Cisco Systems, Inc.
Q3 2006 Earnings Call Transcript
Published:
- Operator:
- Welcome to Cisco Systems' third quarter fiscal year 2006 financial results conference call. At the request of Cisco Systems, today's conference is being recorded. If you have any objections, you must disconnect at this time. Now I would like to introduce Ms. Blair Christie, Vice President of Investor Relations for Cisco Systems. Ma'am, you may begin when ready.
- Blair Christie:
- Thank you and good afternoon everyone. Welcome to our 65th quarterly conference call. This is Blair Christie and I'm joined by John Chambers, our President and CEO; Betsy Rafael, Corporate Controller and Principal Accounting Officer; Rick Justice, Senior Vice President of Worldwide Field Operations and Charlie Giancarlo, Chief Development Officer. Dennis Powell, our Chief Financial Officer, is not able to join us today due to the fact that he recently had back surgery and is home recuperating. As you can imagine, John was adamant that Dennis focus on his recovery rather than join us for today's call and we feel confident that our investors would understand. Dennis, we have no doubt that you're listing to the call today, so please know that we all wish you the best in your recovery and are looking forward to your return in a few weeks. The third quarter of fiscal year 2006 press releases on First Call, First National Business Wire, European Business and Technical Wire and on the Cisco web site at www.Cisco.com. If you would like a fax of the press release, please call 408-526-8890 and follow the instructions. A corresponding webcast with slides and additional information regarding Cisco's financial statements can be found our web site in the investor relations section. Additionally, a replay of this call will be available via telephone at 866-357-4205 or 203-369-0122 for international callers. Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results. Our non-GAAP financial results were previously referred to as pro forma in our prior conference calls. Please note we have provided complete GAAP reconciliation information on our web site in the investor relations section. Additionally, we have provided information relating to both our GAAP financial results and our non-GAAP financial results, along with a reconciliation table between our GAAP and non-GAAP financial statements in our press release. Throughout our call today, we will provide both Cisco and Scientific-Atlanta financial information in order to illustrate the impact of this acquisition on our overall Q3 results. The financial results in the press release are unaudited. The matters we will be discussing today include forward-looking statements, and as such, are subject to the risks and uncertainties that we discuss in detail and our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q and any applicable amendments which identify important risk factors that could cause actual results to differ from those contained in the forward-looking statements. Unauthorized recording of this conference call is not permitted. Consistent with previous quarters, we will conclude our call promptly at 3
- John Chambers:
- Thank you, Blair. I would summarize the quarter as a strong quarter from an orders, revenue and earnings per share perspective. There were a number of major highlights in Q3 which we will cover throughout the conference call, but at the very top of the highlights was our balanced performance from a geographic perspective, especially in the U.S. and emerging markets; our strong product order growth rate, our continued strength in the commercial market segment and in advanced technologies, the balanced performance across almost all of our key product categories and continued strong financial results. This balanced approach to the market in terms of our four customers segments -- core and advanced technologies, business and technology architecture -- combined with our five key geographic theatres continues to work very well. These strong results indicate that both our vision of how the industry is going to evolve, as well as our strategy has positioned Cisco for continued leadership in the industry. In very general terms, as intelligence moves throughout the network, the network is becoming the primary driver of not only IT, but also all forms of communications. If this is the way the market evolves, and we believe it will, Cisco is very uniquely positioned to lead in both communication and IP-enabled by the network. Throughout our call today, we will be covering Cisco's total results and Cisco without our recent acquisition of Scientific-Atlanta's contribution to these results so as to allow for comparisons to prior quarters and prior years. Cisco's record total revenue of $7.3 billion resulted in 18% growth year-over-year and was up 10% relative to Q2. Cisco's revenue growth without the $407 million added from Scientific-Atlanta was 12% year-over-year and up 4% sequentially, which is at the very high end of our guidance that we provided for Q3 in last quarter's conference call. Product book-to-bill was greater than one. Product orders grew year-over-year faster than revenues. Product orders not including Scientific-Atlanta also grew at the high end of our guidance for Q3 of 10% to 15%. GAAP net income was $1.4 billion and GAAP earnings per share were $0.22 which includes a charge from stock option expensing of $0.03 per share and a charge of $0.06 per share from acquisition-related charges, offset by a one-time favorable foreign tax settlement equivalent to approximately $0.02 per share. It was a record quarter for Cisco from a non-GAAP, net income and earnings per share perspective with non-GAAP net income of $1.8 billion and earnings per share of $0.29. The $0.29 non-GAAP earnings per share also included a favorable foreign tax settlement that was equivalent to