思科 (CSCO) 2015 Q2 法說會逐字稿

Welcome to Cisco Systems Second Quarter and FY15 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 would like to introduce Melissa Selcher, Vice President of Corporate Communication and Investor Relations.

Ma'am, you may begin.

Thank you.

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

This is Melissa Selcher and I'm joined by John Chambers, our Chairman and Chief Executive Officer; Kelly Kramer, 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, including supplemental information, that will be available on our website in the Investor Relations section following the call.

Income statements, full GAAP to non-GAAP reconciliation information, balance sheet, 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'll be making references to 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 risk and uncertainties that we discuss in detail in our documents filed with the SEC; specifically, the most recent reports on Form 10-K and Form 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 through this call will be on a year-over-year basis, unless stated otherwise.

As we have said in the past, we discuss product results in terms of revenue and geographic and customer segment results in terms of product orders, unless specifically stated otherwise.

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

Mel, thank you very much.

Our Q2 results reflect continued progress as we transform Cisco to become the number one IT Company.

In the quarter, we grew revenue to $11.9 billion, up 7%, and grew non-GAAP earnings per share to $0.53, up 13% year-over-year.

We generated $2.9 billion in operating cash flow this quarter and returned $2.2 billion to our shareholders through share repurchases and dividends.

We delivered this strong performance despite a volatile economic environment.

Our strong momentum is the direct result of how well we have managed our Company transformation over the last three-plus years and our leadership position in the key technology transitions, such as cloud, mobility, big data, security, collaboration, and the Internet of Everything.

The four key takeaways I have from this quarter are the following.

First, we are executing well and growing at a healthy pace in a tough environment.

Second, we saw very good balance growth, the best balance in twelve quarters across the majority of our key geographies, product categories, and customer segments.

Third, our financials are very strong and we continue to deliver value for our shareholders, with strong earnings, cash generation, and capital return, including another $0.02 dividend increase to $0.21 per quarter.

Fourth, every country, every city, every business, every home, and every car is becoming digital.

In our view, Cisco is better positioned than any other company to help our customers reinvent their business and technology strategies as they become digital organizations.

Today, every company and every industry is a technology digital company; something people would not have said a year ago.

Over the last month, I've met individually with over 100 business and government leaders.

Without exception, these leaders recognize the role technology plays in their future; not just how it creates opportunity, but also risk.

Customers around the world, both business and governments, are aligning with strategic partners in order to be more successful in the digital transition.

They are increasingly choosing Cisco as their strategic partner and you are seeing the evidence in our financial performance.

Let's start with a basic question, like why Cisco?

With the network at the center, Cisco has the portfolio and the ability to bring our customers solutions to drive down cost, help secure their businesses, and increase the speed and agility so they can innovate across their own organizations.

In our view, our track record of disrupting markets by leveraging the power of the internet is unmatched.

Our strategy has always been based on understanding the direction of major market transitions, transforming our sales to meet the needs of our customers and demonstrating the courage to disrupt not just the markets, but even ourselves.

The market is moving fast and change is exponential.

We are in the strong position today we are today because we made dramatic moves in how we're innovating, how we're interfacing with our most important customers, and how we're organized.

To ensure Cisco is leading where the market is going, most companies resist changing until it's too late and their market credibility is eroded, the classic innovators dilemma.

It was our choice to move early and boldly, with incredible speed, to realign 40% of our employees to priority areas to reorganize from product groups and to integrate solution teams, to replace more than 30% of our leaders.

We are seeing the results in our relevancy with our customers and our operational excellence and that is driving our financial performance, where, since FY11, we have added $4.9 billion in revenue with about $300 million in incremental non-GAAP OpEx.

Said another way, for every $1 of revenue we've added over this transition period, we've only added about $0.06 of non-GAAP OpEx.

I think you'll find this is best in class by a factor of five to tenfold.

In the 1990s, we were the best example of a company capitalized on the internet and that gave us tremendous credibility with customers and fueled our growth.

Today, as every company becomes digital, every CEO knows he or she needs to evolve their organization to move with speed, agility, and efficiency the Internet of Everything will demand of them.

Our strategy is to be the model in how we've reorganized and the customers we're driving as a result and we've done the heavy lifting with our peers and customers are just starting.

As a result, I am now spending a significant amount of time with our customers' executive teams and in their boardrooms discussing how they organize for digitization, innovation, security, and the Internet of Everything.

We could not be better positioned in the market.

We've worked very hard to get here and the opportunity feels very much like it did in the 1990s, when the Internet became mission-critical to our customers.

We have said for several years that we believe the impact of the Internet of Everything would be 5 to 10 times greater than that of the Internet today.

At CES and the World Economic Forum, most every leader we saw agreed.

We have been building for this opportunity.

We have the innovation, operational excellence, speed, agility, and efficiencies in our business to drive the greatest possible benefit for our customers, our partners, and our shareholders.

On to guidance, as we said for the last two quarters, we are pleased that, in spite of the headwinds, we are growing well again.

We are well-positioned for a positive turn in either service provider or emerging markets, but we are not modeling those turns for several quarters, despite the better results we saw in this last quarter for reasons you are all very much aware of.

For Q3, we expect to see revenue growth in the range of 3% to 5% and non-GAAP earnings per share in the range of $0.51 to $0.53.

Let me now provide some additional detail on the business momentum we see in our geographies, customer segments, products and services business within our portfolio.

In terms of business momentum, as a reminder, the geographies are primarily the way we run our business.

For geographies and customer segments, I will speak in terms of product orders year-over-year unless otherwise noted.

We finished the quarter with product orders up 5% and product book to build greater than 1. Let's move first to the Americas, the US continued to accelerate, growing 7%, compared with Q1 3% growth.

