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?

Scott Herren: Yes. Campus is doing well for us. And the supply chain €“ while I don’t want to leave the perception that supply chain just got better. Our supply chain team and our product engineering teams have worked pretty relentlessly over the last several quarters with product redesign, with qualifying alternative components, with working with our suppliers to get to their subcomponents to make sure we could free this up so that the increase in supply that’s leading to some of the share gains that we’re talking about is the result of a lot of hard work by a lot of people inside the company. And I think, frankly, it puts us in a better position than many of our peers in the industry right now from a supply chain standpoint.

But €“ the longer answer. The short answer is, yes, we’re doing quite well in that space. And as we continue to deliver what we’ve just laid out as our guidance for the second half of this year, I think you’ll continue to see share gain grow for us.

Amit Daryanani: Got it. That’s really helpful. And I can just ask you really quick on your back half guidance is obviously fairly impressive. But in April quarter, you’re sort of implying gross margins will be down 130 basis points year-over-year, I think, for the April quarter. Can you just talk about how much of a downtick you think is cyclical, things like the supply chain and logistics and so on versus structural? And what do you think normalized gross margin could look like for the company if supply chain is truly normalized? Thank you.

Scott Herren: Yes. The midpoint of the guide for the April quarter is about a 10 basis point improvement from the quarter we just announced. So we do see gross margins improving, and it’s largely driven by €“ it’s less driven by cost. We’re seeing some reduction in costs around logistics, in particular, but component costs are kind of staying where they are in most cases. It’s more driven by the fact that as we ship the backlog more and more of what we ship, reflects the price increases that we put in place last year. So I think you’ll see gross margins potentially continue to expand from where they are, maybe as much as 50 basis points in Q4.

Amit Daryanani: Perfect. Thank you.

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

Operator: Thank you. Paul Silverstein with Cowen, you may go ahead, sir.

Paul Silverstein: Thanks. Chuck and Scott, I appreciate that you all addressed in your prepared remarks the visibility demand trend issue. But €“ so my apologies, but I’d ask you to revisit, especially in your enterprise business, including government and U.S. federal, I’m sure you and your team are aware of what your competitors have served. I know, Chuck, you just addressed the market share issue. But can you give a bit more color in terms of validity of the demand trends and the visibility that’s translating into.

Chuck Robbins: Well, as I said, the €“ our enterprise and commercial business, which is reflective of how most of our peers represent enterprise, that was up double digits sequentially, which is in line with our historical. And public sector actually performed better than €“ it was above our historical ranges during the quarter. So the other thing I would point out is that our quarter itself from a linearity perspective was quite normal, and we actually had a €“ we’re unique in that we had the January month in our Q2. And one of the questions that we had was what’s going to happen to budget as we enter into calendar €˜23. And we clearly €“ we actually finished stronger than we started the quarter. So those are just a few data points for you.

And I think if you look at what our customers are focused on right now, I mean think about some of their top products. They have got a complete rearchitecture of their applications to be cloud native running in both public and/or private clouds. They are having to rearchitect their infrastructure to actually deal with the changing traffic patterns that multi-cloud brings to them. They are dealing with hybrid work and how do I transform our IT infrastructure for that. They are dealing with cybersecurity threats on a massive scale, and they are also all focused on sustainability, which is leading to our IoT business growing significantly as we connect industrial systems for our customers. So if you think about those big five trends, we’re actually in the middle of those with all of our customers.

So we feel good about where we are. And the last thing I’ll say is that I was in Tokyo and Singapore last week and at the same time, A lot of our €“ my leadership team were in Amsterdam for Cisco Live Europe, and no one is talking about cutting technology spending right now. Everybody seems very committed to it. I think the underlying power of technology as it relates to all of our organization strategy is just too strong right now.

Paul Silverstein: Right. And Scott, back on the margin question. I appreciate you got to walk before you run, but you’re now 3 percentage points roughly below peak on both gross and operating in terms of the initial recovery, any thoughts for how much of the 3 percentage points? Can you visually get back to 67 gross? Can you get back to 35 operating and it’s just a function of time or because of the price increases with respect to semis or other things, that’s just a bridge too far?