approximately $0.02 per share. Scientific-Atlanta's net contributions to earnings per share -- that is, profit contribution minus the debt interest expense -- was less than one-half of one cent. Total non-GAAP gross margins, including Scientific-Atlanta, were 65.7%. Non-GAAP product gross margins were 65.3%. Total non-GAAP gross margins for Cisco without Scientific-Atlanta were approximately 67.5% with product gross margins at 67.4% and service gross margins at 68.1%. Cash flow from operations was a solid $2.3 billion. During the quarter, we repurchased approximately $1.2 billion of common stock. We exited the quarter with approximately $18.2 billion in cash and cash equivalents and investments, up from $15 billion in Q2. Q3 non-GAAP operating expenses were 36% of revenue. Or total net head count increased to 48,296 an increase of 8,631 of which over 7,900 were from acquisitions. Staying with the same theme from last quarter's conference call, there were a number of key takeaways from the quarter, primarily relating to directly or indirectly to our advantages from a balanced opportunity perspective and additional resource and management focus committed to the five key areas for fiscal 2006. While there are a number of highlights in Q3 from a geographic perspective, it was probably the quarter of positive extremes between our largest theater and our new emerging market theater. Our largest theater, U.S., which represents approximately 49% of our total product business, experienced an extremely strong quarter with year-over-year growth (excluding Scientific-Atlanta) of almost 20% in terms of orders. This continued the very strong growth momentum we experienced in Q2 in the U.S. While our emerging market theater, also not including Scientific-Atlanta, represents only about 10% of over total product business today, we experienced a year-over-year order growth rate of approximately 40%. This is the strongest rate we have seen since the formation of our emerging markets focus. Rich, that's a tremendously nice job by you and Paul and the whole team. In the spring of last calendar year, our senior leadership team determined what were the key incremental resource and management attention focus areas for fiscal 2006. We decided on five critical areas for additional growth and differentiation within our overall corporate strategy. These five areas include
- Betsy Rafael:
- Thanks, John. Now for some comments on our P&L. I would like to remind you that our GAAP income statement in the press release includes FAS-123R charges for expensing of stock options. Our financial statements for prior period have not been restated for the effect of FAS-123R. However, we have provided a table in our press release and on our website for your reference in comparing Q3 of FY06 net income with prior periods. As a result of closing our acquisition of Scientific-Atlanta on February 24, Cisco's fiscal Q3 FY06 financial statements include two months of Scientific-Atlanta's financial results. We will continue to provide some additional information regarding the impact of Scientific-Atlanta for the next few quarters an order to facilitate year-over-year comparisons. For information purposes only, Scientific-Atlanta revenue for February 2006, which was not included in Cisco's Q3 results, was $163 million. Total revenue for the third quarter was $7.3 billion, an increase of 18% year-over-year. Of the total, as John mentioned, Scientific-Atlanta contributed $407 million in revenue. Without the Scientific-Atlanta contributions, total revenue grew 12% year-over-year. We have categorized the Scientific-Atlanta product revenue into the following Cisco product revenue segments
- John Chambers:
- Betsy, nice job. Thanks very much. Now moving on to our quarterly overview. In this section, we will highlight information from our geographies and customer markets. Starting with the geographies, this is the data on which I primarily rely to run our business and watch very closely on a daily basis. The following is a theater breakout for Q3 in terms of total product orders, including Scientific-Atlanta, unless otherwise specified or indicated. As we said in our prior quarterly calls, we will present the data in our new theater organization structure. U.S. and Canada represented 52% of our business; Europe, 23%; emerging markets, 10%; Japan, 4%; Asia-Pacific, 11%. A number of you have asked for continued geographic discussion regarding the theater and industry segments because of the rapidly changing global economic environment. All of the theater market segments and product discussion will relate to year-over-year product order growth unless otherwise indicated. The key takeaway for the quarter as it has been in prior quarters was the continued balance that we've been able to achieve in our geographies, market segments, architectural evolutions and product families. There was very good balance across all three of our major customer market segments. As we said earlier, the commercial market segment grew in the low 20s on a global basis. The enterprise market segment grew in the low teens and the service provider segment grew in the mid to upper teens. As a reminder, over the last 11 quarters, our year-over-year product order growth rate has been very consistent, usually in the teens or better. As we said earlier this quarter, we saw year-over-year product order growth rate once again in the mid-teens, not including Scientific-Atlanta. Now moving onto the U.S. and Canada theater, which represents 52% of our business. The following five points relating to the U.S. exclude Scientific-Atlanta's contribution. First, from a commercial market segment perspective, balance was good among the four U.S. commercial areas. Year-over-year growth was in the high teens with good balance among all four commercial areas showing growth in the range of 