Latin America returned to double-digit growth at 12%, versus Q1 of 5% and negative growth in FY14.

Strength in the US public sector continued, growing 17% with US federal growing 23%, and US state and local growing 8%.

Moving on to our Europe, Middle East, and Africa operations, as we said in last quarter's conference call, we were more optimistic about Europe than most of our peers and we saw that business play out as we called with growth in EMEA of 7% year-over-year.

We saw phenomenal execution in the UK up 17%, Germany up 12%, and something no one else in the industry is coming even close to, Southern Europe actually grew 20% year-over-year, speaking to the relevancy that we provide to companies and governments.

Over the last six quarters, our growth year-over-year in EMEA has gone from minus 4% to minus 2% to minus 1% to 2% to 6% in Q1 and now 7% in Q2 and we remain cautiously optimistic.

In Asia-Pacific, Japan, and China.

In China, in particular, we continue to see challenges that all of you are aware of and we saw our China business decline by 19%; however, we saw India grow by 11%.

The rest of APJC, not including China, was down 1% this quarter.

Finally emerging markets.

Emerging markets total grew 1%, with emerging markets, excluding BRICS plus Mexico, up 8%, a major change from last quarter.

We continue to see that BRICS plus Mexico challenged, down 6% in total, with Russia down 16%, Brazil down 8%, China, as I said earlier, down 19%.

We did see growth in Mexico up 21%, India up 11%.

While we are pleased with these results, we believe it is still way too early to call a turn in emerging markets and are modeling for them to be challenging for several more quarters.

Customer segments.

Total global commercial grew a healthy 8%.

Our success in the US commercial continues to be very strong, up 12% in Q2.

We have built a model based on success in the US commercial and best practices from around the world and have implemented the model outside the US.

[DNR] orders grow from down 5% in FY14 to up 4% year-to-date.

In total Cisco business terms, that improved performance added a full point to our Company's growth rates.

Our new operating remodel and global service provider is also showing similar traction.

This quarter, our service provider business was down 1%, after having been down on average 10% or more for the last five quarters.

Like many in the industry, we are modeling total global service provider CapEx down in the mid-single digits for calendar year 2015.

We are focused on growing share of wallet.

We believe we are very well-positioned in terms of our portfolio and how we've aligned with our service provider customers, but we expect the next several quarters to continue to be challenging and service provider, along with emerging markets, remain our two challenged areas.

Total global enterprise grew 10%, versus 2% in Q1.

We did see US enterprise grow a bit slower than expected at 3% growth, due in part to the timing of some very large deals.

Enterprise pipeline continues to see rapid growth in very large multi-year deals, which will benefit Cisco over several years.

Our global enterprise US customers, which are the largest 28 enterprise accounts, not included in our regular US enterprise discussion, grew about 30% year-over-year.

Global public sector continued to be solid at 7% growth year-over-year.

I will now move on to discussion of our products and services business, which I will discuss in terms of revenue year-over-year unless otherwise stated.

Starting with Switching.

We saw very strong Switching growth of 11%, with strong performance in both the data center switching and our campus switching business.

We were especially pleased with the continued momentum of our Nexus ACI portfolio, including the Nexus 3000 and Nexus 9000 and the APIC controller.

As an example, the Nexus 3000 plus 9000 grew 350% year-over-year.

We have seen the Nexus 9000 and ACI customers grow each quarter from 580 customers two quarters ago to 970 customers last quarter to 1,700 this quarter.

APIC customers grew to over 300 and the Nexus 9000 passed the 1 million installed port mark this quarter, less than one year after the first shipments.

We are pulling away from our competitors and leading in both the SDN thought leadership and customer implementations.

The market has recognized the benefit of ACI as compared to PowerPoint concepts of aspirational competitors.

ACI and APIC will become the cornerstone of the next generation of networking architectures for many years, much like the UCS has become in the data center.

I am particularly pleased that we have kept gross margins extremely stable in Switching and have actually grown gross margins in many of our product Switching areas which were already very strong and new areas such as the ACI portfolio.

Moving on to Data Center, which grew an impressive 40%, UCS has now reached over $3 billion revenue run rate with over 41,000 customers.

More than 85% of the Fortune 500 have chosen UCS because of the innovative architecture with particularly traction in cloud, big data, and enterprise application solutions.

The innovation underlying UCS, the convergence of compute network and storage is continuing to fuel our growth in the Data Center and differentiates Cisco.

Now we are converging networking, applications, security with scale for our ACI platform and we are doing it with the speed and the scale that no one else is coming close to.

Next to NGN Routing, which grew 2% year-over-year in terms of revenue.

We saw strong performance in high-end routing up 5%, with continued strong performance in our new product introductions such as the CRS-X and NCS.

With the global macro changes and headwinds like net neutrality and industry consolidation, we expect this business to be challenged going forward, but we believe we are taking market share and will continue to take market share.

Wireless had another strong quarter, up 18% year-over-year, compared with Q1 which was up 11%.

We saw strong growth in our traditional business, but in Meraki, cloud networking business continues its stellar growth, up another 100% with an annualized run rate of approximately $400 million.

Security grew 6% with orders growing even faster.

We saw very strong adoption of our Cisco ASA with firepower services, which integrates our Sourcefire software products together.

Our acquisition strategy in our Security business has been very successful, as we integrate the various elements into our overall security architecture.

We fight point players in some areas, but no other vendor can play at the level across the enterprise that our customers need.

In this volatile environment, with change happening faster than ever before, the importance of Security has never been more significant.

The level of danger has been raised from a firewall breach to the potential for enterprise destruction and having robust security solutions before, during, and after attack is table stakes.

