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

While we get situated, I'll read the disclosure off the top of my head. For any research disclosures, please see the Morgan Stanley website at researchdisclosures.com and/or reach out to your Morgan Stanley sales representative. We are delighted today to have Cisco here with us. I'm Meta Marshall. I cover networking and cybersecurity here at Morgan Stanley. We're delighted to have the CFO, Mark Patterson; and Martin Lund, EVP of Hardware and Silicon One Systems. I think, Martin, this is one of your first more public appearances. So we're very happy to have you here.

Well, he's been public. It's hard to keep them off stage.

Yes, exactly. All right. Mark, maybe let's start with you. In fiscal Q2, you guys delivered revenue with product orders accelerating to 18% growth. You subsequently raised your full year guidance. Just what demand trends are you seeing? And maybe kind of contextualize that into the different end markets that Cisco serves?

Sure. Happy to. Yes, first off, I would just say, as you mentioned, 18% really strong demand is what we're seeing right now. And I'd say the other word that I'd use is very balanced. As you look at it, the 18%, if you exclude hyperscale, which we all know was a big number for the quarter, it would still have grown 10%, so double digits on a global basis, just ex hyperscale. If you look at it by geography, you look at it by vertical, the geographies, all 3 geographies that we managed grew double digits, and all 3 of them showed accelerated growth in Q2 than what they showed in Q1. So really strong growth there. Verticals were really strong. If you look at public sector, it grew double digits in all 3 of the geographies as well. Enterprise accelerated from Q1 to Q2 and SP and Cloud also, we're seeing significant acceleration. The other thing that we talked a lot about on the call is 2 big, massive multibillion dollar opportunities that we're going after that are going quite well. One is on the AI infrastructure. side and the other is really this campus data center or campus refresh, rather. And both show really good strength. If you look at the AI side, we took $2.1 billion in new orders from hyperscalers. That's what we did. So in 90 days, we did the same as we did all of last year. And so you're seeing from a lot of the work that Martin and his team are doing a really good momentum, really good relationship building, but also we're delivering the technology that they need, most importantly. And then on the campus side, we saw really strong growth in campus overall. If you looked at the individual components and when you look at wireless routing, campus switching, all 3 of those areas, they're moving to the new platforms faster than prior generation launches. So we're very happy with what we're seeing in both those space.

Got it. Maybe just jumping into memory and gross margins that we can't say that for very long. Gross margins in fiscal Q2 saw a little bit of pressure. This was you mentioned mix shift towards hardware, but also just kind of rising memory prices. And just as you think about AI infrastructure ramping, memory continuing to get more expensive, can you just walk through the mitigation steps you guys are taking on gross margins and then just the trajectory of gross margins throughout the year?

Yes. We should take a moment on this one because as you can imagine, this isn't the first question.

Right. Not the first time you got the question.