15% to 25% year-over-year. Second, from an enterprise perspective, our U.S. enterprise areas grew approximately 20% year-over-year with four of the five operations in the 15% to 30% range. Third, U.S. federal business order growth rate was up slightly year-over-year due in part to a slow budget rollout. Fourth, from a U.S. service provider perspective, Q3 year-over-year growth was excellent, growing in the high 20s. Canada had another excellent quarter with year-over-year order growth rate in low 20s. Now moving on to Asia-Pacific, which represents 11% of our total orders. The year-over-year order growth rate was approximately 20% for the theater. We saw solid year-over-year growth in a number of countries in Asia-Pacific, with India growing approximately 40% year-over-year and Australia and New Zealand growing approximately 30%, while China and Korea grew in the mid-single digits. Moving on to our European theater, which represents 23% of our business in Q3, orders in total grew in the high-single digits year-over-year. Our three largest countries -- the UK, Germany and France -- all grew year-over-year in the low-double digits. Moving on to Japan, which represents 4% of our business. As you probably expected, and as is continuously heard from some of our industry peers, the weakness in IT spend that we've shared with you in prior quarters is continuing. Year-over-year growth was down in the mid-teens, while on a positive note, however, we saw meaningful sequential quarter improvement in orders for the first time in two years, up sequentially approximately 10%. Moving on to our emerging markets, which represents 10% of our business. There are four major geographies in our emerging market theatres
- Betsy Rafael:
- Thanks a lot, John. Let me remind you again that our comments include forward-looking statements and you should review our recent SEC filings that identify important risk factors and actual results could differ from those contained in forward-looking statements. Also, we're providing guidance on a non-GAAP basis with a reconciliation to GAAP. I will be providing guidance for Cisco on a combined basis, including the effect of Scientific-Atlanta. You will also find the details of this discussion in the slides on the webcast. We continue to believe that for next few years, Cisco's long-term annual revenue growth rate should be in the 10% to 15% range, given the normal caveats as discussed many times before. We realize that many factors, including our own execution, will impact whether we will be at the high end or the low end of this range. Additionally, we could possibly be above or below this range. For the full fiscal year 2006, we anticipate that our annual revenue will be just over $28 billion, an increase of approximately 14%; again, including the effect of Scientific-Atlanta. This guidance reflects our previous expectations of annual revenue growth in the 10% to 12% range for Cisco before the effect of the acquisition. We anticipate revenue for the fourth quarter to be in the range of 18% to 21% year-over-year growth. This includes, as John said, revenue in the mid-$500 million range from Scientific-Atlanta. Translating, the guidance for Q4 revenue is $7.8 to $7.95 billion. Regarding gross margins, forecasting gross margins has always been challenging due to various factors, such as shipping, volume, product mix, variable component costs, customers and channel mix and competitive pricing pressures. We believe total gross margin on a non-GAAP basis will be approximately 65% for 4Q06, meaning it could be slightly above or below this level. This reflects the consistency of core Cisco and Scientific-Atlanta gross margins. With the continued investment in our field and engineering organizations that we discussed earlier, the full quarter effect of the salary increases that occurred in Q3 as well as the full quarter impact of Scientific-Atlanta's expenses, we believe Q4 operating expenses will increase by 7% to 8% on a sequential basis. We expect interest and other income to be approximately $120 million in the fourth quarter. While we certainly expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. Given the recent movements in our share price, we are modeling a 30 to 50 million share increase in weighted average shares outstanding for EPS purposes. There could be increased volatility in the share count due to potential changes in the stock price. Our non-GAAP tax provision rate is expected to be approximately 28% for Q4. Regarding cash flow from operations, we would expect $400 million to $600 million per month at these revenue levels. For our Q4 FY'06 GAAP earnings, we anticipate that GAAP EPS will be $0.04 to $0.07 per share lower than non-GAAP EPS primarily due to acquisition-related charges as well as stock option expenses. For the full fiscal year, this would result in a reduction of between $0.20 and $0.23 per share to our GAAP EPS compared to our non-GAAP EPS. And also, please see the slides on our webcast for more details. Other than those items noted above, there are no other significant differences between GAAP and our non-GAAP guidance. This does assume no additional acquisitions, asset impairments, restructuring or other events which may or may not be significant. Regarding fiscal 2007 as we referenced earlier, we do expect the same revenue seasonality we've seen in previous years. We expect revenue momentum will increase over the course of the fiscal year with our strongest quarter being Q4, which means that there will be a shift in momentum from Q4 to Q1 again; and Q1 revenue before the effect of Scientific-Atlanta will likely be at the lower end of the 10% to 15% year-over-year range, consistent with our anticipated seasonality. We plan on giving more detailed guidance on fiscal 2007 in our Q4 conference call. Now I will turn the call back over to Blair.