Scott Herren: Yes. I mean as you talk long-term, there is a number of tailwinds that will come into gross margin, so not necessarily talking about our guide for fiscal €˜23, but longer term, there are several things that are going to be a tailwind there. One is continuing to work our way through the backlog and reflect the price increases. I think we will continue to see leverage and logistics costs, both from a reduction in the freight cost per kilo but also in the mix of how we shift between what has supply airfreight and what will go in the ocean. So I think we will see some leverage there as well. I don’t see a lot of our component providers outside of commodity areas like memory lining up to reduce cost to us, right? So I think it will be the combination of mix that will be beneficial to us and some cost leverage in the non-component areas that will drive that north.

Paul Silverstein: So you think you can get back to 67, 35?

Scott Herren: Yes. So are you asking me for a 5-year forecast on gross margin, Paul, is that where you’re going?

Paul Silverstein: Yes, long-term. Long-term, can you get back to that model?

Scott Herren: Long-term, there is definitely leverage to push it back to where it’s been historically, for sure, and if not beyond.

Paul Silverstein: Thanks, Scott.

Scott Herren: Thank you.

Marilyn Mora: Thanks, Paul. Next question, please.

Operator: Thank you. Meta Marshall with Morgan Stanley, you may go ahead.

Meta Marshall: Great. Thanks. I’m assuming as you’re having conversations with customers, they are looking for more flexible subscription methods and part of your subscription transition has kind of been evolving kind of the ELA model or kind of the subscription model you guys have had. And I just wanted to get a sense of where you think you are on some of the kind of subscriptionization of some of your products and whether you are seeing a big impact to that right now and then just maybe just some commentary about how you see the M&A environment currently? Thanks.

Chuck Robbins: Meta, thank you. So we are probably, I’d say, still in the early innings of transitioning the traditional portfolio to subscription models. The team is working hard on that right now. And we will just continue to keep you updated. But I think we’re several quarters away from really having anything to speak about relative to the size of that business, but we’re working hard on being able to deliver that. And the key is to give customers flexibility. That’s what €“ over the last 7 years or so, we have disaggregated hardware and software and silicon. We virtualized software to run on x86 appliances. So we want to give our customers whatever kinds of flexibility that they would like. So that’s the first part. On the M&A side, I would say our strategy, as you would expect, has not changed.

I think the market dynamics have changed, and I think that the longer valuations remain somewhat muted from their peaks. I think some of the companies are probably coming to more of a real position on what €“ how long these valuations may exist and were prior valuations even realistic in the first place. So we continue to stay aware of what’s going on. We continue to scan the marketplace, but our strategy remains the same.

Meta Marshall: Great. Thanks.

Marilyn Mora: Thanks, Meta. Next question, please.

Operator: Thank you. Simon Leopold with Raymond James, you may go ahead, sir.

Simon Leopold: Thanks for taking the question. I wanted to see if we could talk a little bit about the trends you’re seeing in data centers. In the prepared remarks, I think you mentioned Campus was good, but data center was weak. And I guess maybe I’m looking for not just the switching part of it, but your UCS business. And what are the broader trends? How much of that is reflective of hyperscale slowing versus the broader market, just trying to unpack that a bit? Thank you.

Chuck Robbins: Yes, I’ll make a couple of comments, and Scott, I don’t know if you want to give any detail. But I would say that our customers are increasingly balanced around how they are thinking about private cloud versus public cloud. And so we’ve seen continued focus on revitalizing the private data center infrastructure. And I’ll let Scott speak to €“ I’m not sure on the infrastructure side or UCS, if you want to share that. But the other thing I would point out, Simon, as I said in my comments earlier about market share, everything that we sell in the infrastructure within web scale flows into our routing market share numbers and our routing business. So it doesn’t actually boost our data center switching the way we report it. So it’s a little bit of an apples-and-oranges issue. I just want to make sure you understood that.

Scott Herren: No, that’s a really good point. And on UCS, if that’s the root of your question, Simon, we are seeing nice growth in UCS as well. And at least based on our calculations, we feel like we’re gaining share there as well.

Simon Leopold: Thanks. And then just maybe a quick follow-up, I was a little bit surprised that the metric of hardware attached software in backlog is $2 billion, same as it was in the prior quarter. I would have guessed it would have come down with the basically improvement of shipping the hard €“ associated hardware. So maybe I don’t understand that value or you could talk a little bit to why that $2 billion didn’t come down with the extra shipments of the related hardware? Thanks.