In this environment, customers are migrating to partners they can trust who will lead with innovation and who will be around tomorrow.

This trusted partnership is core to our success and drives everything we do.

Cisco is the number one Security player in terms of revenue and we are progressing nicely toward our goal of becoming the number one security company in terms of mind share which literally, we announced a year and a half ago an intention to do so.

Moving on to Collaboration.

Last quarter, we boldly stated our intention is to lead in the next generation of Collaboration and become the number one Collaboration player.

After a complete portfolio refresh and four quarters of decline, we made very good progress this quarter with growth of 10%.

Kelly, I think it was flat or negative last quarter, if I remember.

Within Collaboration, the strongest growth came from our TelePresence business where we saw, on the back of our new TelePresence portfolio, a 60% growth in units and revenue growth at 35%.

We continue to grow our recurring business in Collaboration.

Our deferred Collaboration revenue was up 26% in the quarter to $1.1 billion.

SP Video declined 19%.

We've announced key partnership wins to develop the next generation end-to-end video solutions from the set-top box to the cloud.

Service revenues grew 5%.

We saw our portfolio in cloud, security, consultant, and analytics all grew in double-digits.

This quarter, we launched Cisco Connected Analytics Strategy to manage the explosive growth of data at the edge of the networks.

As the Internet of Everything evolves, we forecast as much as 50% of the data will be handled and decisions will be made at the edge of the network.

Given Cisco's position in the network, Cisco is the only company positioned to manage and capture the insight from distributive data.

This has the potential to be an important growth area for Cisco, and even more importantly, to drive the value of the Internet of Everything.

Let me now provide an update on Cisco's momentum in the cloud.

Cisco's cloud strategy is pervasive throughout our portfolio.

We continue to lead in the hybrid cloud market and our Intercloud momentum continues.

As you look at our cloud business, I would look at the following metrics to track our success.

First, Cisco's leadership in cloud infrastructure was once more reaffirmed with the release of the latest synergy group's research report showing we have retained and strengthened our number one position for sales of hardware and software used to build cloud infrastructure.

Second, we are growing our cloud services, including managed Security, Project Squared and collaboration, EnergyWise and Meraki for enterprise.

Cisco and Telstra are both in production with open [stock-based] public cloud services.

Third, our Intercloud ecosystem continues to grow and now exceeds over 50 partners, more than 400 data centers across more than 50 countries.

Rob, just a great job by your team and your leadership.

Customers are using Intercloud fabric and ACI to implement highly secure and on-premise hybrid cloud capabilities across heterogeneous environments.

To summarize my comments, our customer conversations today are not about standalone products.

They are about new revenue streams, growth, and outcomes; about securing and about managing their businesses; about how they have to reorganize to drive the innovation their survival requires.

We are executing across our business because we are bringing together our product leadership in every category into architectures and solutions that deliver real outcomes.

I will now turn the call over to Kelly for her comments on the quarter and guidance for the next quarter.

Kelly, welcome, and great to have you leading in the conference call.

Thanks, John.

Overall, we had a strong quarter and executed well.

From a top-line perspective, total revenue was $11.9 billion, growing 7%.

We grew profits faster than revenue with non-GAAP net income of $2.7 billion, up 9% and non-GAAP EPS of $0.53, up 13%.

Our GAAP net income was $2.4 billion and GAAP earnings per share on a fully diluted basis was $0.46.

Product revenue increased 8% and service revenue increased 5%, with product book to build greater than 1. Our non-GAAP operating margin was 28.4%.

In our guidance last quarter, we told you that we expected total non-GAAP gross margins to be in the range of 61% to 62%.

For Q2, our total non-GAAP gross margins and non-GAAP product gross margins came in at 61.7% and 60.8%, respectively, reflecting the mix of our business and especially the strength of UCS.

Non-GAAP Service gross margin was 64.8%.

Our non-GAAP operating expenses were $4.0 billion or 33.3% as a percentage of revenue, compared to 34.1% in Q1 of FY15.

Non-GAAP operating expenses were down 5% quarter-over-quarter and up 6% year-over-year, reflecting investments in key growth areas such as Security, Cloud, and Software.

Our GAAP net income and GAAP earnings per share for Q2 FY15 included a pre-tax gain of $126 million or approximately $0.02 per share related to the reorganization of our investment in BCE.

This gain is excluded from our non-GAAP results.

Now, moving on to our non-GAAP tax provision rate, which was 22% consistent with our expectations.

In connection with the recently reinstated US Federal R&D tax credit, we had a tax benefit of $91 million related to FY14 that we excluded from our non-GAAP net income.

The extension of the R&D tax credit did not have a material impact on our non-GAAP tax rate during Q2 and is not expected to have a material impact on our non-GAAP tax rate for the remainder of FY15, since the benefit only extended through December 31, 2014.

We ended the quarter with our headcount at 70,112, a decrease of 2,135 from Q1.

As a reminder, we took restructuring actions to invest in growth, innovation, and talent, while managing costs and driving efficiencies.

We announced and completed one acquisition during the quarter, Neohapsis, a provider of network and security consulting services to enhance our offerings to our customers.

Looking at our geographic segment results, in terms of total revenue on a year-over-year basis, our Americas segment was up 10%, EMEA was up 7%, and APJC was down 3%.

Total gross margin for the Americas was 62%, EMEA was 61.8%, and APJC was 60.3%.

From a balance sheet and cash flow perspective, total cash, cash equivalents, and investments were $53.0 billion, including $3.2 billion available in the US at the end of the quarter.

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

Deferred revenue was $14 billion, up 6% year-over-year.