- Blair Christie:
- Thank you, Betsey. We will now open the floor to Q&A and we still request that sell side analysts please ask only one question. As a reminder, we will end the call at 3 p.m. Pacific Time. Can you please open the conference call to questions?
- Operator:
- Our first question comes from John Marchetti, Morgan Stanley.
- John Marchetti:
- Just a quick question on the guidance here. You guys sound [Inaudible - technical difficulty] Hi, can you guys hear me okay? Hello? Can you guys hear me okay?
- John Chambers:
- Yes we can.
- John Marchetti:
- Sorry about that.
- John Chambers:
- Go ahead, please.
- John Marchetti:
- John, you sounded very, very bullish on the call, and then the guidance seemed to imply just over $28 billion; it seems a bit conservative given a lot of the ramp that you saw in the business going through Q3. Can we get a little more color there on the guidance?
- John Chambers:
- In terms of the guidance, John, that is about as optimistic as we get in terms of positioning. We view the quarter as an extremely strong quarter and hitting on most all the cylinders in terms of our engine. We're going to continue to be a conservative company in terms of how we manage our backlog and our customer requirements, but we are very optimistic going into Q4 given the changes that are occurring on a global basis, John. Each quarter that you've listened to us, we have slowly over this last year done what we've said we would do and continue to be a little bit more optimistic on the next quarter.
- John Marchetti:
- Thank you.
- Operator:
- Our next question comes from Tim Long, Banc of America.
- Tim Long:
- Thank you. Maybe it is a related question. I just wanted to dig into Scientific-Atlanta a little bit. A pretty impressive performance for the two months that you had it, but it seems like the guidance is down sequentially into the July quarter. Did Scientific-Atlanta actually exceed your expectations in the quarter? Is there just conservatism there, set-top related and maybe there was some product pulled in? If you could just give us your sense on the reaction and what it means into next quarter, that would be great. Thank you.
- John Chambers:
- I think the question, Tim, is a fair one. In terms of Scientific-Atlanta, we gave the guidance of 10% to 12% year-over-year growth, they were clearly in the 11% to 12% in this quarter as best as we can measure; because remember, you're comparing different quarters and different months from their perspective. So if you look at the momentum, they had a solid quarter at the higher end of our expectations for them this quarter and we are expecting another solid quarter next quarter in terms of momentum. In terms of set-top shipments growth as an example for the two months, we'd probably put it at over 20% comparisons on that. So I think they are doing very well in terms of momentum and we're looking for a very solid Q4 from them again in the 10% to 12% range, but looking probably at the upper end of that if we execute well.
- Tim Long:
- But down sequentially, John?
- John Chambers:
- No, it would not be down sequentially. So doing the math on the last two months of the quarter, if this were $407 million and you look out that you will obviously usually ship more in the last month of a quarter than you do in the first month of a quarter and book more along that line, I would anticipate that you would see reasonable sequential growth. But I would focus primarily on year-over-year numbers, Tim. Our Q3 and our Q4 normally are good ones for Scientific-Atlanta. We're anticipating this to continue to go well and the demand looks very solid for them at this time.
- Tim Long:
- Thank you.
- Operator:
- Our next question comes from Brantley Thompson, Goldman Sachs & Co.
- Brantley Thompson:
- I'm going to see if I can get a clarification and a question. On the guidance that you guys talked about for the full year of fiscal '06 of around $28 billion, if we've got the math correct, shouldn't that be closer to $28.4 billion? A little bit higher if you took what you've done for the past three and then take into account your next quarter? That's just a clarification. Then on the LAN business with your switching, you have put in another quarter of double-digit year-on-year growth. If you look across the last six quarters, several of them have been very strong double-digit, year-on-year growth. When we think about switching in terms of an upgrade cycle, could you just give us a little color on where you feel we are? Thanks.