On this topic. So there's really 2 big things that are at play here. So one is memory, and I'll talk about that here in a second. And then the other is mix in terms of what we're selling and the acceleration that we're seeing in different parts of the portfolio. So the first, in terms of memory, what we're really doing is looking to control what we can control. So obviously, everybody has seen the sort of unprecedented pace at which memory prices are going up. So there's 3 things that we really wanted to outline that we're doing that we can control and looking at proactively. One is just updating our prices. And so you're going to actually see our latest price increase will go in effect on Monday. And so we're going to stay very close to that, in particular, on the compute side, more than anything, but also some of the higher memory products just across the portfolio. The second thing is really, we've had some very generous Ts and Cs with partners and customers that allow a fairly lengthy time between when we announce a price increase to when it takes place. as well as, okay, now it's taking place. But if you put a quote out already, we'll honor that for another 30 days. Both of those areas were tightening substantially. And so I've had discussions with both partners and customers, and I think they all get it, right? They don't love it, but they understand this is a new way of doing business. And then the third thing that we just talked about was we're really leaning into our financial position and strength in securing the supply that we need. So if you look at our advanced purchase commitments, just in the last 90 days, those are up $1.8 billion. And a lot of that is to meet the overall demand acceleration that we talked about, in particular hyperscale, but then also the memory supply that we need to. On the mix side, so what I would tell you there is just we're seeing significant growth in our hardware business. It grew in excess of 20% in Q2. And our software business is a little bit softer right now, in particular with security. And so as you look at those 2 pieces, kind of how that impacts gross margins. On the hardware side, I would just say we have very good margins actually in our hardware. They're just not quite as good as software, obviously. As you see -- just to give you kind of a data point on how significant of impact that it has. If we had grown security mid-single digits in terms of revenue in Q2 versus down 4%, which we posted, that would have been a point of gross margin right off the time. And as you look at the hyperscale acceleration, they love our silicon and optics and they love the high-performance systems. They don't buy as much though of the software and the services. But it's not like for every incremental dollar of hyperscale revenue that we got to add incremental OpEx. So it's got a very different go-to market, very different ratio, if you will, in terms of our overall costs. And as that business really ramps, that will help our overall operating margin. So net-net, just to say the last piece on this, I think -- it's important to note that we're going to be very focused on profitability and very focused on operating margin. The last couple of quarters, we've guided 23.5% -- sorry, 33.5% to 34.5%, in terms of our overall operating margin. We also guided that for Q3. You're going to see that focus on despite the ups and downs you may see in gross margin -- you're going to see us very focused on the overall operating margin performance. Q2 is a great example that despite the headwinds we saw in gross margins, we actually posted our highest operating margin in 4 quarters. And we're focused on EPS growth being faster than the top line growth. And you saw that in the first half of FY '26. You also see it in our guide for the full year of FY '26 as well.

Okay. We're going to jump in with Martin in a second around kind of everything happening with silicon and cloud. But Cisco has been on this journey over the last 5 to 10 years to have more software, more recurring revenue. Just how do you make sure that, that kind of software security recurring revenue story continues to build even in light of kind of some of the greater opportunities you're seeing on the AI side of the business right now.

Yes, it's still a very important part of our business. Even though we're seeing this massive acceleration in hardware, it was still a little over 50% of our business in terms of software and subscriptions in Q2. As I mentioned earlier, it's a big part of our overall profitability equation and mix as well. And so we're still seeing good growth in ARR and RPO. We've got $43 billion of RPO on the books right now, and that's going to certainly help just drive the predictability and the durable growth that we're trying to drive over time.

Okay. I want to step into the kind of relationships you guys have had with the cloud and maybe a question for both of you guys. Just in terms of -- what are the steps that you guys took over the last 5 to 10 years to increase to really kind of restart your relationships with the hyperscalers in some ways? And then just how do you think that, that can continue to build over the next couple of years?

So I'll just -- I'll say a couple of words and then Martin can jump in. I have to say some of this because he won't actually complement himself. But I think there's 2 things that come to mind for me. One is we made some key acquisitions, I think certainly, Leaba was a big acquisition for us. Acacia was another big acquisition for us. And then we just -- we brought in some of the very best talent in the industry. And that's certainly Martin. It's also a number of folks that Martin brought in on his team as well. And so I think starting with the very best talent was a big difference as well.

Yes. I think it also started to -- if you go back, there's a strategy shift that Cisco was treating the hyperscalers a little bit like a big enterprise, but they're different. They're very different. And that's -- and when buying Leaba investing into core technology, they also -- we changed the way we approach the customer and said, "Listen, you can -- we will meet you where you need us to be. " If you want us to buy a branded Cisco box with all our capabilities, and it's fine, we will do that. You want us to build your white box with our own silicon in it, we will do that. You want just buy the silicon or the components and you will put the pieces together, then we will do that, too. So it's a complete change in posture. So that was sort of, I think, the pivotal point. Now you have to deliver. Now you can get eligible for doing business. Now you have to prove yourself. And over the last, I would say, 5, 10 years, Cisco have proven themselves in every one of the hyperscalers in terms of we can deliver good technology. We are reliable. We actually know how to support you much better now because it's a different way. It's not like a 1-800 number, right? I like to say doing business at hyperscalers is a little bit like going to final exams every day, every day. It's just that you can't pass, but you can fail. You can mess up and then you're out every day. And another way to think of it, I spent a little bit of time at other companies in the past, including Microsoft. And on the inside of that is you understand -- the stakes are so high, the scale is so big that there is no room for errors. And escalations are happening in nanoseconds or microseconds, not in hours. So that's the mindset that we have built up a culture around. And then -- okay, so that's good. Now you have to be competitive, right? You have to build chips and systems and optics. And I'll give you -- for example, this is one of those chips.