Product deferred revenue grew 14%, largely driven by subscription-based offerings, while Services deferred revenue grew 2%.

We continued to build a greater mix of recurring revenue, as reflected in our deferred revenue balance.

Our DSO was strong at 35 days as compared to 36 days in Q2 FY14.

In Q2, we returned $2.2 billion to shareholders that included $1.2 billion through share repurchases and $974 million through our quarterly dividend.

In the first half of FY15, we returned approximately $4.2 billion or 86% of our free cash flow to our shareholders, comprised of $2.2 billion of share repurchases and nearly $2 billion of dividends.

In addition, today our Board approved an increase of $0.02 to the quarterly dividend to $0.21 per share, an approximate 11% increase, representing a yield of approximately 3.1%.

We remain firmly committed to our capital allocation strategy.

Let me now provide a few comments on our guidance 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 the forward-looking statements and actual results could be above or below guidance.

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

As John mentioned, we expect total revenue to be in the range of 3% to 5% 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%.

As we had said in the past, forecasting non-GAAP gross margin has always been challenging, due to various factors such as volume, product mix, cost savings, and pricing.

As a reminder, non-GAAP gross margin may vary quarter to quarter by 1 point in either direction of our guidance range.

Our non-GAAP operating margin in Q3 is expected to be in the range of 27.5% to 28.5%.

Our non-GAAP tax provision rate is expected to be approximately 22% in the third quarter.

Our Q3 2015 non-GAAP earnings per share is expected to range from $0.51 to $0.53.

We anticipate our GAAP earnings to be lower than our non-GAAP EPS by $0.09 to $0.12 per share in Q3 2015.

The range includes a pre-tax charge of up to $100 million in Q3 2015 as a result of the restructuring actions that we announced in the first quarter.

During Q2, we recognized a pre-tax charge in our GAAP financial statements of $69 million related to that announcement and we expect total charges not to exceed $600 million during FY15.

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 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.

Our guidance does not assume a significant improvement in the emerging markets or the Service Provider segment in the near future.

Although we believe we are executing well in a rapidly transforming market, with these types of uncertainties in mind, we will continue to provide our guidance with all the appropriate caveats one quarter at a time.

We encourage our shareholders to have similar considerations.

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 it back to John for his summary comments.

Thank you, Kelly.

Our results this quarter, which were the best results in three years in terms of balanced growth across all of our geographies, products, and segment, reflects the increased relevancy of Cisco around the world.

The Cisco brand is the strongest it's ever been.

Our vision has always been to change the way the people work, live, play, and learn.

You've heard us say this for nearly 20 years, digitization is the next and perhaps the most significant evolution of our vision.

At CES 15 years ago, we showed a network car Wi-Fi enabled and connected to a coffee shop so you could order your own drinks and make changes to that.

Fast-forward to several years ago, we introduced the market to the Internet of Everything.

While the concepts were thought leadership for many years, this year companies and countries are seeing the Internet of Everything as a business imperative and top priority.

To take advantage of the Internet of Everything, every country, company, city, home, and car has to be digital.

The single most important investments are at the center of their digital business and technology strategy for our customers.

At the center of that, will be the intelligent network, from the data center to the edge through the cloud, all brought together with an end-to-end security and Cisco has never, ever been better positioned.

In the 1990s, when companies need to get online on the Internet, Cisco was the thought leader, the Company with the product leadership, and the best example of a company capitalizing on all the transitions.

Our customers wanted our help and to follow our example.

Fast-forward to today, the next generation of the Internet, the Internet of Everything, should generate at least 5 to 10 times the value of the first generation of the Internet to date.

Again, no one is better positioned than Cisco in terms of strategy, market position, product leadership, architectures, and organization structure.

I am not sure those outside Cisco appreciate the magnitude of the changes we have implemented over the last year, largely because of our ability to continue to deliver long-term value to our customers and to our shareholders, despite the challenges in the market.

Most companies wait to change until they have to, when it's obvious and it's often game over and those companies get left behind.

In the last year, we were willing to disrupt our leadership position, for example, in Switching and Routing by introducing entirely new platforms.

We knew we'd see a short-term impact, but told the market how we would grow.

Once again, we did what we said we would do.

This is just one of many examples and these are exactly the hard decisions our customers, employees, partners, and shareholders have trusted us to make so we can lead in these market transitions.

I want to congratulate and thank the Cisco team for believing in the vision and executing one of the most successful company transformations the industry has witnessed.

Very few companies could do what we have done with the speed and the results we have driven and the opportunity we've created for ourselves is truly exciting and in many ways, just getting started.

Our transformational work will continue as we help our customers digitize everything, secure everything, and organize their companies, their governments, their businesses for the Internet of Everything.

Because of the agility we built into our organization and our ability to align directly with our customers' goals, we are helping our customers with their business outcomes.

Let me be very direct here, we're winning very large service provider, enterprise, and public sector deals that we would not have won just as recently as one year ago.

We do see our competitors struggling and, no, we are not immune from economic or other challenges in the market.

While we believe we have positioned the Company better than any of our peers, we do still see the same challenges we had discussed in the past few quarters; specifically, emerging markets and service providers as continuing to provide a negative drag for the next few quarters.

What I believe the market now understands is that Cisco is managing effectively through a challenging macro, leading through transitions, disrupting markets, increasing our relevancy with our customers, and delivering value to our shareholders.

Looking forward, we've laid an incredibly exciting foundation for future growth, innovation, and leadership, reinventing the network with application-centric infrastructure, a platform at the very early stages of its future potential, our leadership and security the most important topic in IT today in many ways, our emerging role in data and analytics at the edge and how we will bring all this together to enable the Internet of Everything.

