actually in Q1. Q1 is our largest quarter for U.S. Fed by far, and Q2 is actually one of our smallest as it revolves around the U.S. federal government year-end. The thing to keep in mind though for us is it's about 80% of our business now is in defense and intelligence versus the civilian agencies where a lot of the real drastic cuts have happened in the civilian agencies. So we probably have less exposure there. And then it's just as far as seasonality, we've gotten past our biggest quarter of the year by far and actually showed kind of mid- to high single-digit growth in U.S. Fed and just kind of see this as a good, stable business that will continue with decent growth in kind of that same range that we're seeing right now.

Okay. Maybe shifting to a financial question. You mentioned stable. I think if -- Cisco's viewed as a company with pretty stable gross operating margin profile. So continue to move up the percent of software in the mix. So kind of talk to us a little bit about the margin view over the next few years and how much more room is there for positive mix effects, and does that $1 billion to $3 billion of hyperscaler caused a little pressure, probably not a lot, but maybe a little.

Yes. That's a good question. So first, on just the software piece, we reached a high of maybe 54%, 55% of our total business being subscription few quarters back. What you're really seeing now is we are a secure networking infrastructure company. And at times, it's going to be software, at times it's going to be hardware, at times it's going to be silicon-based, optics. And that's all good. It's all goodness. I think you're going to see us continue to be about roughly half -- probably at least half of our business will be subscription. On the margin side, while software certainly is real high margins, and we love that, of course. We've got a very diverse portfolio, as you kind of alluded to, and we've been able to manage that. We always have higher-margin geographies than others. We always have lower-margin customer segments than others and products that are higher and lower as well. The key thing for us, I think, is to focus on really the profitability and -- so by the way, our margins came in at 68.1%, so very, very strong, and we really haven't seen any significant -- any real degradation whatsoever in those yet. But I would just tell you that we'll manage the overall portfolio to be one that is going to show leverage. You're going to see operating expenses growing lower than the top line, a real move to have earnings growing faster than the top line. If you look at our Q4 earnings, our Q1 earnings that we just closed, our Q2 guide that we just gave as well as the full year guide that we just gave, all of those show earnings growing faster than the top line. So while there will always be some headwinds and some tailwinds in that space, and certainly, you've got tariffs, you get supply chain challenges, but you've got a lot of software we're selling -- there's just a lot of variables. We're committed to managing that to be very profitable and continuing to show leverage as well.

Okay. Yes, I'm glad you're more switching than -- so I don't have to go crazy about NAND and DRAM because it's less of an issue for you, luckily but...

We do have an issue, but it's not nearly as great. So it's going to be interesting to see how that plays out with some of our competition.

Right, right. Yes, it's a headache, but not as big a headache as others. When you think about -- you mentioned OpEx growing less than sales, but as a company that also develops their own silicon, you have a little bit heavier lift than some of your peer companies. So how do you keep that evolution of Silicon One comparable to a Broadcom or somebody else that's making comparable products while still keeping it under that envelope of leverage?

Yes. So we think Silicon One is one of the absolute key strategic differentiators for us as a company. As I mentioned earlier, the largest companies on the planet, the most complicated networks on the planet are using it to run their networks. And so we feel good about the silicon itself. To go do this, it's not for the faint of heart, as you mentioned. I mean, you have to have some significant scale and being certainly one of, if not the largest networking companies on the planet helps us in terms of having that scale to be able to invest and to be able to have the kind of innovation cycles that are required in this space. And Silicon One will give us a couple -- several advantages, but two in particular. One is really to manage our own supply chain and be in control of our own supply and our own destiny there is important to us. The second thing is really you don't have any margin stacking as we're not buying other people's silicon. And certainly, it's conceivable to say with our scale and the success of Silicon One that not only do we look to deploy that across all of our networking products by FY '29 is what we've publicly stated, but we're moving quickly on that. It's conceivable that you'd see other networking vendors and -- that may or may not even compete with us in certain niches, that they may want to buy that as well. It's not currently part of the plan, but it's certainly possible at a later date as well.

Okay. Great. I think we are out of time here, Mark. Really appreciate it. Thank you so much.

Thank you, appreciate it. Thanks for the time.

And thank you, everyone, for joining.

Thanks.