Very expensive.

It's not functional when you touch, it is game over. But this is a 100-terabit chip. This is -- was announced just recently. We announced another version of that. I have a few of them in my pockets here. So just in case you can see. But what you may not know is that there are very, very few companies in the world that can actually design these solutions. Broadcom is one of them. This is a Tomahawk 6 equivalent called G300. This is a Jericho equivalent. It's actually double Jericho, but it's called P200. And there's essentially 2 other companies that can do this in the world, Broadcom and NVIDIA. And now we're in a good company. And I think what we come at is a slightly different approach. We come under system -- with systems background with a networking background. And that sets us apart, I think, and it will do even more so over time. I think when we're moving the AI revolution is a lot of data movement that is at the essence of it, which is networking. And we are moving into a token economics model where it's about uptime and dollars per token. And so that's kind of what we do pretty well. We've done that with hyperscalers in the old days, they're called telcos, right? That's uptimes 5, 9. It's about everything needs to be working. And I think that sets us apart as a strategic supplier. And now that we show up, we know how to do business with them. We've proven that we're willing to be flexible and do business on their terms. And now we have road maps and technology. I think that's what I think is different.

Yes. Okay. I mean you just announced and showed us the G300 Silicon One chip. Maybe just how does that position you guys in the scale-out market? And how does the programmability of Silicon One kind of differentiate you guys in terms of total cost of ownership?

Yes. I think that's a very important part. First of all, you have to be time to market is definitely key in this space, and we are -- I think we're in the playing field alongside with others. But what -- but we're not just a me-too copycat of something else. We have a distinct and different approach to to networks silicon, and it's what we call the Silicon One architecture. So it's a unified architecture that allows us to do both switching and routing in the same architecture where others having different architectures that are distinct and different. And they kind of don't really actually play with each other. They have different software stack and behaviors, we have won. And at the heart of that is a programmable engine that allows us to basically drop down microcode or it's called P4 into the chip that will decide -- help it determine its behavior or forwarding behavior. And we can do that after the chip is in the network. We don't have to spin a chip, a new requirement shows up. You don't have to go back and build a new chip to bring it up. We can write some software and meet it. And that becomes increasingly important as you're seeing I mean the networking for AI is changing so fast. We're moving towards more of a heterogeneous compute architectures where you have different types of compute they need to -- they will have different behaviors. So we can meet those behaviors programmably, Others are hard coded and have very, very fixed capabilities. We have this programmability. And what it also allows us to do is to have the same silicon serve in different roles in the network. So even in a scale-out network, there are different -- many different roles, whether you're top of rack or whether your end of row or whether you're sitting in aggregation functions. And what we can do is that we can give different personality to the same box, and that's over time, will give a lot of benefits. And I think play into this token economics architecture is like you want to have flexibility in your deployment models.

Yes. You mentioned you've kind of expanded the portfolio for the P200, for DCI or kind of scale across. Just how do you think of these distinct architectures work together to capture kind of the full AI opportunity? And you mentioned this is differentiated that you don't have these kind of 2 separate platforms. But kind of what is -- are you seeing the response from the customers of being excited about kind of that ability to have a centralized platform?

