思科 (CSCO) 2014 Q2 法說會逐字稿

Welcome to Cisco Systems' second-quarter and FY14 financial results conference call.

At the request of Cisco Systems, today's call is being recorded.

If you have any objections you may disconnect.

Now, I'd like to introduce Melissa Selcher, Senior Director, Analyst and Investor Relations.

Ma'am, you may begin.

Thank you.

Good afternoon, everyone, and welcome to our 96th quarterly conference call.

This is Melissa Selcher, and I'm joined by John Chambers, our Chairman and Chief Executive Officer; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, President of Development and Sales; and Gary Moore, President and Chief Operating Officer.

I would like to remind you that we have a corresponding webcast with slides on our website in the Investor Relations section.

Income statements for GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements, and other financial information can also be found on the Investor Relations website.

Click on the financial reporting section of the website, to access these documents.

Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results.

The matters we'll be discussing today include forward-looking statements, and, as such, are subject to the risks and uncertainties that we discussed in detail in our documents filed with the SEC, specifically the most recent reports on Form 10-K and 10-Q, and any applicable amendments, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

Unauthorized recording of this conference call is not permitted.

All comparisons to this call will be on a year-over-year basis, unless stated otherwise.

I'll now turn the call over to John for his commentary on the quarter.

Mel, thank you very much.

In Q2 FY14, Cisco delivered non-GAAP earnings per share of $0.47, on revenues of $11.2 billion, down 8% year over year.

The market and the dynamics in our business played out largely as we described in our last quarterly conference call.

We saw the impact of our emerging markets, service provider, and high-end product transitions in our business, as we discussed last quarter.

I will provide more detail in the business update.

As we navigate these economic and product cycles, we are managing our business to deliver shareholder value.

In this quarter, we returned a record $4.9 billion to shareholders, through dividends of approximately $900 million and $4 billion in share buyback.

We managed non-GAAP operating expenses, reducing them into high single digits year over year.

And Gary, Frank, really nice job on that.

And we built backlog, just as we said we would.

We believe the strategy that has enabled us to emerge stronger from every previous cycle remained solid.

We capitalized on the major market transitions.

We partnered with our customers to deliver innovation and solutions that fuel their business.

In our view, this next wave of the Internet, the Internet of Everything, will encompass every technology transition we are seeing in the market today, with the network squarely at the center.

We are building the platform for the Internet of Everything with scale and security to address the unparalleled complexity requirements.

We plan to continue to disrupt the market and disrupt ourselves to deliver the value and solutions our customers require.

Last year, we introduced entirely new approaches to networking, designed around future-proofing the best customers are making today, and enabling them to harness the benefits of the Internet of Everything.

As we've capitalized on these transitions, I would like to summarize the dynamics of our business in the following five points: First, the Internet of Everything has moved from an interesting concept to a business imperative, driving opportunities across every major vertical.

It was the central conversation at the Consumer Electronics Show, and the World Economic Forum of the last couple months, with CEOs, industry and country leaders globally.

Anyone walking away from these events should characterize this year as the tipping point.

Second, we continue our strength in US enterprise and US commercial, as we said we would do last-quarter conference call, with year-over-year orders up 13% in US enterprise, and 10% in US commercial.

While we face SDN, fight label servers, and public cloud solutions to this market, we see our ability to deliver architectures and cross-portfolio solutions with scale, security and CapEx and OpEx savings as a driver of our success in this market.

Third, we are managing through the economic and product cycles, just as we outlined on the last call.

Emerging market orders declined 3% year over year, as compared to last quarter's down 12%, with the BRICs, Mexico down 10% this quarter.

SB orders declined 12%, and product transition and core routing and switching contributing to double-digit revenue declines.

As we move to reaccelerate growth across the businesses, we remain focused on managing the levers to deliver value to our shareholders, while making the investments to position Cisco for the long-term.

Fourth, we believe our focus on architectures is really paying off.

As the pace and complexity of IT increases, Cisco's ability to bring together technologies, servers, and solutions across silos should continue to drive differentiation, preference, and over time, gross margins.

Point players will push us faster at times, but I believe you will see our advantage, in delivering integrated architectures, at scale, win in the end.

And fifth, we said last quarter that our goal was to build product backlog and we exited Q2 with book-to-bill greater than 1. We are pleased with our progress managing through the cycles in our market and our businesses, and as such, wanted to give you an update on our Q3 revenue guidance, before Frank details guidance later.

That allows you to help frame the rest of the discussion this call.

For Q3, we expect revenue to decline in the range of down 6% to down 8%.

As we execute on our plan to return to growth over the next several quarters, subject to all the appropriate caveats discussed during this call, we also plan to continue to build backlog.

There's no question that we have moved from a compute-centric to a network-centric model for IT.

Cisco is building the simple, smart, and highly secure solutions that will enable our customers to capitalize on the cost efficiencies, agility, and growth opportunities that lie ahead.

Our approach is unique.

It starts with the central role of the network, which is the only place that connects everything; people, process, data and things.

Our transition is from selling boxes, like most of our peers, to selling business outcomes.

Our delivery is through architectures, partners and services, and we will help our customers utilize their $180 billion Cisco install base to capture the most value today, and build for tomorrow.

As we move into this next area of the Internet with our customers, our commitment to you is to invest to sustain our industry leadership position, while balancing the evolution in our business, and a very strong focus on shareholder return.

Frank, at this time, I'd like to turn it over to you.

Thank you, John.

In Q2 FY14, our business performed as we expected.

We continue to manage through the transitions in our business, and challenges we outlined in our last earnings call.

From a top and bottom line perspective, total revenue was $11.2 billion, down 8%.

Non-GAAP net income was $2.5 billion, and non-GAAP EPS was $0.47 per share, down 8% year on year.

Our GAAP net income was $1.4 billion, and GAAP earnings per share on a fully-diluted basis were $0.27.

