Highlights From CSCO's Q3 Conference Call: Guides Below For Q4, But Still Extremely Well Positioned to Lead in Networking

Last night, Cisco Systems (NASDAQ: CSCO) reported Q3 EPS of $0.42, ex-items, $0.05 better than the analyst estimate of $0.37. Revenue for the quarter came in at $10.9 billion versus the consensus estimate of $10.86 billion. Shares are currently down 4.47% to $16.99

Highlights From CSCO's Q3 Conference Call:

• (John T. Chambers) The network is driving the future of the core internet and has clearly become one of the most valuable assets in IT. Cisco is extremely well positioned to lead this change.
  
• In short, Cisco is a very strong company in a healthy market with a few problematic areas and that we are taking comprehensive action to address. The first of these is simplifying actions that we're going to do and focus on our organization and operating model.
  
• Second, aligning our cost structure given the transitions in the marketplace. We will take out $1 billion in costs from our FY12 expense run rate. We also expect changes in how we do business will assure a lower cost base going forward.
  
• Third, divesting or exiting underperforming operations. As we have already started to do this, we are examining our operations through the filter of the five company priorities as well as our own comprehensive metrics.
  
• Fourth, delivering value to shareholders. We are working on both the financial and operational fronts to realize value that rewards our shareholder for their investment and their support.
  
• Starting with the current environment. As we make these changes we will stay very focused on five company priorities: leadership in our core, i.e., routing, switching and services which includes comprehensive security and mobility solutions; second, collaboration; third, data center virtualization and cloud; fourth, video; and fifth, architectures for business transformation. These five company priorities are the key drivers of the future of the network and core internet.
  
• Moving on to areas of concern, as we have discussed before, we've had several areas of our business come under pressure: consumer, traditional set top boxes, switching, and our public sector customer segment. We have taken action in our consumer business and are executing well with our next generation of video delivery and IP set top boxes, so I will focus on the two remaining primary areas that impact our business today, switching and the public sector.
  
• First, switching. The switching market is in the midst of a significant transition. Across the industry, prices at each speed have been driving down price per port along with significant transitions from 1-G to 10-G where we're at the forefront of this innovation. This is good for our customers as it will enable faster and more efficient infrastructure long term and will enable even faster adaptation of cloud-based solutions. As we have said previously, in the short term, this has placed pressure on our revenue opportunities across the market as customers have begun to adopt these new technologies.
  
• Specific to Cisco, our gross margins have come under pressure due to the transition of our own products at the high end of our switching portfolio as customers adopt the Nexus 7000. The gross margins of the remaining Catalyst and Nexus switching product lines have continued to improve over the course of this fiscal year to our traditional switching gross margin levels.
  
• From a product capability and innovation perspective, we are positioned well. As a skilled market leader with the broadest switching portfolio of products to serve our clients, we are highly leveraged to benefit as this market stabilizes. With all the appropriate caveats, we feel we are also well positioned to get our fair share of any market growth.
  
• Now on to public sector. We are seeing a broad focus on cost reductions in public spending in almost every developed market around the world. We shared our initial concern about public sector spending in the U.S. state and local government several quarters ago. We are in almost every sector of government, every category of public sector, and with the vast majority of our business being new every quarter, we tend to experience challenges and opportunities quicker than others.
  
• Public sector historically has been approximately 20% of our business. Routing and switching represent our largest market share in this segment, and we must address very aggressively the dramatic spending changes that will occur.
  
• We have seen significant declines in the growth rate of our public sector business since the beginning of our fiscal year going from over 30% year-over-year four quarters ago to declines in the current quarter order growth rate of 8% in Q3. No excuses. We must adjust quickly. We are and we will.
  
• Let me just focus on some key areas in terms of the opportunities and current momentum. First, let's start with collaboration, which is already at a $4 billion pace from both revenue and order perspectives. Our year-over-year revenue growth in collaboration has been consistently strong over the last five quarters, exceeding 25% growth in every quarter, and in Q3 at 39%. These include the benefits of our TANDBERG acquisition. With collaboration, our TelePresence flagship products continue on a very strong growth path.
  
• Our TelePresence solutions reached an annual revenue run rate of $1.15 billion with product revenue growth in Q3 at approximately 25% year-over-year as normalized for TANDBERG.
  
• Second, data center virtualization and cloud which is approaching a $1.5 billion annualized revenue run rate growing at 31% year-over-year and an order run rate of $1.8 billion growing at 61% year-over-year in Q3. Our UCS server experienced strong momentum and pipeline growth across almost all of our geographies and customer segments. We grew our UCS customer base by 1,570 customers to approximately 5,400 customers during Q3, with product orders now at an annualized run rate of $900 million.
  
• Third, emerging markets continues to be an opportunity for Cisco. While results will always vary with geopolitical factors such as those that you are seeing today, our largest emerging countries are doing extremely well. For example, in the BRIC countries Brazil grew at 18%, Russia grew at 14%, India grew at 44% and China grew at 16% from an order perspective in Q3 year-over-year.
  
• Fourth, Asia Pacific continues to have very consistent and strong results with Q3 product order growth at approximately 14% year-over-year.
  
• Fifth, global enterprise and commercial continues on a very strong pace especially in the U.S. In Q3, total global enterprise grew at 12% year-over-year and commercial grew at 14% year-over-year in terms of orders.
  
• Sixth, we continue to gain both mind share and architectural leadership in many of our global service provider customers. In key areas that are very important to them such as cloud, convergence and the network, storage and compute, new business models, video, mobility and security, we are positioned extremely well. Service provider video remains a key priority for Cisco and for the service provider business.
  
• Seventh, services, which represent approximately 20% of our total revenue, grew 14% year-over-year.
  
• (Gary B. Moore) In terms of simplifying our organization and operational model, we have already taken aggressive steps by reorganizing the major functions of sales, engineering and services as well as moving away from a broad council and board structure. Under this new organization structure we will be accelerating the pace of innovation and our technology refresh cycles as well as driving clear accountability for top and bottom-line performance.
  
• Our more than $5 billion R&D budget will be focused on accelerating our leadership in our core products and next generation technology platforms while employing world class product development processes. To achieve this, we are focused on speeding up the time to innovation by reducing the complexity of decision making and allowing for greater agility on the part of our engineering leadership.
  
• To align our cost structure, we will focus on a number of areas. First, we will achieve gross margin improvements through product simplification, aggressive value engineering, maximizing commodity pricing opportunities, and enhanced supply chain strategies. From an expense reduction perspective, we are also looking across the business with an emphasis on actions where we can lower costs and improve operating margins.
  
• As John mentioned, we will take approximately $1 billion out of our annual expense run rate, using Q4 as our base, the majority of which will be executed upon by the end of Q1 fiscal year '12. Expense reductions will come from the consolidation and streamlining of our processes, portfolio rationalization and simplification of our operating model and an enhanced focus on workforce deployment levels.
  
• Decisions will be made in compliance with all laws governing labor practices in any affected location around the world. As our people would expect from Cisco, we will treat our employees and contractors with respect, support and fairness. Our values here are very clear.
  
• (John T. Chambers) From a customer perspective in terms of year-over-year growth, global product orders, Cisco total grew in terms of products 4% year-over-year, enterprise grew 12%, public sector decreased 8%, service provider grew 3%, commercial grew 14%.
  
• From a product revenue perspective on year-over-year basis, routing grew 7% with high-end routing growing 12% and mid-range routing decreasing by minus 2%, while low end routing decreased by minus 4%. High end routing accounts for approximately 70% of our total routing business.
  
• New product revenue grew 15% year-over-year with collaboration at 39%, the data center at 31% from a revenue perspective, security at 2%, wireless at 32% and video connected home decreasing by 5%.
  
• In terms of a couple of new products that may be of interest to you, our Nexus 2000 and 5000 grew 105% and 29% respectively year-over-year. ASR 1000 grew at 46%, ASR 5000 grew at 353% and ASR9000 at approximately 140%. Now let me turn it over to Frank for a discussion on Q3 financials and Q4 guidance.
  
• (Frank A. Calderoni) During the quarter, we increased total revenue to $10.9 billion, up 5% from the prior year. Our total product revenue was $8 billion which $3.3 billion was switching. This represents a 5% quarter-over-quarter increase in revenue, while our switching product transitions continue to gain traction as evidenced by the performance of our Nexus product line and the new fixed switching products in the data center and campus. We did see a 9% decrease in switching revenue year-over-year.
  
• Routing revenue was up 11% quarter-over-quarter and 7% year-over-year to $1.9 billion. The growth reflects continued acceptance of the new CRS in our core. Overall strength in our edge ASR product families and the stability in access routing with increased adoption of ISRG2.
  
• The new products category, totaling $3.3 billion, increased 15% year-over-year and 2% quarter-over-quarter. Total service revenue was $2.2 billion and that was up approximately 14% from the prior year.
  
• We did experience year-over-year growth of 12% in technical support services and approximately 19% in advanced services.
  
• Looking at our result by theater, revenue increased across all geographic segments on a year-over-year basis ranging from 11% in emerging markets to 3% in our Asia Pacific markets. U.S. and Canada and our European market both came in with 4% year-over-year revenue growth and beginning in the first quarter fiscal 2012.
  