Scott Herren: It’s a great question, Simon. And we actually did see €“ if you noticed, our overall software revenue grew 10% this quarter, so back to double-digit growth. And some of that growth is on the back of shipping some of the backlog out, both the hardware and the software that’s had in backlog. So we are seeing the benefit of shipping that out. At the same time, as Chuck said earlier, demand remains steady. And so our overall backlog, while it came down only about 6% sequentially, there is still a significant amount of software stock in that backlog, some of it attached to hardware.

Simon Leopold: And software as a total percent of revenue or product revenue, that metric, where is that now?

Scott Herren: Yes. Just for software, it’s in the 30% range. Overall, we’re in the 44% range.

Simon Leopold: Thank you very much.

Marilyn Mora: Alright. Thanks, Simon. Next question?

Operator: Thank you. Sami Badri from Credit Suisse, you may go ahead, sir.

Sami Badri: Hi, thank you. I had one quick one and a follow-up. The first one is on just the data center switching redesign. You guys made several mentions regarding supply and the team kind of working hard to get redesign through. But does that actually mean the data center switching portfolio is now completed with redesign and that part really did drive the better revenue guidance for the year? So that’s my first question. The other one is we’ve seen several companies report elongated lead times for sales cycles and extra signatures and all these other elements. And I appreciate, Chuck, you did hit on the fact that you aren’t seeing any kind of tech spend get cut. But are you seeing some kind of resistance or slowdown as far as sales cycles impacting the speed at which you guys have historically done business. And I take into account also I appreciate your comment regarding linearity. But I just wanted to kind of ask this question to get it through.

Chuck Robbins: Let me take the second one first, and then Scott, you can talk about the data center switching redesign. We absolutely are seeing some elongated sales cycles. What our teams have told me is that, in many cases, there are extra signatures required. We just seem to, in general, be getting them. It just takes a little bit longer. So €“ but look, it’s a complex world right now. But if you look back at historical sort of what we would consider a bit of a crisis or a complex world environment, I’ve experienced demand falling off a cliff, and we obviously haven’t seen that in the current situation. Scott, do you want to talk about the redesign?

Scott Herren: Just to finish up on that pipeline looks strong, close rates still look good. So we’re not seeing a huge difference there. There is, in some cases, a slight elongation. On the redesign, that’s absolutely contributed to the growth that we’re seeing, particularly in secure agile networks, less so from €“ in terms of releasing the next successor product, more being able to design around problematic components that we couldn’t get supply of. And as we work those redesigns to build the product around components, we can get our hands on, that’s what we’re talking about when we talk about the redesign. And so there is no question, that’s driven some of the growth that you saw in the quarter we just announced. We will continue to drive the significant growth that we’ve put out for the second half.

And to be clear, we will continue to see growth into fiscal €˜24. All the trends we have talked about that are driving the uptick that you see in our guidance in the second half of this year, those trends continue into fiscal €˜24, and we continue to expect nice growth there. I just think it’s a little too early to start to quantify that and give you a guide.

Sami Badri: Got it. Thank you.

Marilyn Mora: Next question please.

Operator: Thank you. George Notter from Jefferies, you may go ahead sir.

George Notter: Hi guys. Thanks very much. I guess I wanted to ask about your impressions of backlog and product orders relative to three months ago. And I think I have this correct. About three months ago, you guys were talking about if product orders were down 10% for the year, then your product backlog at fiscal year-end would be 2x to 3x higher than the normal kind of $4 billion or $5 billion range. And Chuck, I think you were quick to say that it didn’t feel like a 10% order decline was in the cards for you. So, it feels now like you are going to burn more backlog than you were thinking previously and orders will be a bit worse than previous, am I perceiving that correctly? And what are your thoughts there? Thanks.

Scott Herren: Yes. George, I will take that, Chuck, and then you can jump in. I don’t think it is burning down backlog. We clearly are €“ the good news is we are able to ship more of the backlog. That’s good news for our customers. They are waiting for these components. They have got projects that they are holding up that they need to get done. It’s good news for our channel in a sense that the channel is sitting on, in some case, partial shipments. They need that last box, so they can go out and implement that and relieve some of the pressure on their own working capital. So, it’s not €“ I am responding to the burning down backlog. This is good news, our ability to ship the backlog, and that’s what you see reflected there in the guide down €“ or sorry, in the guide up that we have in the second half of the year.

We have €“ what you see now is a significantly higher revenue projection for the second half of the year than we had before. And some of that clearly is our ability to ship backlog because of the great job our team has done to free up supply.

Chuck Robbins: And I would say on the demand side, if I go back 90 days, I would say, in general, I think there was more risk, at least there felt like there was more risk. And when I talk to my customers, there is more uncertainty. And even when you hear €“ listen to the news and we talk €“ I talk to my colleagues, we were in Davos, it feels like the longer we go without seeing some major shift, then the better our customers are feeling. So obviously, we are not immune to anything, and we will have to continue to monitor it. But after traveling in Asia last week, our team being in Europe, I actually saw customers in New York while I was here this week, and customers are moving forward.

George Notter: Okay. That’s helpful. Thank you very much.

Marilyn Mora: Thanks George. Next question.

Operator: Thank you. David Vogt with UBS, you may go ahead.

David Vogt: Great. Thank you, guys and I apologize if you covered it. My line cut out a little bit more. Scott, I am just trying to clarify the order versus the backlog comment. I think if I am not mistaken, your run rate backlog had been sort of roughly $5 billion as you exited fiscal year. So, are you suggesting to us that the backlog comes down by about $3.5 billion over the next several quarters? And if that’s the case, if I just kind of back that out of your guidance, would that imply sort of that the business is effectively flat year-over-year ex the backlog drawdown as we exit €˜23 into €˜24? And then I have a quick follow-up.

Scott Herren: Yes. So, let me try and walk through some of the moving parts there, David. It’s a great question. What we said previously is we thought we would end the year with somewhere between 2x and 3x normal backlog. And normal backlog, as we said last quarter, is between $4 billion and $5 billion at the end of the year. What we now see is that it’s still going to be roughly double what that same range. So, there is definitely our ability to ship some out of the backlog, which is again, great news for our customers and our partners. The one piece that’s missing in your equation is, as we ship the backlog, remember, we said there is more than $2 billion of software in there. A lot of that software is ratable. So, as soon as we ship it, it doesn’t all drop into the revenue stream.

It ends up dropping into deferred revenue and being recognized over time. So, there is a €“ you have to consider not just the reduction in backlog, what’s the uptick in the revenue guide, but also how much of this is going to contribute to growth in deferred revenue. That may be the piece that you are missing.

David Vogt: Got it. And then maybe just as a quick follow-up, so as we enter, let’s say, the next fiscal year, I mean given your excellent work on supply chain, and the team has done a phenomenal job, would that imply €“ I mean basically, we could be back at normalized backlog within a quarter, maybe two quarters at the worst-case scenario if trends hold consistent where we are today. Is that a reasonable expectation?

Scott Herren: Rather than try to say it’s a quarter or it’s two quarters, I do expect it to normalize in fiscal €˜24.

David Vogt: Great. Thanks guys.

Marilyn Mora: Next question please.

Operator: Thank you. Tal Liani with Bank of America, you may go ahead sir.

Tal Liani: Great. He stole my thunder with the previous question. That was exactly my question. So, I want to €“ I want to understand something just a clarification on what you just answered. So, at the minimum, the decline in the backlog was $600 million at the minimum because end of year is going to be $8 million to $10 million. Take 6% of that and the backlog is now higher, so that means that the minimum year backlog declined $600 million. And that means that product growth, we should take out some of the $600 million because some of it goes into deferred revenue. Am I correct with what you just answered?

Scott Herren: Yes. Well, you are close. Let me run through it again, Tal, and if it’s still not clear, we can catch in the follow-up. The 6% was the decline in backlog from Q1 to Q2, right. So, we were able to work off about 6% of the backlog that we came into the quarter with. What we have said is, at the time that we gave you that Q2 guide in the full year, the previous full year guide, we expected to end the year with somewhere between 2x and 3x our normal backlog. We are not saying it’s going to be roughly double the normal backlog. Some of that, obviously, will ship out and will be a part of the significant guide up that we have given you in the second half revenue. Some of it, instead of turning into immediate revenue, will go into deferred revenue and be recognized ratably over time.

Chuck Robbins: And show up in RPO.

Scott Herren: I hope that’s €“ yes, it will show up in deferred revenue and RPO. I hope that’s clear, Tal, if not, we can follow-up.

Tal Liani: Yes. Very clear. So, my question €“ I want to go back to the basics and understand, last quarter, we were all concerned about environment slowing down. We don’t hear you saying environment continues to slow down. We didn’t hear Arista saying it. We didn’t hear you saying that service providers were weak. Can you take us through the big customer account and tell us what is the situation of spending with your enterprise customers, commercial customers, service provider customers? Did the environment further deteriorate from the previous quarter, or did it stabilize? And does it make you think that at least the trends so far, the year would continue to be normal on a sequential basis, or do you expect some more deterioration going forward?

Chuck Robbins: Yes, Tal. So, we €“ on the enterprise and commercial space, we saw a double-digit sequential growth, which is in line with what we have seen historically. And as I have said, public sector was actually higher than historical ranges and Federal was €“ U.S. Federal was extremely strong during the quarter from a demand perspective. On the service provider side, I think you are seeing many of our competitors and peers, some of them anyway, don’t give order data. And so I think for us, those customers are the ones who did the most planning for long-term ordering. So, as lead times begin to come down, we would expect them to change their ordering patterns and they have already got 6 months to 12 months’ worth of consumption lined up in the backlog.

So, we will see that normalize over the next few quarters. I will say in the web scale space, there are roughly 35 use cases or franchises within the largest players, and we have actually been designed into 18 of those at this point. And we are very confident that we will continue to get designed in. I got a note today that we had just got noticed about a new design win today. And so we are still very optimistic long-term, we just think it’s a short-term normalization for our service provider space.

Tal Liani: Got it. Layoffs and the economic slowdown, my question was whether these factors you see an impact on your business on orders or they stabilized from previous quarter?

Chuck Robbins: Well, you mean layoffs in €“ like in our customers?

Tal Liani: Yes, across the industry?

Chuck Robbins: Yes. Well, if you think about what occurred, there was a lot of companies that had a massive surge in employment, and we didn’t. But I think the thing that we are seeing right now is that we have seen the sequential growth be in line and some €“ like it was towards the lower end. So, it’s not performing at the highest end, but I think that it’s in range. And if you €“ and I also shared that in Q3, our current forecast is also in line sequentially with historical ranges, which we normally don’t give. We just wanted you guys to have that visibility. So look, it’s certainly an uncertain time, and I am not €“ I don’t want to paint a picture that we are immune. And I don’t want to paint a picture that every customer is spending everywhere on everything.

But we have been able to maintain and continue to see our customers moving forward with projects. And the one thing that was really encouraging for me was to see January as strong as it was, given our €“ the uncertainty around €˜23 budgets.

Tal Liani: Got it. Thank you.

Marilyn Mora: Thanks Tal. Next question.

Operator: Thank you. Tim Long with Barclays, you may go ahead sir.

Tim Long: Thank you. Just hoping I can get two in here. One, could you talk a little bit about, obviously, the enterprise campus is still very strong. But I think traditionally, that’s kind of a GDP-ish type of business that has been running above that. And it sounds like your confidence for next year is pretty strong as well. So maybe, Chuck, any insights like what’s kind of different there? Are we starting to decouple from like macro GDP for that campus networking fees? Any thoughts there would be great. And then second, obviously, a lot of excitement out there about AI, ChatGPT, all that stuff. Just curious what you think for your data center and cloud businesses, what kind of impact if there is kind of more of an arms race with big customers around AI, what that would mean for switching and routing business for you guys? Thank you.

Chuck Robbins: Thanks Tim. So first one, on enterprise campus, I do think that the pandemic was a great educator for our customers about the need to maintain modernized infrastructure because moving into the pandemic, I think it became quite obvious to many of our customers that they had not been updating, and they had €“ they were sweating assets a little longer. So, that’s one thing that’s shifted. The second is we are really seeing €“ these trends of multi-cloud, the trend of hybrid work and the overall re-architecture of their networks. If you really think about what €“ how we built networks for 20 years, we built it on a premise that we have branches and we have a private data center, and all the traffic flows are very understood.

Now, I have to upgrade my entire infrastructure to deal with this brand-new world that I live in, supporting hybrid work, supporting hybrid cloud, etcetera. So, I think that’s been driving a lot of this as well as safety in the office, IoT, creating new experiences to get our employees back to work, etcetera. So, that’s what I think has been driving a lot of the enterprise campus stuff. As it relates to your second question around the AI play, I think that look, these AI networks that are being built, whether it’s in web scale or whether we have some of our largest enterprise customers that are building AI networks and training AI algorithms, these are €“ like in the web scale space, they are like bigger than the core infrastructure networks that they are running, which was astonishing to me when I learned that.

And the network performance required is 3x to 4x what they have historically needed. And so this is a massive opportunity for us and we are in active discussions with lots of customers around it. And so we do think that this shift is going to create a good opportunity for us in the future.

Tim Long: Okay. Thank you very much.

Marilyn Mora: Thanks Tim. Next question.

Operator: Thank you. Samik Chatterjee with JPMorgan, you may go ahead sir.

Samik Chatterjee: Yes. Hi. Thanks for taking my question. Congrats on the strong guide. Maybe if I could just quickly hit on two of the product areas mostly security, what sort of benefits are you seeing given your broad portfolio there in terms of customers looking to maybe some level of €“ consolidation just given your position as a more broader security portfolio supplier. And what sort of benefit does supply eases, maybe on the firewall side, should we expect revenue growth? And a similar question on Internet for the Future segment seems like a bit more supply constrained than other segments. But what sort of are you €“ what are you seeing on the supply side there? Thank you.

Chuck Robbins: Okay. I will take security and you can take the supply side. So, I think that €“ look, all of our customers definitely want to consolidate their security infrastructure. They have got 40, 50 different vendors, and trying to correlate these threats is very difficult and it’s just €“ you can’t add enough people. So, our teams right now are heads down working on some new capabilities that we are going to be bringing out over the next 12 months to 18 months, and some of that is focused on exactly that, how do we consolidate and how do we create the ability to correlate threats in real time much more effectively. And so we think that you are probably going to start seeing the benefit of that three quarters or four quarters out.

So, the team has got work to do. We have hired a significant amount of outside talent. We have invested heavily in this space. So, while we may see €“ we may not see the growth that you want to see in the near-term, but you will see this begin to accelerate in FY €˜24. And I think that we will €“ we are playing a long game here and really believe that there is a lot of consolidation that we can drive over the next few years. Scott?

Scott Herren: Yes. Internet for the Future, Samik, it is one of the spaces. We have worked so hard and done so much across our entire product portfolio. So, we have made great progress in many cases. I would say Internet for the Future is one of the spaces where we are still €“ we have improved lead times there, but we are still not back to more normal lead times in that space. What I would also say though, is we have already picked up orders just in the last several weeks from some of our peers that are also selling into that same space who couldn’t meet demand. And those orders came to us instead. So, while €“ it’s a space we continue to work on. And while we are seeing improvement, it’s not where we want it to be, I feel like we are performing pretty well on the supply side and Internet for the Future.

Samik Chatterjee: Thank you.

Marilyn Mora: Alright. That wraps up our Q&A. I am going to turn it over to Chuck for some closing remarks.

Chuck Robbins: Well, first off, I just want to thank everybody for spending time with us today and also really thank our teams. They delivered on very strong results. I want to thank the supply chain and our engineering teams for quarter-after-quarter-after-quarter of hard work and redesigns, over 100 product redesigns, aggressive actions to get us to the position we are in today, the entire company for the progress we have made on our business transformation. And I will just leave you with our feeling that our demand has remained stable. The business transformation is contributing significantly, our backlog, all of those give us the visibility and confidence in the future. I think the relevance of our portfolio, given the most pressing needs of our customers, is as high as it’s been in a very long time, and I am super proud of what our teams have accomplished. So, look forward to talking to you in the future and thanks for joining us today.

Marilyn Mora: Thanks Chuck. Cisco’s next quarterly earnings conference call, which will reflect our fiscal 2023 third quarter results, will be on Wednesday, May 17, 2023 at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. This concludes today’s call. If you have any further questions, feel free to reach out to the Cisco Investor Relations group, and we thank you very much for joining today’s call.

Operator: Thank you for participating on today’s conference call. If you would like to listen to the call in its entirety, you may call 866-361-4941. For participants dialing from outside the U.S., please dial 203-369-0189. This concludes today’s call. You may disconnect at this time.