We have our stakes in the ground to capture tremendous opportunities in front of us and are well on our way to becoming the number one IT company.

The momentum in the business feels extremely good and we're excited about the opportunities ahead.

We will now move, Mel, to what I enjoy the most, which is the Q&A section.

It's over to you Mel and I'll try to keep my answers tight and I'll do better this time.

Operator, can we please open for questions?

Amitabh Passi with UBS.

I had maybe two half questions.

John, I guess the first one for you, Services gross margin probably came in at the lowest level that we've seen in a few quarters.

I was hoping you could maybe elaborate on what's happening there?

Secondarily, on your Security business, I know you've sounded very bullish on Security and the momentum.

6% seemed a little disappointing -- would love to get some clarity there.

Got you.

Amitabh, I like the way you went.

We probably had eight or nine areas that were very close to the highest growth rate we've had in two years and you're focusing on the two challenges, more than fair.

So let's go to the issue of Services gross margins.

If you watch, we start with the big picture.

Our revenue growth areas, what is our gross margins, our OpEx, Kelly and I have a lot of leverage we can pull within that.

Within the gross margins we have never been more comfortable and actually, I said this almost three or four quarters ago, Mel, I've never been more comfortable with any aspect of our business than our ability to maintain gross margins.

It's a mix issue as you go through it.

To the Services question, we've had great Services gross margins unequalled in the industry.

Gary, our Technical Services, what you and Joe Pinto have done is amazing there.

Our Advanced services is an area that we're moving very aggressively in and that's where you see a little bit of the pull down on the services model and as you become outcome-based, as you refocus on these new growth areas, being able to literally digitize a country, digitize a city, digitize a manufacturing company, a healthcare company, et cetera.

You saw us invest an awful lot in vertical consultancy, you saw us invest in security in a big way with major expectations in terms of expertise centers, et cetera, and in cloud.

So we're going to continue to make investments in these areas and I'm very comfortable with our gross margin portfolio.

I actually think our gross margins has been the most predictable part of our total business, although we have a lot of various variables in that.

On Security, Security will occasionally be bumpy.

We reorganized our organization and realigned our security across the whole globe with a separate sales force.

As you make those changes, you occasionally lose a little bit of momentum before you pick it up.

The order growth was actually at 9% for Security.

I expect Security to grow very healthily as we move forward and you'll continue to see us make a number of both resource investments in areas like Services, sales investments to really lead in this and consultancy in a way that really brings this picture to life.

But I think you're going to see good growth overall out of our Security business.

I think we're positioned extremely.

I kind of, in a fun way, challenge you, when an enterprise customer has 45 to 60 security players in their environment, how many do they really have?

You look at a CEO in the eye and they go, I get it, John.

We've got to consolidate this in the networks where it's going to get consolidated.

Very comfortable in terms of our Security growth over time.

Do not see any issues in terms of strategy, vision, or margins here.

Great.

Thanks, Amitabh.

Operator, next question.

Brian Modoff with Deutsche Bank.

I'd like to talk about Meraki.

You had, obviously, good numbers $400 million annual run rate.

At Cisco Live, you announced that you were expanding it out to a broader range of customers.

Can you talk a little bit about that and what that might do to the growth there and how this might affect your overall margin mix as you continue to say you're comfortable with where that's headed?

Sure.

So Meraki overall, Kelly, keep me honest here, very good margins.

We were very comfortable with that.

When you begin to look at a Company that is now at $400 million run rate and grow it at 100%, that's hotter than almost any start ups in the industry with great gross margins.

What Rob is doing in leadership out in cloud and what Nick is doing with our Service Providers and what we're seeing is a continued leverage of the Meraki-type of vision for how we grow our resources and how we grow our relevance to our customers.

Rob, would you like to add something to that?

I would just add that we are expanding globally with recent additions of Meraki presence in EMEA, as well as building out in Europe.

They are not -- there's no margin impact.

It's a very profitable it business model.

We did expand and announce the expansion of the Meraki portfolio at Cisco Live in Milan, in January, which will see an expansion of the enterprise offer, including a really neat mobile device manager.

So profitable platform, John, growing very, very quickly at 100% and geographic expansion is part of that model.

Got it.

It's a nice way of saying, this is really hot, it's going to, Kelly, be one of our better acquisitions.

But then you turn to Sourcefire, which was the other big one we did in the last year and a half.

It's literally on fire, too.

Thanks, Brian.

Operator, next question.

Simona Jankowski with Goldman Sachs.

You had, obviously, a good quarter and good guidance but John, your tone seems even more bullish than kind of the numbers would suggest.

I mean I couldn't count how many times you said that you've never been better positioned and I just wanted to see if you can just provide another layer of detail behind that to just let us understand better what's behind that tone?

I think you referenced some large deals in the US with enterprises, service providers, public sector and I noticed your deferred was up 6%, the long-term deferred, even though short-term was flat.

So, are there large multi-year deals in there that are giving you that kind of bullish outlook?

Simona, it literally is across the board and we see this in every country, every segment of our business, even those that are challenged like emerging markets and service provider.

We made huge inroads because of the momentum we've gained.

Mel told me not to be too enthusiastic on the call.

I went out and ran four miles this morning.

I had my best time and the last year, I lifted weights, et cetera, and I'm sorry, Mel, I'm just full of energy.

It's exciting what's in front of us and when you sit across from a customer, if could have been at WEF and if I could take this to our shareholders, anybody who walked out of WEF, 21 of the sessions were about Cisco-related areas, from what you're going to do with infrastructure to digitizing countries to cities to how you bring this to bear to how does it affect the environment?

We're right in the middle and in so many different ways, we are not just in thought leadership, no one can compete.