- John Chambers:
- Betsy, if you want to do a clarification on the total number, and then I will talk about the switching.
- Betsy Rafael:
- Absolutely. So I think the way that I would think about that is, clearly we have three quarters of actuals in and we gave the guidance range for Q4 both on a total business including Scientific-Atlanta as well as separately. You are right, if you do the math, that creates a range of a little over $28 billion. What we were trying to do is just provide you some context about where it was going to come in at, but I think the best way to do it would be to, again, take the results plus the sequential range and add those together.
- John Chambers:
- I think it was you, Brant, that asked the question, your math was fairly accurate in terms of your interpretation of us rounding down. To the second part of the question on switching, switching was unusually strong. The Catalyst 6500 had one of its best year-over-year quarters we've seen in a long time. It was equally as well-balanced in fixed and modular switching across the board. Momentum feels good in the enterprise. To the indirect part of your question, Q4 is usually a good enterprise quarter and Q3 is usually a service provider stronger led quarter. So we feel very good about the momentum in the enterprise segment, especially in the U.S. and I would look for the switching business to continue on an optimistic basis.
- Brantley Thompson:
- Thanks John.
- Operator:
- Our next question comes from Nikos Theodosopoulos, UBS.
- Nikos Theodosopoulos:
- I wanted to ask about the two relatively mature markets you have, U.S. and Europe. The U.S. in the last couple of quarters continues to grow strongly, Europe not as strongly. Is this purely a function of business confidence and GDP growth which is better in the U.S. versus Europe? Or do you see more of a competitive environment there? Why are we seeing such a difference in these two markets? If there is really a upgrade cycle, why would it just be the U.S.? Why wouldn't it be Europe as well? Thank you.
- John Chambers:
- If you look at the momentum on a total global basis by all segments of our market, whether it's the enterprise, the service provider, the commercial marketplace, all of them are in the teens or low 20s, as we refer to it, for commercial. In terms of the U.S. operations, we continue to gain both market share and good momentum there. Part of it as you said is GDP growth, part of it also in the U.S. was an outstanding service provider quarter with growth in the upper 20s in terms of year-over-year growth. That is the best quarter they've had ever since 2001. If you look what is occurring in the U.S. also, you saw very solid growth again in the high teens from the enterprise and very solid growth from the high teens for the commercial marketplace as well. In Europe, as many of our peers have experienced, you are seeing not as much momentum. We were actually pleased that Germany and France and the UK were all in low-double-digits quarter-over-quarter growth. Our Eastern European numbers, which we do not include in Europe, were growing in the high teens as we alluded to earlier. Russia and the Middle East, which we used to include as part of the European operations, Russia grew in the 40% range and the Middle East and Africa grew about 70%. So I think what you are seeing in Europe in my opinion is primarily related to economics. We did not get as much service provider business this quarter in Europe versus what we traditionally have done in other parts of the world. So I think it's fair to summarize the quarter as we're hitting on almost all of the cylinders well. Europe was a little bit less than we would liked to have seen, Japan appears to be flattening out and may be headed back, we'll see over time. But that is how I would account for it.
- Nikos Theodosopoulos:
- You're not seeing any market share loss in Europe, you just see it as a slower market then?
- John Chambers:
- We see it as a slower market, Nikos, but after your question I will check. But no, we think we're gaining market share in most product categories. We also within Europe, as you know, if you're referring to service provider business, we do not recognize the revenue until we get transferred in customer acceptance. So we don't sell through systems integrators where you have a different revenue recognition issue. That may be in part what you're asking also, Nikos.
- Nikos Theodosopoulos:
- Thanks a lot.
- Operator:
- Our next question comes from Jeff Evenson, Stanford Bernstein.
- Jeff Evenson:
- How big a role are VoIP upgrades playing in your strong switching and enterprise routing businesses?
- John Chambers:
- I'm going to let Charlie take part of the question, but let me lead with I think a more basic one. What you're seeing Jeff is that I think you are finding almost all of our customer segments begin to think about their product play -- data, voice, video, with mobility. I think you are beginning to see people not make a VoIP decision as much as they're making moving toward a unified communications and if you're in the service provider business, service generation by new capabilities. If you're in the enterprise business, voiceover IP really being the infrastructure on which you're going to expand unified communications. So I think you're seeing in combination ,all of the above. Obviously, the better we do, Jeff, on the architectural wins, the better position we are as we go forward for not just voice, but for video as well as the mobility. Charlie?
- