Cisco Systems, Inc. (NASDAQ:CSCO) Q2 2023 Earnings Call Transcript

Cisco Systems, Inc. (NASDAQ:CSCO) Q2 2023 Earnings Call Transcript February 15, 2023

Operator: Welcome to Cisco’s Second Quarter Fiscal Year 2023 Financial Results Conference Call. At the request of Cisco, today’s conference is being recorded. If you have any objections, you may disconnect. Now I would like to introduce Marilyn Mora, Head of Investor Relations. Ma’am, you may begin.

Marilyn Mora: Welcome everyone to Cisco’s second quarter fiscal 2023 quarterly earnings conference call. This is Marilyn Mora, Head of Investor Relations and I am joined by Chuck Robbins, our Chair and CEO; and Scott Herren, our CFO. By now, you should have seen our earnings press release. A corresponding webcast with slides, including supplemental information, will be made available on our website in the Investor Relations section following the call. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements and other financial information can also be found in the Financial Information section of our Investor Relations website. Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results and we will discuss product results in terms of revenue and geographic and customer results in terms of product orders unless stated otherwise.

All comparisons made throughout this call will be done on a year-over-year basis. The matters we will be discussing today include forward-looking statements, including the guidance we will be providing for the third quarter and full year of fiscal 2023. They are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically, the most recent reports on Forms 10-K and 10-Q, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. With respect to guidance, please also see the slides and press release that accompany this call for further details. Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

I will now turn it over to Chuck.

Chuck Robbins: Thanks, Marilyn. I hope everyone is doing well. With the tremendous results we delivered in the first half of the year, fiscal €˜23 is shaping up to be very strong, fueled by demand for our cloud-driven networking portfolio, our continued business transformation success and an improving supply situation, thanks in large part to our team’s aggressive actions. Before I dive into additional details on the quarter, I wanted to take a moment to say how incredibly proud I am of the team here at Cisco. While the environment we are operating in remains dynamic, Cisco is better positioned today than at any time since I became CEO almost 8 years ago. We have reshaped and transformed the company and our portfolio while remaining highly disciplined both financially and operationally.

This gives me great confidence that we will continue to succeed in the long-term. Now I will touch on the quarter in more detail. Our Q2 financial results were strong as we again exceeded the high-end of our guidance ranges. We delivered our second highest quarterly revenue of $13.6 billion, up 7% and record non-GAAP EPS at $0.88. We also delivered solid ARR growth, sequential non-GAAP margin expansion and record non-GAAP net income. In terms of our business model shift, we continue to make great progress with 10% growth in software revenue and with software subscription revenue up 15%. Recurring revenue also now represents 44% of our total revenue. In addition, we have built up nearly $32 billion in remaining performance obligations and our backlog remains robust.

Even as we drew down backlog by 6% sequentially, our total backlog still grew year-over-year. These metrics, along with our increasing visibility, led us to raise our full year outlook, which Scott will address in a moment. This quarter, we also achieved record operating cash flow, enabling today’s dividend increase and the buyback of over $1 billion. We continue to deliver on our commitment to drive returns to our shareholders. Let me also provide an update on the supply situation. While components for a few product areas remain highly constrained, we did see an overall improvement. Combined with the aggressive actions our supply chain and engineering teams took to redesign hundreds of our products, we increased product deliveries and saw significant reductions in customer lead times.

As our product deliveries increased, channel inventories also declined as our partners were able to complete customer projects. Like I shared last quarter, as supply constraints ease and lead times shorten, we expect orders would normalize from previously elevated levels as customers return to more typical buying patterns. As a result, sequential quarterly order growth is a better indicator than year-over-year growth. And in Q2, despite improving lead times, our quarter-over-quarter order growth was again in line with our historical ranges across most of our geographies and customer markets. With that, let me touch on what we are seeing with customer demand. In our customer markets, we experienced normal double-digit sequential growth in both our enterprise and commercial markets, while public sector performed better than we have seen historically.

Within our service provider business, our order rate was below recent sequentials as some customers are absorbing the improved delivery of our products into their production environments. We saw another consecutive quarter of rapid adoption of our 400-gig Cisco 8000 and Silicon One platforms. This reflects the ongoing investments our customers are making in our innovative solutions and AI optimized infrastructure. Within web-scale, while we saw overall slowing due to normalizing product lead times, two of our largest customers grew their orders with us over 40% in the first half of fiscal €˜23. We continue to take share in this space. And over the past few years, we have grown web-scale cloud infrastructure from effectively zero into a multibillion dollar run-rate business.

I am incredibly pleased about the overall progress we’ve made as we are continuing to win more and more use cases within their infrastructure. We are also still at the beginning of what we believe to be a massive growth opportunity going forward. While we continue to closely monitor the global macroeconomic conditions, the overall demand environment remains steady and on par with Q1 and our pipeline and win rates remains stable. Looking at the broader landscape, digital transformation and hybrid cloud remain top areas of spend, which is fueling growth across our portfolio. Many customers have told me that while their spend levels maybe slowing in some areas technology remains essential as it is vital to their overall business resilience, competitive differentiation and success.

In fact, Gartner and IDC’s most recent surveys make it clear that technology budgets are growing as they forecast IT spend to increase in the mid to high single-digits in 2023. We are also seeing many customers moving ahead with their hybrid work, AI and ML investments while building the modern infrastructure they need to deliver on their objectives. IoT has also been accelerating. We saw record revenue growth in Q2 as customers look to connect their industrial systems in order to optimize power consumption, automation and efficiency. Lastly, cybersecurity and full stack observability remains strategic priorities where we continue to invest and innovate. From a product revenue perspective, we saw strong double-digit growth for Catalyst 9000, enterprise routing, Wireless, Meraki, DUO and ThousandEyes, reflecting the ongoing investments our customers are making to modernize their infrastructure to rapidly digitize and secure their organizations.

We are increasing our investments in our cloud management platforms that deliver the simplicity our customers need. You will see us continue to bring AI and ML into those platforms to further simplify how networks are managed. For example, in Q2, we announced several new innovations across our cloud managed networking and security portfolios that offer greater visibility with AI-driven insights, enable secure connectivity, and give our customers the ability to simplify their IT operations. Last week, we introduced a preview our cloud-native full stack observability platform, the first network visibility solution to support open telemetry. This platform brings together our ThousandEyes and AppDynamics capabilities for unmatched data correlation and insights from the user to the application to the network.

To simplify network security and policy management, our unified SASE solution, Cisco+ Secure Connect, now supports integration into Cisco SD-WAN fabrics using Viptela technology, as well as our existing Meraki SD-WAN fabric. We also introduced new flexible, more powerful and energy-efficient servers, which not only help lower cost, but also help our customers meet their sustainability goals, an increasingly critical area for most of our customers. To close, I am proud of what we achieved this quarter. We delivered a strong financial performance, innovated across our portfolio and continue to make great progress on our business transformation. In addition, the increased visibility we have from almost $32 billion in RPO, a healthy backlog and pipeline and improving supply give us the confidence to raise our full year outlook.

We expect those same factors to continue into fiscal year €˜24, giving us conviction in our ability to deliver on our commitments. The modern, resilient and secure networks we are building serve as the backbone of our customers’ technology strategy. Cisco is well-positioned to benefit from multiyear investment cycles with our market-leading hardware as well as our innovative software and services. Together, these allow our customers to digitize rapidly, secure their environments and achieve their sustainability goals, all while delivering differentiated experiences. Now, I will turn it over to Scott.

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Scott Herren: Thanks, Chuck. We delivered another strong quarter and exceeded both our top and bottom line expectations driven by our focused execution, continued success of our business transformation and improved availability of supply as the actions our supply chain team have taken over the last several quarters are bearing fruit. Total revenue was $13.6 billion, up 7%. Non-GAAP net income was a record $3.6 billion, and non-GAAP earnings per share, also a record, was $0.88. Looking at our Q2 revenue in more detail, total product revenue was $10.2 billion, up 9%. Service revenue was $3.4 billion, up 2%. Within product revenue, secure Agile Networks performed very well, up 14%. Switching revenue grew in the double-digits with strength in campus switching driven by our Catalyst 9000 and Meraki offerings.

While data center switching declined slightly, we saw strong growth in our Nexus 9000 offerings. Enterprise routing had double-digit growth driven primarily by strength in our Catalyst 8000 Series routers, SD-WAN and IoT routing. Wireless had very strong double-digit growth with strength across the entire portfolio. Internet for the Future was down 1%, driven by declines in optical and Edge. We saw growth in our Cisco 8000 offering and double-digit growth in web-scale. Collaboration was down 10%, driven by declines in meetings and collaboration devices, slightly offset by growth in contact center. End-to-end security was up 7% driven by our unified threat management and zero trust offerings. Optimized application experiences, was up 11%, driven by double-digit growth in our SaaS-based offering ThousandEyes.

We made solid progress on our transformation metrics as we shift our business to more recurring revenue-based offerings, driven by higher levels of software and subscriptions. We saw strong performance in our ARR of $23.3 billion, which increased 6% with product ARR growth of 11%. Total software revenue was $4.2 billion, an increase of 10%, with software subscription revenue up 15%. 84% of the software revenue was subscription-based, which is up 4 percentage points, year-over-year. We continue to have $2 billion of software orders in our product backlog. Total subscription revenue was $6 billion, an increase of 9%. Total subscription revenue represented 44% of total revenue. And RPO was $31.8 billion, up 4%. Product RPO increased 7% and service RPO increased 2%, and total short-term RPO grew to $16.9 billion.

While total product orders were down 22%, they compared against 34% growth in Q2 fiscal €˜22, which is one of the largest quarters for product orders in our history. We saw year-over-year declines across our geographies and customer markets. Sequentially, total product order growth was in line with our historical growth rates. Within our customer markets, we experienced double-digit sequential growth in both enterprise and commercial and public sector was better than we have seen historically. We continue to have very low order cancellation rates, which remain below pre-pandemic levels. Total non-GAAP gross margin came in at the high end of our guidance range at 63.9%, down 160 basis points and up 90 basis points sequentially. Product gross margin was 62.1% down 220 basis points year-over-year and up 110 basis points sequentially.

Service gross margin was 69.1%, up 30 basis points. In our product gross margin, the year-over-year decrease was primarily driven by higher component and other costs. This was partially offset by our strong product mix and positive pricing as the benefits of the actions we took in the prior fiscal year flowed through as we shift our backlog. Non-GAAP operating margin came in at the high-end of our guidance range at 32.5%, down 180 basis year-over-year and up 70 basis points sequentially. The year-over-year decline was primarily driven by the higher component and other costs that I just mentioned. Backlog for both our hardware and software products continue to far exceed historical levels. As we navigated a complex supply environment, we were able to drawdown total backlog by 6% sequentially, although it still grew year-over-year.

Just a reminder, backlog is not included as part of our $31.8 billion in remaining performance obligations. Combined, our significant product backlog and RPO continued to provide great visibility to our top line. Shifting to the balance sheet, we ended Q2 with total cash, cash equivalents and investments of $22.1 billion. We had record operating cash flow for the quarter of $4.7 billion, up 93% year-over-year driven by strong collections and we deferred our Q2 federal tax payments due to the IRS tax relief related to the California floods. We expect to pay these federal taxes by the end of the fiscal year. We returned $2.8 billion to shareholders during the quarter, which was comprised of $1.6 billion for our quarterly cash dividend and $1.3 billion of share repurchases.

We also ended the quarter with $13.4 billion in remaining stock repurchase authorization. Today, we announced that we are raising our quarterly dividend by $0.01 to $0.39 per share, which represents our 13th consecutive increase. This reinforces our commitment to returning a minimum of 50% of free cash flow to our shareholders annually and confidence in the strength and stability of our ongoing cash flows. To summarize, we had a great quarter, delivering better-than-expected top and bottom line performance. We continue to make progress on our business model shift to more recurring revenue while making strategic investments in innovation to capitalize on our significant growth opportunities. Turning now to our guidance, our guidance ranges reflect our strong pipeline and significant visibility driven by healthy backlog, ARR, RPO and improving availability of supply as we continue to benefit from the actions our supply chain team have taken over the last several quarters.

We expect those same factors will continue into fiscal 2024 giving us greater visibility and confidence in our longer term goals. For fiscal Q3, our guidance is: we expect revenue growth to be in the range of 11% to 13%; we anticipate the non-GAAP gross margin to be in the range of 63.5% to 64.5%; our non-GAAP operating margin is expected to be in the range of 33% to 34%; and our non-GAAP earnings per share is expected to range from $0.96 to $0.98. There is also a significant change to our full year fiscal €˜23 revenue and non-GAAP earnings per share guidance driven by these same factors. For fiscal year €˜23, we are raising our expectations for revenue growth to be in the range of 9% to 10.5% year-over-year. Non-GAAP earnings per share is expected to range from $3.73 to $3.78.

In both our Q3 and full year guidance, we are assuming a non-GAAP effective tax rate of 19%. I will now turn it back to Marilyn so we can move into the Q&A.

Marilyn Mora: Thanks, Scott. I am going to turn it over to Chuck just for a few comments before we start the Q&A.

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Q&A Session

Chuck Robbins: Yes. Before we get into Q&A, I just wanted to send our condolences to those impacted by the earthquake in Turkey and Syria. It’s been absolutely devastating to watch as the death toll has climbed and we are working closely with our teams in the region to give them support and help on the ground as much as we can. We just want to let them know that we are all thinking about them and we are here to help.

Marilyn Mora: Thanks, Chuck. Michelle, let’s go ahead and open up the queue for questions and answers.

Operator: Thank you, Marilyn. Ittai Kidron, you may go ahead, with Oppenheimer & Company.

Ittai Kidron: Thanks guys and nice quarter, nice guide. I guess the big question is when you think about the outlook that you have for continued supply chain improvement, how long would the order backlog normalization process is going to take in your view? And maybe you can quantify in the quarter itself or perhaps on the guidance €“ when you look at the guidance, how much of that is coming from your ability to fulfill more versus the true underlying demand? I am just trying to gauge for how long you can kind of keep this going at above normal growth rates for yourself?

Chuck Robbins: Yes, Ittai, thanks for the question. And shockingly enough, that was the first question I expected. So let me just summarize sort of what we are seeing and then I can give you more detail. But number one, let’s start with the fact that our demand is stable and that’s first. Based on the sequentials that we saw, demand remained stable. And in fact, if you look out at our Q3 forecast, which we normally wouldn’t give you, the current forecast in Q3 is also in line with historical ranges of sequentials. So that’s the first piece. The second thing is, as Scott said, while we €“ backlog came down 6% sequentially. It was up year-over-year, and we expect that we will end the fiscal year even with the guidance we gave you today with a backlog that’s roughly double what we would normally end the year with.

The other thing to take into consideration is the business transformation with 44% of our revenue now recurring really helps a great deal. And we have $23 billion of ARR, which we can actually renew in the next 12 months. So if you go back 8 or 9 years ago, we might have had to take orders for 75% of our revenue in any given quarter. And now we have 44% of our revenue coming from the balance sheet and recurring revenue. So all that said, we actually believe that we will still be able to deliver. We’re confident that we will deliver positive growth in fiscal €˜24, obviously, with pretty significant comps based on the guidance that we gave today.

Ittai Kidron: Okay. I guess when I think normal, given your historical ranges before the pandemic, I always think about 4 to 6 is kind of the range plus/minus that you run at. Is it fair to say that from here on anything above is kind of order €“ eating into backlog? And while your backlog is double, that can still mean that you can run above normal ranges for at least a couple of years, it sounds like, unless something unusual happens. Am I misinterpreting your comments?

Chuck Robbins: Scott, do you want to take that?

Scott Herren: No, not at all, Ittai. But what I would say is it’s obviously too early for us to guide fiscal €˜24. What we wanted to give you confidence is we have better visibility than we’ve ever had in the past, both from the backlog and the $17 billion €“ almost $17 billion of RPO that’s current, that’s going to turn into revenue in the next 12 months in the ARR. But €“ and we’re going to roll in backlog that’s roughly double what it normally would be at the end of the year. So we have good confidence in where we’re headed in fiscal €˜24. I think it’s a bit too early given where we are in the year just at the end of our second quarter for us to be a little more precise on that.

Ittai Kidron: Okay. Appreciate. Good luck. Thanks.

Chuck Robbins: Thanks.

Marilyn Mora: Thank you, Ittai. Next question, please.

Operator: Amit Daryanani from Evercore, you may go ahead, sir.

Amit Daryanani: Thanks. Congrats on a really good quarter for mine as well. I guess maybe if I think about the secure agile networking segment growing at 14%, that’s really notable. And I don’t think the industry is growing nearly close to that pace. So I’d love to understand, I mean, do you think you’re starting to see some share gains come back to with Cisco, especially the supply chain start to improve? Is that a tailwind that you see and perhaps that continues for the rest of the year? Maybe you could just talk about that and also maybe talk about how campus did within that segment? That would be helpful.

Chuck Robbins: Thanks, Amit. Let me take the share question because I think I’ve said on several calls that, obviously, market share is reflective of revenue and with our backlog that as we began to ship certain products that we would be a gainer of market share, and we certainly expect that when these numbers are digested and the new reports come out for Q4, that you’ll see that to be the case. One example is, during last quarter, our wireless revenue was up 57% year-over-year. And I suspect that, that’s going to be a share gainer. And the other thing to keep in mind is that market share is inexact. I would tell you that when we ship products into the web scale infrastructure space, as an example, it goes into our routing reports and many of our competitors put it in data center switching.

So it’s very difficult in some cases to get complete apples-to-apples, but I do believe that as we continue to ship our backlog that we will be gaining share. Do you want to talk a little bit about the campus switching?

Scott Herren: Yes. Sorry, I missed that part of the question.

Chuck Robbins: Amit, can you repeat your question about the campus switching, the second part?

Amit Daryanani: Yes. No I was just wondering, like within this context of 14% growth that you saw in that segment, how is campus performing for you very specifically? And how is the supply chain kind of alleviated over that view?