• Our Q3 FY11 non-GAAP total gross margin was 63.9%, up 1.5 percentage points quarter-over-quarter and down 1.3 points year-over-year. Non-GAAP product gross margin for the third quarter was 63.1%. That was up 2 points from last quarter.
  
• On a year-over-year basis, our non-GAAP product gross margin was 63.1%, down 2.2 points primarily driven by pricing and discounts and product mix, which was partially offset by cost savings and volume. We saw a consistency quarter-over-quarter in our non-GAAP service margin of 67%, up from 64%, 64.8% in Q3 FY10. For total gross margin by geographic segment, please refer to the accompanying slides.
  
• Non-GAAP operating margins for the quarter was 27.2%, our non-GAAP net income for the third quarter was $2.3 billion, a decrease of approximately 5% year-over-year.
  
• As a percentage of revenue, non-GAAP net income was 21.6%. GAAP net income for the third quarter was $1.8 billion as compared to $2.2 billion in the third quarter of fiscal year 2010. Non-GAAP tax rate was 21% for Q3 FY11.
  
• During Q3 FY11, we did recognize restructuring charges to our GAAP financial results with a pre-tax impact of approximately $150 million, and this was in connection with our consumer business. This included the announced exit of our Flip video business and included charges related to inventory, supply chain, severance and other items.
  
• Now moving on to our balance sheet. We did close the quarter with a total of cash, cash equivalents and investments of $43.4 billion. That was up $3.1 billion from last quarter which included net additional borrowing of $1.5 billion as well as continued strong operating cash flow of $3 billion. Of this balance, $4.6 billion was held within the U.S. at the end of the quarter.
  
• Accounts receivable balance at the end of Q3 was $4.4 billion with a DSO of 37 days as compared to 40 in the second quarter. We ended the quarter with total inventory of $1.4 billion with non-GAAP inventory turns of 10.3, which was up 0.3 compared to last quarter. We had inventory purchase commitments of $4.3 billion, which was up approximately 10%, or $382 million quarter-over-quarter and this increase in purchase commitments was driven primarily by securing supply components in Japan, which contributed approximately $300 million of that increase.
  
• With an increase of 14% year-over-year, we ended the third quarter with deferred revenue of $11.7 billion, $3.7 billion of which was deferred product revenue and $8 billion of deferred services revenue with increases of approximately 6% and 17% year-over-year respectively.
  
• This quarter included share repurchases totaling $1 billion of 54 million shares and our first quarterly dividend payment of $329 million.
  
• At the end of Q3, our head count was totaling 73,408.
  
• OUTLOOK - We expect to take further restructuring charges in Q4 as related to our consumer business of approximately $40 million, bringing the total aggregate pre-tax charge for Q3 and Q4 to approximately $190 million.
  
• In Q3, we also identified an opportunity to allow for a segment of our population in the U.S. and Canada to take advantage of a voluntary early retirement program similar to the program that we introduced in 2009. We do expect pre-tax charges to our GAAP financial results relating to the program in Q4 in the range of $500 million to $1.1 billion. The extent of the charge will be dependent upon the number of employees who voluntarily elect to participate in this program.
  
• So for Q4, we expect revenue growth to be in the range of flat to up 2% on a year-over-year basis. Our non-GAAP operating margin is expected to be in the range of 24% to 25%. And our non-GAAP tax provision rate will be approximately 22% in the fourth quarter.
  
• Our Q4 FY11 non-GAAP earnings per share is expected to be in the range of $0.37 to $0.39 per share (Consensus is $0.42) and we anticipate our GAAP earnings will be $0.14 to $0.23 per share lower than our non-GAAP EPS. This range includes our typical differences as well as an impact of $0.06 to $0.13 per share as a result of our anticipated restructuring associated with our consumer business and the early retirement charges.
  