Individual pinpoint products are going to get killed in this marketplace.

The different competitive models that you see evolving or different models we saw coming for four to five years.

So yes, I feel really good and the only area that I would be really critical of is we've got to do better in Service Provider Video and we you have a portfolio like we have and customer segments and products, it feels good.

But to your point, our relevance in major government bids and major enterprise bids, we're winning bids that we would not have come close to in a year ago.

It isn't just we're winning from the beginning, we've got an ability to adjust in engineering and sales and services to meet their needs, the speed we're taking the competitors.

It really feels good and it's really fun.

See you tomorrow, by the way, Simona.

Go easy on your questions tomorrow on me.

Thanks, Simona.

Operator, next question.

James Faucette with Morgan Stanley.

Thanks very much.

Just a quick question, you said that you're expecting a turn in service provider and emerging markets, not for at least several more quarters.

Others have indicated that they thought we could see a rebound in service provider spending and maybe in the next couple of quarters.

Just wondering what's making you a bit more cautious than that?

I guess trying to gauge your level of confidence that you can really see your service provider and emerging market business rebounding I guess this year and going into 2016?

So let's start with the overall premise.

My premise on Service Providers is you're going to see negative growth in terms of CapEx for this year and a lot of the experts saying its actually going to be uglier in the next six months than it will the back half of the year.

So our assumption is any gain in Service Providers will be share of wallet gain and market share gains.

What makes me very, very bullish on this is on the things we can control, if you watch what Nick Adamo, heads up sales, Kelly Ahuja, [that Nike have done services Kelly's engineering] we are now winning big service provider deals that we would not even have been in the game in a year or two ago.

Our ability to do this at a different margin level, our agility on this, and we are taking it to our competitors and you're seeing this across the board.

I would have vastly preferred it, you can never do it exactly how you want, but having had five quarters of 10% or more negative Service Provider growth, I would rather go on from negative 10 to negative 5 or negative 6 to negative 1, then positive then up from there.

We got a couple deals brought in this quarter which caused us to go from minus 10 to minus 1.

That's more than I think anybody else anticipated in the marketplace, especially when you have areas like SP Video which drag you down by two or three points off of that.

I just didn't want the market getting ahead of us.

My comfort level with seeing growth this year, by the end of the year and probably before that, is extremely good in this market, but I'm modeling all wallet share gains and market share gains.

I do not think Service Provider CapEx will be up this year.

I hope I'm wrong, in which case we'll get more of our share there.

So I feel very, very good in the positioning.

Thanks, James.

Next question.

Rod Hall with JPMorgan.

Hello, guys, thanks for taking my question.

So the quarter-on-quarter trajectory is switching seasonality a little bit more than normal, about down 6% quarter-on-quarter if our math is right and the average a little bit below 3% over the last five years.

I know that last year there was some Osborne effect ahead of the 9000, just wondering if you guys could comment on color there?

I mean what light of driven that seasonality?

Did we see some FX impact, just normal seasonality from your point of view, et cetera?

Also John, I know you're lifting weights and running doing all this stuff, could you just give us an update on your tenure at Cisco?

It doesn't sound like you're in the mood to retire, but could you just give us some kind of an update on what your plan there is?

The next time you hear, Rod, any talk about the change will be when we announce it and that hasn't changed overall.

We've got an amazing team with several of the players around this table being examples of it and we'll make this a non-issue as we make the transition.

To the first part of the question, no, I disagree with your basic premise.

We don't give booking by category, by seasonality, but if you watch our normal booking trends and if you watch where we've gone and let's use total bookings as an example, from Q1 to Q2 it was up at the very high end of our seasonality bookings sequentially and the year-over-year numbers.

So either way you want to measure it, we're in good shape on that.

I do agree with several of your premises in terms of the 9000 growth, it feels very, very good.

Rod, you've got to know, I completely disagree dramatically with your comment about our Switching products commoditizing.

They're going the opposite way.

This is one that I think you're going to see us get our competitors very aggressively and even in merchant silicon like the Nexus 3000, we're doing extremely well in terms of growth in gross margins.

It's an architectural play now, we saw this coming 4.5 years ago.

With Switching, you've got to have Security, you've got to have Collaboration, it's got to integrate to processor capability, it's got to tie the Internet of Everything, there has to be an architecture that brings us together business results, and I think our relevance and our value to the customers are going the exact opposite way.

We have shown remarkable consistency in Switching gross margins and I feel very good about our future on that one, Rod.

Thanks, Rod.

Operator, next question.

Mark Sue with RBC Capital Markets.

The gross margin improvement and the cash returns was a major driver in your stocks outperformance last year.

I'm trying to understand the opportunities ahead on top of the ongoing improvements you've made to date.

For example, I know that it's a multi-year progress but the progress in terms of becoming a software company, maybe if you could give us an update there in your go to market?

As it relates to your financials, maybe thoughts on future cash flow returns to investors considering free cash flow is now on parity with net income?

Got you.

So I'm going to have Kelly take the other part on thoughts about cash and where we're going, Kelly, in our overall.

I don't mind you even commenting a little bit about the programs we have on gross margins through that.

We have leverage in every single category.

If you watch what we're doing, whether it's operating expenses, whether it's the gross margins by products, products in Switching, funding areas that don't have as good a gross margin picture to gain momentum, et cetera, and there's leverage literally everywhere.

While we're seeing no unusual competition in the market, no unusual competition of white label or white box nor will we in the future, we saw that coming, as I said a long time ago.

It wins on architectures and this whole call literally is about that.

So I feel very good about our total gross margin mix.

We will absolutely be aggressive when we want to move consulting, as an example, to play a much larger role in business outcomes, but our ability to have multiple leverage that we can touch on, I think, feels very, very good.