Definitely, I mean, that's part of why we are seeing our business is going because we are -- there's -- it's resonating with customers. Architecturally, the fact that we have a unified approach gives us the ability to play independent on where the choices are. Some people will say, scale across needs to be deep buffered. We believe in that. But we also can do the scale across with our G300 shallow buffered solution as well. We can have the same functionality there. So that's one example where maybe the scale across here is that you're 20 kilometers instead of 500 kilometers. And you can now pick a solution for that. So that blending of blurring of roles, I think, is very we see that trend is happening definitely. And I see our architecture responding very well to that.

Are you -- I guess the question is like do you end up getting down these rabbit holes where it's like, oh, everybody wants you to customize so much stuff. I mean it's easier for you to customize it, but how is that relationship?

Well, we can -- I mean, we had examples of large, call them, Neoclouds as an example, where they come in and say, we need you to do this particular load balancing because that's how we have architected our network. Can you do it? Nobody else can do it. Can you do it? And we go back and we say, yes, I think so, give us a week, we'll come back and we come back with something, and now we have an optimized solution on an existing platform, not something we had to go and reengineer that software. And we could take that to extreme. We could -- if we wanted to and if customers really wanted to, we could hand them the compiler and say, knock yourself out. And I think long term, that can be an advantage because the competitive nature of where we are right now is like everybody is fighting with the same tools in a way. But when you start to optimize your economic model and get your network 5% more efficient over time, I think that becomes a vector of competitive for the hyperscalers.

And what is that process of kind of -- we spent a lot of time about Silicon One with the hyperscalers, but kind of the cost benefit that you guys get or the process of moving that throughout the kind of whole Cisco portfolio?

Yes, I would start by -- and we can argue about that. But obviously, it costs money to build silicon. It's not for everybody. It's a big investment, has been a big investment for Cisco for a long period of time. And that investment is paying back and is starting to kind of get paid back as we are deploying our solutions into not only hyperscaler platforms, but also into the rest of our portfolio. And -- and one way to think of that is the alternative is to go and buy these chips from companies like Broadcom. And if you look at Broadcom's gross margins, they're pretty healthy. So you can imagine that there is some margin stacking going on in there. And that over time, and there's some pricing power and all sorts of good things, supply and all sorts of things that we get out of this. And I think you'll see us see some of those benefits show up as we are deploying and our product lines are migrating to full adoption. And we're still at the beginning of that, I would say.

Okay. And then I'll ask it because somebody else in the audience will, if I don't. Just how do you see your opportunities in the spine within hyperscalers, which seemingly gets the most attention.

I mean we have adoption with hyperscalers, 5 out of 6, I think we have said repeatedly, and we have adoption in many different roles. The scale-out opportunity is where we are seeing a lot, but also in the scale across where we see a lot of adoption. And the silicon that we built is optimized for these applications, and we can reprogram them so they can fit the role that is needed. So I think we feel very good about the space. But there's a lot more dynamics than just technology. There's also business models and other partnership that gets into that. So I think when I look at our position, it's like you have to be eligible, right? You have to have products, you have to be eligible. You have to be a trusted vendor. You can -- and you can be trusted to show up and solve problems as they are. I think we are on that journey. I think we have earned trust in these -- which is a very big different like for 10 years ago where we were just not relevant.

Yes. And then maybe just last question to co-packaged optics has been -- we've had every optical networking vendor here all week talking about it. You guys have not only Leaba, you have Luxtera, you have a lot of pieces of the portfolio that kind of help. Just how are you guys thinking about the co-packaged optics opportunity?

Well, first of all, it will happen at some point in time. And there is a lot of push in the marketplace for it to happen maybe sooner than later. But at the end of the day, it's a big transition for the industry. Customers will have to get comfortable with not only the business model associated with this and vendor concentration and so forth, but also the operational realities of how does this stuff actually perform in a network, so that stuff is not overnight. It will not be flip a switch. You mentioned Luxtera and Luxtera is an acquisition that was done a number of years ago. It's also in my group. And it is have some of the best silicon photonics technology, which is critical for the CPO adoption. And while we haven't announced anything yet, we did do a technology demonstration of a CPO solution in 2023. So kind of watch the space.