• (Q&A) Gary, I was wondering if you would spend a little bit of time on switching in particular, down 9% and that may be picking on one of the worst numbers, but if you could help us understand what has shifted in the switching landscape and then how long you think you will need to correct that and get back to where you would like to be in switching? (A) Gotcha. Jeff, it's no problem asking the tough questions. Those are one of our two problematic areas that we have to address. Let me start with the most basic elements. I'm very pleased with the new products we have introduced over the last year. We're extremely competitive at the low end with the Catalyst 3000-2000, at the mid-level with the Nexus 2000 and 5000 and if you look where we are, we need a little bit of work on our high-end at the 7000 to be very candid. If you watch what we just announced in terms of organizational alignment from an engineering perspective, under Gary's leadership and now Padma and Pankaj leading the engineering team, for the first time in many, many years, we have all of our resources together so you will be able to share those switching resources across engineering and one priority to be able to work together as we do this. You will see us be able to also look at how we bring products to market faster. Instead of thinking about a product cycle of five years plus, we're going to be thinking three years. Instead of thinking gross margin improvements in the - if you will, what we have traditionally seen, Frank, say two, three, four years to play out, we're now thinking of how we do it in one to two in terms of the direction. If you, Jeff, want some additional data, we didn't share it, but our orders for the switching category, the fixed orders were up 8%. The modular were down 10%. So we have seen a little bit of balancing here, and too early to call it a trend. We want to watch it into Q4 and Q1. As we have traditionally done when we get hit with new competitors, we get back on our heels a little bit and we adjust. We have got the product breadth here that feels very good. Our problem is, you can now do with a 2000 what you used to do with a 3000 or more, which is a nice way of saying we are coming down Moore's Law, but faster than Moore's Law which means our sales force has to sell two to three times as much. Our customers would tell you in the enterprise environment and many of our government accounts, we're not losing share, but they would tell you in that environment, they wouldn't focus on how much did our revenues go up or down. Clearly, we have some share challenges in a few areas, but overall, our port position is very, very solid. Bottom line, I like the progress we're making. You didn't ask about gross margins that go with that. Our gross margin challenge is candidly at the very high end. It's to transition the 6000 to the 7000. Gross margins on the prior generation 2000 and 3000 and actually our new generation are within a couple points which is pretty good at this stage and I want to congratulate our Nexus team on the 2000 to 5000, the middle, you have seen improvements in gross margins by almost ten points this year. So a lot of what Gary talked about was good, but we are going to take it to a different level as we move forward and streamline this and this is what Kathy is going to be leading for us with Randy in terms of some of the direction. So Jeff, a long-winded answer to your question, I apologize, but it's the one on people's mind along with public sector.
  
• First, thanks very much for the very clear disclosure about your plans. It makes life easier. John, I would like to ask about the next quarter guidance, but before that, just clarification; you did not address in your comment, your long-term growth target that you used to be 12 to 17% and whether you have any plan to change it. My question is not about that. My question is really just about the components of the next quarter. The revenue growth is pretty healthy sequentially, but then the margins you expect it to go back to the difficult last quarter. While gross margin this quarter was pretty good. So the margin you guide down to 62%. So I'm just wondering about the dynamics. Why do we see revenues growing sequentially nicely, but then gross margins going back down again next quarter? (A) Gotcha. So a couple of questions and let me maybe try to summarize. During Q4, it's traditionally our strongest quarter. Our sales force is strongly incented there and actually we have incentives in place for those that may not be in position to achieve their goal. It's a quarter that we traditionally grow well but usually, it comes toward the back end of that quarter. Second, during this quarter, we had a very good booking UCS quarter as you all saw: 61% growth. It was clearly - we did not get a lot of those shipped so that's why you saw 31% in revenue. Q4 is going to be a very solid quarter for us in the data center. You're starting to see cloud activity take off. You are seeing us take on the big guys in that environment. I'm very comfortable with where we are in terms of the data center strategy, but you are clearly going to see in that quarter more influence from some of our areas that don't have as high a gross margin. We will provide, in our September analyst conference, an update in terms of where we see the long-term guidance being. We clearly are taking 12% to 17% off the table on that. We ran at that pace for, I don't know, a number of quarters, but no excuses. Here's where we are. Here's what we see our growth rate going forward and we are going to do that one quarter at a time. So as we go, we're going to show you that we deliver on Q4. During that time, we are going to do behind the scenes the very heavy lifting that our shareholders fully expect us to do to bring expenses back in line with revenue, and we expect to grow revenue faster and Gary, if we do our job well, by a lot faster than we do expenses as we look out three, four, five quarters out and then we will show you the progress. If we do our job right with all the appropriate caveats, each quarter next year and as you make these changes in Q4, Tal, it takes a while to really drive those through the organization. By the time you do the easy stuff, such as the consumer, such as the early retirement, then you change the organization structures, you put your first layer in, then you put additional layers in below that and as people get responsibility for their area, then they are able to input in terms of where we prioritize resources and then you're able to take the expenses out in a constructive way. That is hard and it is heavy lifting and communications is challenging on it. We're going to do that over the next 120 days very crisply and when you do that, candidly, it slows down your momentum in the quarter you do. I'm not making any excuses on that, we are going to focus on driving our orders very, very aggressively and if you were watching momentum coming out of Q4, I would watch book to bill coming out of Q4 and I would watch our booking growth.

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