We are going to invest in some of the areas and we're going to do a large part of it by literally what we said earlier, moving 40% of our resources around in a year is almost unheard of.

Then literally, unfortunately, taking down 6,000 people and back up 6,000 people with the different skill sets speaks to the agility we have in the market.

Kelly, your thoughts?

Yes, to answer your question, Mark, on our cash, as you can tell, our commitment to the capital allocation hasn't changed, as evidenced by giving back 86% of our free cash flow back of the dividend and to buy back and as well as increasing our dividend going forward, so that's not changing.

We are extremely focused on increasing our cash flow and to John's point, focused on driving that through improvements in our margin, both in gross margin and operating margin.

So that focus will continue and we still have lots of flexibility with our balance sheet to continue the balance of giving back to our shareholders, as well as having that flexibility strategically for M&A and other investments.

Gary, you and Kelly are working jointly on gross margins.

Any additional thoughts?

So Mark, I think we've demonstrated our ability to manage the gross margin and pull the levers and the different things that we have.

Those haven't gone away.

The investments we're making in value design, value engineering is the gift that keeps on giving and we have doubled down our efforts there, so we'll keep going.

We're going through functional transformation, John pointed out the $0.06 for every dollar of revenue over the last 3.5 to 4 years and I think we can continue to do that.

So it's about freeing up those assets to reinvest in the growth areas for the future and we're doing that spot on and we're looking at this for the long-term.

Mark, if you watch what changes, architectures save our customers huge amounts of operating expense.

It allows them to get the business outcomes much quicker.

When you combine an architecture like data center with an architecture like Intercloud, with an architecture like Collaboration, with an architecture like Security, with architectures about big data at the edge of the network with mobility, we can do that in a way that no one else can to get business outcomes.

Customers will pay probably three to five times more for a business outcome than they will for a standalone switch or a standalone router.

As we make that transition, this is where you really see our relevance change and this is why, when you talk about digitizing countries or digitizing cities, we're all by ourselves in our ability to do it.

It's about how we bring all those together in the Internet of Everything and that has great gross margins.

That's where I think the market we need to do a better job, Mel, of explaining to the market why our gross margins and why we're so optimistic about our future here if we do it right.

Thanks, Mark.

Operator, next question.

Ittai Kidron with Oppenheimer.

Thanks and congrats, guys, on great execution on the quarter.

Following up on this last point of gross margin, John, looking at the regional gross margin, it seemed like Europe was certainly a standout.

We haven't seen a gross margin that poor since -- I had to go all the way back to 2011.

Was that just a function of FX, meaning with the move and that depressing in dollars you had to do a little more active discounting in order to get the volumes that you need?

How do we think about that?

Yes, a fair question.

I think Europe's a great example.

First of all, Europe was 7% growth, which I don't think anybody else is getting.

You take Russia out and it would've been 9% growth, but you did see remarkable growth across many of the countries where they're really being impacted by foreign exchange, et cetera.

The way we look at foreign exchange, we do business in dollars, as most of you know on that, so we perhaps, can't draw the correlation as quickly as others, but it does mean the deal size may not be as large or it does mean that there might be pressure on discounts to provide a total solution.

When you see us grow at 20% across Southern Europe, I mean I'm not aware of anybody else that is growing in Southern Europe period, much less at those types of numbers.

It speaks to our strategy working.

Foreign exchange does have some impact on it and Kelly, maybe if you'd like to add something in addition to that?

Just to add to that, Ittai, from a pricing perspective, actually, our pricing is in line, our normal quarter-on-quarter pricing, as well as year-over-year, if I look over the last six quarters, so we haven't really seen that increase on discounting.

What we did see driving the margins in Europe is it's definitely the mix of our strength in our UCS was a big, big driver of it.

Great, thanks, Ittai.

Operator, next question.

Tal Liani with Bank of America Merrill Lynch.

I have a question on Switching.

Great growth, the question is, can you distinguish between plain vanilla upgrades just because you have a new platforms and between really changes to the architecture of Data Centers?

One has a short cycle, one has a longer cycle, longer impact on the company.

Is there any way we can look at it, think about our side, is there any way we can have evidence that the cycle is longer rather than shorter when it comes to Switching?

I think the Data Center Switching cycle is a very, very long one that I think we'd all agree with in scale and even though we'll face new competitors, white label, et cetera, in this market, we saw that, as I said, coming long time ago.

This is where it isn't about Switching the Data Center, it's about convergence, it's about Switching with storage, with servers, with security even within the Data Center and then the ability with application-centric infrastructure to run that in the Data Center or a cloud, in the WAN, all the way to the edge and that's about applications again with the network with security with scale.

You combine those two and we're almost unbeatable in the approach.

You do have a natural upgrade cycle with new products coming in and there was probably a little bit of a stall when we stalled ourselves a year ago deliberately.

We knew what we were doing but we needed to transition to the new ion switching and needed to signal people where we're going.

There were additional drivers, we're starting to win network refresh and some competitors refresh, purely because of security.

In this environment, they aren't going to take risks.

This is where we're just going to really crush the white label people.

It's got to be a security architecture type of approach.

If you just say, I'm going to get merchant silicon and throw software on top of it and run data centers and run WANs and everything, all it takes is one breach and you've done more damage to your brand as a company or as a government than you could in 100 years of saving on a little bit of switching difference and that's before you get to the outcomes in terms of the direction.

Now, is Switching going to grow double-digits?

Of course not, but I think more down in the mid-single digits and it will go up and down depending on the quarter.

There'll be a different mix in the Data Center versus campus.

Great, thanks, Tal.

Operator, next question.