Okay. Got it. Mark, I'm going to circle back to you. You're seeing a lot of this campus switching base go through a larger refresh. Just what inning are we here? And then just how is that conversation that maybe is starting with Campus refresh and company to mean kind of all this part of what you've called AI modernization across the greater stack.

Yes, I'd say we are -- I think Chuck characterized it as the top of the first inning even. So very early on, multiyear, multibillion-dollar opportunity. I think that as I look at Campus, I would say there's probably more reasons today for customers to upgrade in terms of the AI capabilities, making your network smarter, faster, more autonomous, bringing together of the network and security, the fact that there's a real recognition that aged out equipment is a big time security risk, given the sophistication of security threats today with AI. And so I think there's like more reasons than ever to upgrade and probably our portfolio is in as good shape or better than I've seen it in a long, long time in terms of all the refresh that we've done kind of up and down the stack as well.

Got it. And then just -- you mentioned security, maybe security has kind of underperformed expectations, at least from an investor standpoint over the past couple of quarters. Just where do you see your guys in terms of being able to kind of position yourself better or some of the changes that are just taking time to kind of show up?

Yes, I'd say probably the biggest headwind that we've seen in terms of just revenue and security is this transition that we're seeing with Splunk and customers moving to cloud versus on-prem. The accounting is different instead of recognizing it upfront, you recognize it ratably over the life of the contract. In the end, that's actually a really good transition. We can deliver features faster. They can adopt technology. And we see the longer-term prospect of revenue actually much higher than we would on-prem. But that's a headwind we're facing. On the sort of organic or ex-Splunk security side, we're actually seeing really good momentum that it's just going to take some time for it to translate into revenue growth, given that a lot of the offers are ratable. And we still have some legacy business as well that is a headwind there. But in terms of new offers, you look at Hypershield, you look at Secure Access. You look at XDR and AI Defense, that just that -- those products right there, 1,000 new customers that we signed up in Q2 alone, which was 100% more than we signed up in Q1. And so we're seeing really good traction. We think by the end of this fiscal, if you just -- you kind of put the transition aside for Splunk, which is what we talked about. Just the organic security business, we think we'll be approaching double digits. So we think we're on the right track. It's just going to take time. Recognize it's taken a little longer than we would have liked, but we also were real clear and took the risk out of the guidance that we don't need any substantial increase from here.

I get this question a lot from investors. I'm sure you mean it as well. Just in terms of why does Cisco need to stay together? There's a lot of different businesses. There's a lot of different areas? And so how do you kind of express what the value of Cisco together is?

Yes. I think I have gotten that question. But I think it's just a -- I think it's one of the unique advantages that we have and really providing a full stack for AI use cases as well as more traditional use cases that includes silicon optics, networking, observability, security, collaboration, everything that our customers really need to get the most out of all of those technologies, if you will. And I think that together, those really just provide our customers to be able to unlock value that they wouldn't be able to do otherwise. And we find it pretty compelling. We're really the only one that can bring all that together.

Yes. And then maybe just last question.

It's also a key part of our overall profitability. Each one of those plays a role as well.

Cash flow. minor topic. And that kind of rounds out the conversation just in terms of capital allocation, you talked about there's various pieces of the business generate a lot of cash. Just how do you think about capital allocation? And we've seen some depressed software valuations of late. Does that change how your aperture for kind of our appetite for M&A?

Yes. I think no real change in capital allocation policy. What you have seen, I think, with G2 and what he's really driving is more build here and versus buy. But at the same time, we're going to be very opportunistic and understand that there will always be opportunities to ultimately get to market faster or build the technology that we need and to drive revenues faster if we were to do something inorganic, so we'll continue to look at it. But the big thing is just, is there a moat and can we really drive differentiation, and I think that's why you're seeing more tech and talent, more stuff that is just going to either add a feature or get us to market faster, grow the top line faster.

Okay. Perfect. All right. Well, Mark, Martin, thanks so much for being here today.

Thank you, Meta.

Thank you.

Appreciate it.