Product revenue declined 11%, and service revenue increased 3%, with product book-to-bill greater than 1. Overall non-GAAP operating margin was 27.8%.

In Q2, our total non-GAAP gross margin was 61.3%, within our expectations of 61% to 62%.

Non-GAAP product gross margin was 58.8%.

As our overall volume of business was down this quarter, it's negatively impacted our non-GAAP product gross margins in several ways:

First, we have less leverage in our cost structure.

We did not get the full benefit of cost efficiencies at these lower volumes.

Second, as our volumes in higher-margin core products were lower, we saw an unfavorable mix impact toward lower-margin products, such as SP video and servers.

Third, while the impact from pricing was consistent with prior quarters, it was at the higher end of our historical range in Q2.

As we improve business volume, we expect it will balance the drivers of our product gross margins.

Our non-GAAP operating expenses were $3.7 billion, or 33.5% as a percentage of revenue.

That's compared to 34.1% in Q2 of FY13.

Our headcount decreased by approximately 1,000 from the end of the fiscal year to 74,065.

Our expenses benefited from reduced variable compensation expense, as a result of our lower financial performance, and efficiencies associated with our recent workforce rebalancing.

GAAP net income for the second quarter of fiscal 2014 included a pretax charge of $655 million, related to the expected cost of remediation of issues with memory components in certain products, sold in prior fiscal years.

The charge is related to the expected remediation cost for certain products containing memory components, manufactured by a single supplier between 2005 and 2010.

These components have been determined to have a potential to fail, due to a design or manufacturing defect.

These are widely used across the industry, and are included in a number of Cisco's products.

Although the majority of these products are beyond Cisco's warranty terms, and the failure rates are low, Cisco is proactively working with customers on mitigation.

This results in a charge to product cost of sales during the second quarter of FY14.

This charge has been excluded from non-GAAP results, as Cisco does not believe it is reflective of ongoing business and operating results.

Total cash, cash equivalents and investments were $47.1 billion, including $3.3 billion available in the US at the end of the quarter.

We generated operating cash flows of $2.9 billion during the quarter.

We continue to drive our capital allocation strategy.

As you recall, in Q4 FY12, we committed to return a minimum of 50% of our free cash flow annually, through dividends and share repurchases.

In FY13, we returned over 50% of free cash flow, and I'm pleased that in the first half of FY14, we have returned in excess of 150% of free cash flow to our shareholders, comprised of $6 billion of share repurchases, and $1.8 billion of dividends.

In Q2, we returned $4.9 billion to shareholders, a quarterly record for Cisco.

This included $4 billion through share repurchase and approximately $900 million through our quarterly dividend.

Our diluted share count decreased by approximately 100 million shares, driven by these repurchases.

We expect the remaining impact of the Q2 share repurchase to further reduce share count this next quarter.

In addition, today, our Board approved an increase of $0.02 to the quarterly dividend, to $0.19 per share.

An approximate 12% increase, representing a yield of approximately 3.3%.

This dividend increase, combined with the anticipated share repurchases in the second half of the fiscal year, would comfortably exceed a return of over 100% for the full fiscal year of our free cash flow.

In Q3, we anticipate incurring additional debt to refinance our maturing bonds and enhance our domestic cash balances to support our ongoing commitment of returning cash to shareholders.

John, turn it back over to you.

Thank you, Frank.

I'll now provide some additional detail on our Q2 performance, and trends we are seeing in our business, and in the market.

I will start with an update on the three economic and product cycles we outlined in our last call.

First, we saw emerging orders declined 3% year over year, compared to the 12% decline in Q1.

With the BRICs plus Mexico down 10%, as I said earlier.

While we saw some improvement quarter to quarter, the emerging markets remain challenged, as we discussed in the last conference call.

While this economic trend remains out of our control, we have put in place important programs and efforts to design to capture growth and position Cisco to capture share, even if these markets remain challenged.

Second, service provider orders declined 12% year over year.

SP video orders, including the set top boxes were down 20%.

Service provider orders, excluding SP video were down 7%.

Product transitions in core routing, along with the emerging markets weakness also negatively impacted search router results.

And third, product transitions.

At the end of last year, we introduced new switching and routing platforms, which typically can be ramped up over 4 to 8 quarters.

Our next-generation routing business saw year-over-year revenue decline of 11%, with orders down 5%.

As we managed through these transitions, we have announced reference customers for the NCS platform, including Telstra, KDDI, and BSkyB, and we expect both the NCS and CRS-X to ramp through the back half of the year.

Switching revenue declined 12% year over year, with orders down 6%.

As we saw some deals delayed as customers' architects and qualified their new application-centric infrastructure systems.

We were very pleased with the first shipping quarter of the Nexus 9000, as the booking pipeline from the beginning to end of the quarter nearly tripled.

We believe we are firmly taking share in the 10 gig and 40 gig data center switching markets.

I'll now walk through the elements of the product portfolio that I've not yet mentioned, in terms of year-over-year revenue growth.

Data center revenue grew 10%, with order growth rates in the mid-30s.

Revenue this quarter in data center had some impact from lower backlog coming into the quarter, and the timing of shipments.

The pipeline continues to look very strong, and UCS continues to take market share.

Wireless declined 4%.

Cisco's cloud networking platform, Meraki, continues to perform very well, growing over 100% year over year, and more than doubling customers from 4,300 to one quarter ago, to 9,600 in this quarter, due largely to the power of the Cisco channel.

Approximately one-third of Meraki's business is deferred.

We have seen -- also seen the wireless impact by more complex architectural deals, in our large enterprises and service providers, where wireless is part of a much broader solution, which have long sales cycles.

Security revenue grew 17%, with particular strength in network security, up 21%, and content security, up 5%.

We are seeing the orders grow significantly faster than revenue, up 30% this quarter, as we continue to shift toward more recurring revenue models in this business.

The Sourcefire acquisition continues to perform very well, and there is no question that the Sourcefire acquisition has accelerated our position as a leading security company, and in our view, the only one capable of delivering an end-to-end architectural approach.

We are very pleased with the performance of both Meraki and Sourcefire acquisitions as part of our build, buy, and partner innovation strategy.

Now moving on to collaboration, collaboration revenues declined 7%, with a decline of 9% year over year in the unified communications, as we plan for an upcoming product refresh with our customers, the WebEx conferencing business had a very strong quarter, up 21%.

In WebEx we saw many matrix, including billable minutes and new customer adoptions grow quite well.

This growth came from both very large enterprise deals, as well as good traction in the SMB space.

It is worth noting that our goal to move more of Cisco's revenue to recurring is taking place today in our collaboration businesses, security businesses, and with respect to some of our recent acquisitions like Meraki.

This quarter, we saw product deferred revenues increase approximately $100 million quarter over quarter.

Over time, you will see us introduce new consumption models in other parts of our business that align with how our customers want to buy IT today, which will also help us drive better visibility going forward.

Service's revenue grew 3%, with both technical services and advanced services up 3%.

As we discussed last quarter, service revenues are currently tied closely to product growth, so the deceleration in product momentum continues to impact service revenues.

Continued investment in consulting services, remote monitoring smart services, and analytics, will drive additional opportunities in the quarters to come.

We did begin delivering a new set of security services this quarter, continuing to better address our customers' top priorities.

Now onto our cloud business.

While not reported as a specific product category but rather reflected across our product categories, continues to grow very well.

On the cloud infrastructure side, we once again advanced our position as the leading cloud infrastructure provider.

In Q2, we saw double-digit booking growth, with massively scalable data center customers, as they chose and purchased the Cisco UCS and Nexus portfolio.

Our cloud services business also continued very strong growth.

As mentioned before, we experienced very strong growth in Meraki, WebEx and security cloud services business.

At Cisco Live in Milan, in January, we announced several important additions to our cloud portfolio, including Cisco InterCloud, the ability to create interoperability and highly secure hybrid cloud environments across multiple public and private clouds.

While peers count workload mobility within their proprietary cloud offerings, only Cisco can enable organizations to combine and move workloads, storage, compute, and applications.

Across different clouds, and hypervisors, securely, with all the associated network and security policies.

I will now move on to provide background on our geographic and customer segments in terms of Q2 year-over-year product orders, unless specifically stated otherwise.

In Q2, product orders declined 4% year over year, and as we said earlier, total product book-to-bill was greater than 1.

To provide a geographic view of orders this quarter, Americas declined 5%, in the US, balancing out strong enterprise and commercial momentum, US public sector declined 4% Within US public sector, state, local, and education grew 7% and US federal declined 16%.

US service providers declined 11%, as we managed through the SP video transition, and product cycles mentioned earlier.

Now moving onto Asia-Pacific, China, and Japan, which as a region declined 5%.

China declined 8%, as we and our peers continue to work through the economic and political dynamics in that country.

The Europe, Middle East, Africa, and Russia region declined 2%.

Northern Europe and the UK are showing good momentum, while southern Europe continues to be challenging.

Signs suggest Europe is stabilizing, though still fragile, especially in the South.

Moving on to a segment view, enterprise declined 2%, commercial grew 1%, public sector grew 1% on a global basis, and as mentioned above, service providers declined 12%.

As we said in our last call, managing through product and market cycles is part of being a leader in the technology industry.

We feel very confident in our ability to work through these cycles, over the coming quarters.

We will continue to tell you exactly what we see, and manage the business to perform to the expectations we set with you, as we did this quarter.

Frank, I'm now going to turn it back over to you.

Let me provide a few comments and our outlook for the third quarter.

Let me remind you again that our comments include forward-looking statements.

You should review our recent SEC filings, that identify important risk factors and understand that actual results could materially differ from those contained in these forward looking statements, and that actual results could be above or below our guidance.

The guidance we are providing is on a non-GAAP basis, with a reconciliation to GAAP.

As John discussed earlier, we expect total revenue to decline in the range of 6% to 8% on a year-over-year basis.

For the third quarter, we anticipate non-GAAP gross margin to be in the range of 61% to 62%.

Given the business volumes assumed in our revenue guidance, it is most likely to be at the low end of this range.

Our non-GAAP operating margin in Q3 is expected to be in the range of 26.5% to 27.5%, and our non-GAAP tax provision rate is approximately 21% in the third quarter.

Our Q3 FY14 non-GAAP earnings per share is expected to be in the range of $0.47 to $0.49 per share.

As we communicated last quarter, we expect FY14 non-GAAP earnings per share to range from $1.95 to $2.05.

We anticipate our GAAP earnings to be lower than non-GAAP EPS by about $0.10 to $0.13 per share in Q3 2014, and $0.56 to $0.62 for the full year.

This range includes a pretax impact of approximately $50 million in Q3 FY14, and up to $550 million for the full year, as a result of our anticipated restructuring charges, related to our workforce reduction plan that we announced last quarter.

During Q2 FY14, we recognized pretax charges to our GAAP financial statements of $73 million, related to that announcement.

Please see the slides that accompany this webcast for more detail.

Other than those quantified items noted previously, there are no other significant differences between our GAAP and our non-GAAP guidance.

This guidance assumes no additional acquisitions, asset impairments, restructurings, and tax or other events, which may or may not be significant.

And as a reminder, Cisco will not comment on its financial guidance during the quarter, unless it is done through an explicit public disclosure.

I'll now hand the call back over to John for detail on our business momentum and trends.

John?

Frank, thank you very much.

Managing transitions has been a core foundation for of our success for nearly 30 years.

The Internet of Everything is the biggest market opportunity ahead, encompassing every technology trend in the market today.

In recent months, the Internet of Everything has become the center of most every conversation with CEOs, industry, and country leaders.

2014 will be the inflection point for the Internet of Everything.

The level of excitement we see in the conversations we're having today and with customers about the next wave of the Internet, reminds me of the mid-1990s.

At that time, we saw the Internet and e-commerce moving from just a tech thing to something that did impact every industry.

Like customers did when the Internet and e-commerce were becoming mainstream, customers are turning to Cisco as a trusted partner today, to capitalize on the opportunity, and minimize the risk in their business, as they move into the Internet of Everything.

As we saw in the e-commerce space, there's a lag between thought leadership and mainstream adoption, and we still are only in the beginning stages.

We are seeing tangible early traction.

For example, in our top 50 targeted accounts, with over a $2 billion opportunity for Cisco.

We are managing the transitions in our portfolio today, and building for the Internet of Everything for tomorrow.

This is how I'm looking and evaluating our progress: First, our willingness to change and disrupt.

You've heard me say for at least two years the pace of change has become exponential.

Multiple transitions are occurring at the same time, requiring Cisco to transform on multiple fronts, faster than we've done before.

Our scale, customer relationships, and number one market position in most of our targeted categories gives us a huge advantage, as we deliver a new model for IT.

The next generation of network will collapse the OSI stock from seven layers to three, bringing applications, networking, and security together at scale.

This will not only happen in the data center as we are seeing today, but across the campus, access, and into the cloud.

Second, customer traction.

We don't get to decide whether or not we will emerge as the number one IT company, our customers do.

What we do get to decide is how we continue to deliver the value to our customers, to retain the market-leading position.

This will be done by selling business outcomes enabled by architectures.

I look closely at how we are engaging with customers, and moving from a technology provider to a trusted business partner.

Whether it is the $3 billion of value created in the City of Barcelona through connected intelligent infrastructure, or the first digital country, Israel, or several major retailers basing their networks on Cisco in order to prepare for the Internet of Everything, our customers are coming to us to capitalize on the opportunity.

Third, operational excellence and disciplined cost management.

We manage non-GAAP operating expenses very well this quarter, decreasing 9%, as we focused on cost management and productivity.

This execution shows we are able to focus on cost as we transition the business.

We continue to focus on operating as an efficient organization, while at the same time, making the right investments to drive long-term growth.

Fourth, creating shareholder value.

As we execute our strategy to become the number one IT company, we have also committed to returning at least 50% of cash flow annually to our shareholders.

As Frank said earlier, we will comfortably exceed this amount for the balance of the fiscal year.

When our operating results have been impacted by a challenging macro environment in the emerging markets, along with choices we are making to transform the Company, we've demonstrated our confidence in the future and our support for shareholders, by materially increasing our capital return, as we did last quarter.

We continue this focus on shareholder value with the $4 billion share repurchase this quarter, and the dividend increase we announced today.

Change has always been good for Cisco, and our track record for transforming ourselves, both as a company, and as leaders, is unparalleled.

We are as close to our customers and partners as ever.

We understand their challenges, and where they need us to be there, and we are using this position to build the products, solutions, and platforms to meet the demand for the market.

This, to me, has always been the key leading indicator of future success and financial results, and gives me confidence that we will emerge as the number one IT company.

Mel, let me turn it over to you.

Great.

Thank you, John.

We'll now open the floor to Q&A.

We still request that sell side analysts please ask only one question.

Operator, please open the floor to questions.

(Operator Instructions)

Jess Lubert, Wells Fargo Securities.

Question's on the product gross margin, which declined quite a bit sequentially, and was at the lowest level we've seen in a while.

And you went through some of the volume and mix issues in the call, so I was hoping you could touch upon the competitive environment, from both traditional and non-traditional vendors.

To what degree there was any change in pricing.

And perhaps beyond Q3, do you think you can get the gross margin back towards the mid-to upper end of the 61% to 62% gross margin range as volumes improve and new product ramp.

Or should we be thinking about the lower end of this range longer-term?

Frank, I'm going to have you handle the second part.

The first part, there was nothing abnormal about this quarter's pricing trends at all.

No abnormality in terms of competitors we saw, new or existing models, or new start ups.

The field is going to go after key wins.

And opportunities to capture major franchises in key strategic, beginning of architectural plays.

And I think it's good, as we begin to drive for growth.

In terms of the timing, what we said traditionally in terms of the growth, you watch our order improvements, you watch our steady progress each quarter, which I think we've done up to this point in time, and we're going to do it again this next quarter, and you will see as we come through these product transitions at the high-end routing and switching.

And as you see us begin to core our service provider strategy more together, you will see these turns up in Q4 and Q1 and Q2, in terms of momentum from an order perspective.

Frank, I'm going to switch it over to you in terms of gross margin comments.

Jess, as I mentioned, we came in at 61.3% within the range of 61% to 62% and provide guidance in the range of 61% to 62% for the next quarter and saying that's at the low end of that range.

Primarily in Q2 as well as Q3, the issue is volume.

So to answer your question, and that's driving mostly the costs as well as the mix that I talked about, so as volume does improve, that gives us the ability to also improve the gross margin.

So when I think about it from a long-range perspective, we talked about 61% to 62% for some period of time, as volume improves and we get into a more growth scenario from a top line perspective.

That enables us to be the high end of that range, or even above that range.

Great.

Thanks.

When you think about it, Jess, we have control of our pricing, our expenses, and gross margins.

And we're managing these as levers.

As volumes come back, as Frank said, and I believe very firmly that they will, you will see the gross margins improve as well.

But reminding everybody for the last couple years, I've been saying gross margins would be in the 61% to 62% range, and plus or minus 1% or 2%, and I think middle of the last time we said that, very openly, was in fact in 2012.

Absolutely.

Thanks, Jess.

Operator, next question?

Amitabh Passi, UBS.

John, what is the risk that you've got yourself too spread across too many areas, where you're fighting multiple battles on multiple fronts, with just a massive rate of flux in each of your markets?

And the reason I ask is, I'm a little surprised at the service provider segment for you continues to remain relatively weak.

NCS has been up for some time, so I'm surprised we're not seeing any traction there.

So I'd love to get your thoughts in terms of the portfolio, is there room for further rationalization, are you spread too thin?

Okay.

So first, the answer is no.

If you watch if you are a single product company in today's market, you're going to have a real tough time competing against a number of different competitors, and differentiating yourself.

We saw these trends coming, and we've articulated for four or five years the importance of architectures, where you combine products that combine 13 products that are number one in their field, four products that are number 2 in terms of market share, and two product areas that are number three.

You combine these into architectures with services and partners that very quickly bring you to solutions and dramatic differentiation.

And that is what you're seeing them play very strongly in the US commercial and US enterprise, as proof points.

The second part of your question in terms of service provider, we basically are again going with an architectural approach.

We are literally saying how do you influence the key issues that are most important to the service provider, from mobility, to video, to cloud, to speed of services delivery, to reducing OpEx and CapEx and say how you approach these as an architectural approach?

So I think this will be an industry where architectures will win, and I think we are very well-positioned versus our key traditional IT players and future challengers.

Great.

Thanks, Amitabh.

Next question, operator?

Subu Subrahmanyan, The Juda Group.

My question is on the product transitions you're seeing.

Is there any way to quantify the impact of data center transition and core routing product trends on this quarter?

John as you look at the recovery in these, is there a timing expectation, which one will rebound first?

Between these two?

Sure.

As you look at it, let's go to the data center, and let's go to switching.

If you watch and use the Nexus 9000 as an example, our product pipeline is up to 522 customers.

That's almost a 2.9% increase quarter-over-quarter.

Our win rate is extremely good versus traditional players and new challengers.

You'll see us, over the next four to five quarters, blow by some of the early start-ups in this area.

And if you look at the transition, I think you'll watch our orders in Q4 and Q1 in this area, and we're going to follow a path very similar to what we did in UCS, a similar game plan that this team, that has done so many times before from a technology perspective, we will put in place our steps in terms of how we identify the top customers, how we get the close rates, how we ramp the volume.

And at the same time tie that's what we're doing in the Nexus 7000 and below in the terms of the data center.

In terms of the routing, the routers are a little bit longer sales cycle.

As you know, when you put these routers that have such tremendous capability and function where you can literally transferred the whole Library of Congress in a second or the Netflix library in a second, you basically are talking about tremendously powerful capabilities, with the NCS and CRS-X.

That will take it a little bit longer.

I'd watch our franchise wins in Q3, and then you should begin to see orders pick up in Q4 and Q1 on those.

Little bit longer sales cycle in terms of implementation.

Great.

Thanks, Subu.

Operator, next question?

Brian Modoff, Deutsche Bank.

Continuing on -- switching the Nexus 9000 order ramp, will we see that this quarter?

Our checks in continue to indicate more of an evaluation phase of that product still.

Will we start seeing that ramp this quarter?

Will that help get switching back into positive territory heading into July, and into fiscal 2015?

And then can you give us an update on campus switching, and how that's doing?

Thank you.

Sure.

Rob, I'm going to give you the campus switching piece.

Let me go to the Nexus piece.

Literally I review almost every other week with the team where we are on this.

Reminding everyone, this team has never missed in terms of our telephony approach, our combination of storage, with the network, with processors that really made us a major player in the data center, and now what you watch on this one, you're going to see a steady ramp to where we will just pick up momentum in key accounts, and we're tracking those key accounts.

The volumes are small.

We won one for example today that is a huge opportunity, but it was the first opportunity to get the door and the foot.

So we deal with first getting the pilots in, and then scale, but this is a product that is extremely competitive, and every aspect of the commitments they've made on the product are on schedule on the quarters that they committed to.

So I feel very comfortable with the product ramps on this.

And as you begin to see the Nexus 7000 and 9000 both available in the market, then you will move through, perhaps a little bit of pause, where customers are saying, which way do I go?

And I have a hesitation here.

Rob, additional thoughts on campus?

John, in addition to the data center, I think that the entire two big transitions, which are from 1 gig to 10, and now from 10 to 40, are playing to the strongest hand we've had in terms of our portfolio.

3 So we have a product for every part of the market right now.

And you covered some of the data center technologies.

We haven't talked about the new 40 gig uplinks on our Nexus 5000, an important part of the product.

And of course the 10 and 40 gig links on the campus switch, which is a 68000.

So right across the board, great portfolio strength, and you mentioned it, but we do have the pedal to the metal on the 10 to 40 gig transition, and I think you're going to see some good market share movement in the quarters ahead.

I think the market share gains of that are going to be dramatic.

Great.

Thanks, Brian.

Operator, next question?

Ittai Kidron, Oppenheimer.

John, I want to focus on two specific segments, the wireless and the data center.

Both for a couple of quarters now, have either completely flattened out, or in the wireless cases, have even declined on a sequential basis.

And I'm trying to understand, I understand, I would assume that some exposure there relates to emerging markets and that's probably one of the sources of the weakness But nevertheless, for you, those are very high growth opportunities especially on the server side and on the wireless, many of your competitors are still growing at a very nice clips.

So I'm trying to understand if there's something going on in those two businesses that's not related to the macro issues you've been discussing.

First on the data center, the answer would be out and out no.

If you watch the rate at which our orders come in, as I said in the script, the order rate was in the mid-30s.

And this is more of a timing of shipments.

Book to bill across most of our product lines you can do the math as quickly as I can, most all of them were in good shape in terms of book-to-bill.

We truly built backlog in many of the categories.

And I'd be very surprised if you don't see the numbers up in the 30% range this next quarter, with all the appropriate caveats.

That momentum feels good.

We are very, very well-positioned versus competition.

On the wireless side of the house, there were areas such as Meraki that were just very, very good, where you go with solutions and position it.

Some of the other wireless decisions on very large service provider decisions are long sales cycle, such as small cell, SB, Wi-Fi, et cetera on it.

And I think you're going to see as we brought out some additional product functionality, that just came out with our wireless LAN capability, Rob, you'll see the orders in that category pick back up as we look out over the next couple quarters.

So on the data center, we're going to win that one, and I think you see tremendous momentum there.

And we have no fear here.

That one really feels good.

And then in terms of the wireless, there are a couple areas that we need to pick momentum back on.

Rob, I think we know what we want to do on that.

You talked that group the other day, I think.

I talked to them the other day, and again this morning, so we've got some actions in place.

Sounds good.

Great.

Thanks, Ittai.

Operator, next question?

Paul Silverstein, Cowen.

I'm hoping you treat this a clarification, but let me give it a shot.

Going back to gross margin, I just want to confirm something.

With respect to the pricing environment, I think John, if I go back to the previous quarter, you all were fairly assertive in your commentary about the health of pricing, especially with the new products, that they were coming in consistent with your current margin structure.

So returning to this quarter, is it essentially a volume issue, or when we look at pricing, when you look at the platforms has there been any change in terms of the margin profile of those new products in particular, and more generally in terms of the overall product portfolio?

I heard your response on the call previously.

Not an issue, but I just want to clarify to what extent is this a volume issue or is this something more?

Paul, great question.

It allows me to expand on a little bit.

It's purely a volume issue.

If you look at costs, you look at mix, you look at pricing, et cetera, those three come together.

Volume is what is driving each of the areas.

The area that you are being very gentle with me on, is you're saying all right, John, you're seeing unusual things in switching.

Has that been a surprise?

Even within the switching segment, our gross margins are remarkably stable, even with lower volume.

So we're not seeing anything unusual in the switching at all.

We're very, very competitive.

And as we mentioned before, Paul, these new products, which we're just now beginning to get out, and you haven't seen the effects on gross margins, are all coming in with gross margins that are very typical of our high-end gross margin.

That's a much better job than we've ever done on high-end products, where usually we bring them out in the low 50s, and over literally almost two years, bring them back up to more traditional margins.

So I feel good with that.

So it's volume and volume ties to what the cost, what the mix, and what you see overall in terms of pricing in the field.

Pricing in the field is a little bit up versus what we've seen before.

But well within the range of what we see.

A point plus or minus a half point.

Great.

Thanks, Paul.

Operator, next question?

Kulbinder Garcha, Credit Suisse.

Just a question on the services side.

I think Frank mentioned early on in the call were services should follow product revenues, and I guess what we're seeing is that we're seeing the product revenues that obviously declining.

Can you upsell services to offset that, or is there risk that one or two quarters out, we start to see services maybe decline?

How should we think about that dynamic?

And then just one for the clarification on gross margin if I can, are you saying that there's no real change in the pricing environment?

It's all volume driven?

The reason why I ask is that you knew that revenues were going to be pretty weak this quarter.

And your guidance for lower gross margins will weaken part of this quarter, they are going to be relatively weak next quarter.

So why aren't the cost efficiencies coming through, or is that more longer-term discussion?

Any comment on that would be helpful.

Thanks.

Gary, do you want to take the services one?

I don't know if you could hear it or not.

I think I do, John.

Kulbinder, on the services, the services business is tightly tied to product, but we have added a number of services that John mentioned during the call earlier.

And those are ramping up, and the fact that our product decline has been what it's been, those services aren't coming up as fast, and offsetting that.

But we're very happy with the way we've been able to drive continued growth in the services business, as well as continuing to drive the margins that we've had.

In terms of the gross margin comments?

As far as the gross margin just to reiterate, so as far as the guidance that we gave last quarter, 61 to 62%, as I said, we came in at 61.3%, so we did assume the lower volume when we gave the guidance, and then also assuming the lower volume for Q3 and the guidance that just gave for the coming quarter.

As far the volume and cost impact, so when you take your volume down, we have a fixed base within our manufacturing organization, things like logistics centers, things like the data center, that supports WebEx, and things like t hat.

When you have lower volumes you're spreading that fixed base over those lower volumes, and therefore you don't get some of the magnitude of cost benefits that we have seen in prior quarters.

So some of the initiatives that we're driving, like value engineering, we're continuing to drive those.

We don't see the full impact when the funds are down, because it's offset by the fixed cost piece of it.

So as the volumes, as I said before, as the volumes improve, back to let's say, normal levels, then you can definitely start to realize those sufficiencies from a cost, and then also from a mix standpoint, as the volumes improve in switching and routing, which that was one that basically have the most delta on a quarter-on-quarter basis, which tend to have higher margins.

That's going to overall affect the mix in a positive direction, so we're having those impacts in periods when the volumes are lower, and as the volumes improve, they should be upset.

Very simple, if we were seeing major pricing pressures, we'd just tell you.

And the switching is the prime example, where even in the product transition time period, the margins are remarkably stable on that.

So we control the pricing, we control the expenses, control the gross margins.

And we think we are positioned very well versus the changes in competition at this time.

Great.

Thanks, Kulbinder.

Operator, next question?

Mark Sue, RBC Capital Markets.

So I guess the bigger the better within our gross profit cash flow approach here.

Some of your assets are past their peak cycle, and having a negative impact to your financial model.

So are we at a point with where Cisco has to choose between customers and margins?

And Cisco actually proactively look at some corporate ecology, so that we can actually have margin customers happy, and investors happy as well?

I think I got part of the question.

The question is, do we have to choose between customers and margins?

And I would say, the two actually come very tightly together.

And this is something that I think we need to both articulate, and give you a feel for the examples.

When you begin to look at an architectural sale, and I was just at Worldwide Tech this last week, WWT Technologies, and they this last year did about $2.8 billion as a partner reselling for us, growing in the high 20%s year-over-year.

They aligned completely with us by architectures, and they aligned completely with us as we made the transition into the Internet of Everything.

Bear with me as I walk through this, because you'll understand why I'm sharing this with you.

They standardized on Cisco, and they literally build in their labs the architectures, and instead of interfacing the customers with white papers or slides, they basically say, here's what you can do through architectures, and it's why you have to have all of these 18 different product areas, to be able to get the result that you want, when you combine it with services, to get the outcomes much faster.

And they already show that in each of their labs, with a capability to bring it to life, so you see the growth, you see the realization on it.

On the Internet of Everything, they are already almost ahead of us, Gary, in terms of, they are already talking to areas like in mining, where you connect the sensors to all the equipment in a major mining operation.

They get feeds, if you can imagine, probably 10,000 sensor feeds per second.

It goes into six or seven different databases applications.

As you begin to think about the Internet of Everything and as they share that architecturally, you all of a sudden show by doing this how you can make the decisions with people, process, data, and things, much quicker get the right information at the right time to the right person, or device, or machine, to make the right decision.

So this is why you have to be in these various product areas.

This is why when you bring those together your gross margins come up, because you're delivering results.

This is what you don't want to be a single product group like a router, or a switch, or a wireless capability, et cetera.

You can get caught in a huge squeeze as you move forward, and it's that combination to provide gross margin capabilities.

If you are in service providers, and of course we look at the analysis as we go forward, we're very much committed to the video side of the market, because video after voice is -- sorry video after mobile is their number one application area, that they really see differentiation in.

And two-thirds of the load on mobile devices in just a year will be video.

So you have to be in these areas to really tie it together.

Does that make sense?

Helpful.

Thank you.

Great, thanks, Mark.

Operator, next question?

Ehud Gelblum, Citigroup.

It's not a Cisco, if it was, it would be easier for me to figure out how to get off of mute.

Couple clarifications, and a couple of questions.

One big one, really.

Clarifications, first, if you can give us Frank, because you're buying back some stock just what the ending quarter share count was, that would be helpful.

And then a comment on linearity, if you could.

Clarification on the services business, I had thought at your analyst day in December, you said 80% of your services is maintenance.

I had thought it was more a function of your installed base, than on quarter by quarter product revenue, so if you can clarify that?

And then my real question is about service provider.

Service provider video obviously continues to fall.

Is there a bottom, is there a spot that you can calculate it, and you look at your cost base where that bottoms out and should we be modeling that?

And on core routers, is that a cyclical funk that we're in right now in core routing?

You're getting so many questions I can't even write them down quick enough.

Let me stop right there.

And see if we go through it.

I'm going to take the linearity question.

The quarter was very linear.

No surprise on that at all, and played out much in the range that we do.

With the first month being a little bit average and 25% let's say, second month a little bit more, and third month in the 40% to 45% range, depending on which quarter you're in.

This quarter was very, very much in line with what we've traditionally seen in Q2s.

I want to say so that everybody understands this, we exited the quarter with the best booking backlog, in terms of weeks, that we've seen in 10 years, in Q2.

So the number of weeks of backlog we had was very solid, coming out of the quarter.

Frank, I gave you a minute to look at the share count.

So the diluted share count, the average diluted share count at the end of the quarter was about 5,300, approximately 5,300 (sic -- see press release "5.3 million").

And as I said, it came down about approximately 100 million quarter-on-quarter, related to the buyback that we did, the $4 billion of buyback, that we did the past quarter.

I also noted that when you do the buyback over a period of time, depending on the timing, you don't get the full impact of the reduced share count.

It takes another quarter.

So we'll see a further reduction this coming quarter, and then whatever other additional buyback that we do in Q3 and Q4 will then reduce it even further.

It also has offset any increase to the share count, related to options and RSUs and ESPP that normally increase, so we have offset that and then reduced it through the buyback.

And our objective, as we said over a period of time, is to manage share count down over the next couple quarters and over the next several years, in order to help improve the return to shareholders.

Frank and I always provide a good balance.

We're going to be aggressive in the market, you're going to see us well above our 50% free cash flow buyback, and we'll continue to be opportunistic there, much as we were in the first six months of this year.

Gary, in terms of services, let me break the question in three pieces.

First how much services is actually tied to the product side of the house?

And maybe a real quick discussion of technical services versus advanced services, and then advanced services, how over time, we're going to move to more outcome-based.

All in two minutes.

Or less.

So the first part of that is roughly 80%, and that's a combination of technical support services, as well as advanced subscription services.

Those contracts are normally one to three years, and you book them, and then you deal that revenue out over, on an equal basis over whether it's a 12-month deal or 36 months.

So as product ramp, product revenue and bookings have ramped down over the last several quarters, there's no new attach to that, on either TS or AS.

On the business that is not subscription, the advanced services that are more advanced engineering, and capabilities around support services that are project oriented, when people aren't building out new networks, or we're not deploying large deployments, then that business also comes down, and that has come down fairly significantly, as well, over the last several quarters.

We're ramping up in the areas that John mentioned around smart services, the analytics around that, as well as remote managed services, some large wins there, and we're really doubling down on our capability there.

And then we also shifted and brought together the we're building out a very architecturally oriented with technology people, as well, consulting services, and then security and we've already delivered some of that.

And those are ramping up, and that's why we have this gap here.

You'll find us being less dependent on product as we go forward, and you'll see us continue to manage that business extremely well, through automation of things that allow us to drive the margins we do.

So two real quick thoughts because I think you'll find services really make a difference in our future.

Gary and I have given Edzard a challenge to move 50% of these advanced services to outcome based capabilities.

That's only about 20% today.

Very important in the transition.

If you look at the Internet of Everything, purely the consultancy piece, over the next several years, is $1 trillion market that we can address, and so you begin to look at us looking at this as a major new revenue scenario, versus the consultancy services, but more importantly pulling through our whole product architectures.

And once again, going back, there's a reason that so many people fail with the Internet of Everything, they're doing cities.

They do it one step at a time.

It is complex, it's got to be able to scale, it's got to have the architectures all coming together, it's got to be mobile, it's got to be data center, it's got to be analytics at the edge, it's got to be secure, it's got to be collaborative, and you have to have a game plan to bring these customers together, and just using cities or countries as an example, when you bring them together with these architectures, that's why you win.

That's why you see a digital Israel where literally our business grows in the high teens year after year, because of what we've done together there.

Thanks, Ehud.

Next question?

Tal Liani, B of A Merrill Lynch.

I have just one question left, which is, I'm still trying to understand, in your numbers, what's related to the last quarter, what's related to the next quarter?

What I mean by that is, the quarter is definitely weak but I don't know if it's incrementally weaker than last quarter, and what are the parts that are incrementally better?

So maybe you can just go through the major segments, just to tell us where did you see improvement from the previous time that you updated us about three months ago?

And just overall the delta from the last time?

Thanks.

Just repeating some of the same themes, and expanding on them, the quarter played out almost exactly as we expected, in terms of the three areas that were challenged.

And in those challenging areas, from a revenue perspective, using high-end routing switches as an example, they were down in double digits, yet bookings were down in the minus 5% and minus 6% respectively.

The emerging countries were better this quarter than last quarter, but way too early to call a trend and I don't want anyone to take away, we're basing our estimate on this next quarter with no improvement in terms of the current economic scenarios.

Or what we're seeing with inconsistencies in emerging countries, in terms of the direction.

The product orders were down 4% in the direction, and as we alluded to earlier, there were several of the areas that we felt very, very good about in terms of security and the data center progress that we made.

Recurring revenue, that's about 1% delta that we would have had if we had recognized this in traditional ways, in ways that just increased from last quarter to this quarter.

So I feel very good about where we are now.

I think the transitions are working.

We're playing it out.

We gave guidance for this next quarter, last quarter was 8% to 10%.

We said this quarter is 6% to 8%, and you're going to see us move this market right along through the transitions and returned to positive growth one quarter at a time.

So I feel a lot better where we are now versus where we were a quarter ago.

I don't know if you I don't know if you want to add anything to that, Frank.

Great.

Thanks, Tal.

Next question?

Brian White, Cantor Fitzgerald.

I'm curious, sales down 8% this quarter.

6% to 8% in the third quarter.

To get growth moving again, here, do you feel like Cisco needs a new product category?

You're obviously a leader in networking, you have done very well in servers in a short period of time.

But to get the revenue growth to more reasonable levels, do you think Cisco needs a new product category?

Let me think about that for just a second, and collect my thoughts.

I think we've got four or five major product categories, using your words, in play, at the present time.

We have the explosion, and remember when we entered the data center, of saying, we're going to bring together the network with server technology, with storage, which has really been a huge part of our growth, and positioned us very well in the data center from the CIO's perspective as well, and that's playing out extremely well.

We talked about the application-centric infrastructure.

Remember just four months ago, when everybody really got what we're doing with this, and how you can have intelligence throughout the high -- your entire network and what we're doing with both applications, and the network, and the infrastructure, and the ability to do northbound and southbound APIs.

That is a huge product category for us in terms of direction.

Then as you pull together the Internet of Everything, and we've been on this for six years, heavy lifting, a year ago, I'd have to buy somebody a drink for me to talk very long about the topic.

Now, they're often offering to buy us dinner, and they bring their Board of Directors here.

A light switch went off in a very, very positive way, with the CES and the World Economic Forum, and when Google bought NES, it was a light switch that all of a sudden, every consumer player manufacturer realized.

Now, the size of those markets is $19 trillion.

That's a profit potential.

That doesn't count all of the infrastructure underneath of it.

$1.5 trillion in retail alone, $2.9 trillion in terms of manufacturing.

So you can imagine the conversations that we're having with the leaders in this, and we don't go in there selling them routers and switches.

We sell them outcomes and there's probably no better example of an outcome sale, than what we did in Israel.

The challenge from the top government leaders in Israel 18 months ago focused on job creation, focused on inclusion of minorities, focused on healthcare, education, innovation, the ability to move of the cities to the south, security, and to do this in terms of support with all three major political parties from the top down.

And we did that together in 18 months.

And we've won every single major bit in toto on that.

So you really begin to think about the key takeaway here is the network is at the center of every transition you're seeing, every one of it.

And it's going to be an Intelligent Network and we've positioned ourselves very well to both handle the new competitors coming at us piecemeal and the old peers who candidly, have also stayed piecemeal, and if you're just a piecemeal hardware player with a single product you're going to really have a tough time as you go forward.

I believe architectures win, and I believe the categories we outlined, if we execute well, will fuel Cisco's growth for the next decade.

So I actually think we have plenty in terms of the opportunities in front of us and I want to be careful with how we are prioritizing right way.

I think that's the last question?

Mel, you're the boss.

Go ahead.

I think that's going to conclude our call.

Cisco's next quarterly call, which will reflect our FY14 third-quarter results will be on Wednesday May 14, 2014 at 1:30 PM Pacific, 4:30 PM Eastern.

Again I'd like to remind you that in light of Reg FD, Cisco plans to retain its long-standing policy to not comment on its financial guidance during the quarter, unless it's done through an explicit public disclosure.

Please call the Investor Relations department with any follow-up questions from this call.

Thank you for your participation and continued support.

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