Benjamin Reitzes of Barclays Capital.

Can you talk about the new relationship you have with the VCE?

Is there any change?

The Data Center numbers were very good, but I was wondering if there's any impact on Switching in the quarter?

Do you see yourself partner strategy changing and getting more robust perhaps with some other partners with what's going on with that, that could be material to revenue going forward?

Yes, Ben, let me answer your direct question and the second one that you didn't ask me, which I know is on people's minds, as well.

In terms of VCE, we have a very good relationship with EMC.

I look for that to be continued very strong.

Gary, you're our key interface there.

You and Howard and Joe and I all the time go back and forth.

VMware is a competitor, we view them as a competitor, we're going to beat them as a competitor and we will beat them and have fun doing it.

I wish I was a better person, but I'm not.

We are going to take it to a bunch of our competitors and I think you'll like the progress that you're going to continue to see there.

We are, however, going to continue to partner with NetApp, which is a great relationship, almost no competitive overlap.

We announced what we're doing with IBM.

I think to the second part of your question, when we talk about pace of change, it means that your strategic partnerships, and the Wall Street Journal had an article, I think before December, that talked about the role of strategic partnerships would dramatically change and this will be customer partnerships, as well, will be dramatically different looking out over the next several years and determine a company's success or not in ways they haven't in the past.

Part of that pace of change is you're going to have, at times, even very good customers or very good partners go into our area, we're at the center of every transition, so anytime anybody makes a network announcement, they're going to say, [does this business fit] Cisco or doesn't and you're going to see our evolution of our partners go on that.

Having said that, you'll see us do more strategic partnering, much deeper with many, may partners such as players like Rockwell that you might not have thought of before or GE or a players that we are literally getting closer to in terms of the direction here.

Relationship with EMC is very, very good.

We like them, they like us and we do a lot of business together.

I think, Gary, the run rate was 50% year-over-year growth together plus some?

Plus some.

It's a strong relationship and the partnership has all the elements it does before, we just restructured it some.

Thanks, Ben.

Operator, next question.

Simon Leopold with Raymond James.

I wanted to follow up on the VCE relationship in terms of how it affects your business from a modeling perspective.

As I understand it, you do sell a significant amount of the UCS products and maybe some Switching products through that channel.

If you could help us put that into perspective as to how significant that is as a source of revenue for the UCS?

Then in terms of below the sales levels, I understand that you have some benefits exiting the VCE that you're not incurring the expenses you had been in the partnership.

Can you help us understand the implications of this from a both revenue, as well as operating expense perspective?

If I were to summarize the revenue perspective, it's a very good one for us, just like NetApp is.

The growth rates are unbelievable.

Our field sales teams, the EMC sales team and the Cisco sales team, you often can't tell the difference between them out in the field in terms of how they come together.

It's very, very good for us and we feel very good growth from that relationship and by the way, the same is true with the other partners we've alluded to in terms of the direction.

So I think what you're seeing is just an evolution of a partnership model and some competition versus VMware, which is, I think, the world we live in today.

Paul Silverstein with Cowen and Company.

Good evening.

One clarification, I think it's obvious from your previous comments, but I just want to make sure I understood.

The traditional breakout you gave us between pricing and productivity improvement volume, et cetera, it appears and again, I just want to confirm, that the rate of price erosion did not change from the trend we've seen recently and same thing with your rate of productivity improvement.

Can you give us the numbers if you have them?

Kelly.

Hey, Paul.

You'll see that in our Q filing, but I can tell you the ranges that we typically see on a quarter-on-quarter basis has been in the range over the last six quarters from 0.5 percentage point impact on gross margin up to over 1.5 and we're basically in the middle of that range and in the year-over-years are in the middle of the range as well when I look over six quarters.

You'll see that when we have our 10-Q filing.

I want to just summarize with I've never felt better about our business and our future.

We are, as many as you've already said, we're back.

This movie I have seen before and I wish I could just bottle WEF and I wish I could bottle the conversations that we're in with government leaders and business leaders and how different than before, it's just not one product area, it's how we can bring architectures together with services in a different sales motion.

We had the courage to disrupt our sales starting three years ago and we did a huge amount of organizational evolution over the last year that allowed us to do fast innovation and agility and speed with which others cannot meet.

There is no surprises to us in the market and I mean none at the present time.

It's playing out very much like we expected.

It's a world that pace of change will grow exponentially, but as you walk away just kind of think about it.

Executing extremely well and healthy growth, digitization will be 10 times, I think, we'll say 5 to 10 to keeping solid, the impact of the Internet of Everything really affects every country, every citizen in the world, and every company.

Our product portfolio across the board, you saw all but one area increase and it's nice when I get beat up on just 6% growth.

That is a pleasant position to be in, Kelly, probably one we won't always experience as nicely as that.

The balance geographically and even our headwind areas while, we've signaled there'll be a couple more quarters to work through, showed a lot of progress and it means we are positioned, as they eventually turn in emerging markets, which they will and there will always be challenges in a group like China and Russia and Brazil.

But the rest of them feel headed in the right direction pretty well.

If you watch where we're doing in terms of our product leadership in each category and then integrating them together with architecture, it feels good.

I get pumped up.

It hasn't changed and I hope that came across.

The pace of change and the new competitors and new challenges is something that will not change, it will go up next exponentially.

I believe we're going to become the number one IT company and our goal was to show you that and get the reward our shareholders, our customers, and our employees deserve.

Mel, back to you.

Cisco's next quarterly call, which will reflect our FY15 third quarter results will be on Wednesday, May 13, 2015 at 1:30 PM Pacific Time, so 4:30 PM Eastern Time.

I'd like to remind you that in light of Regulation 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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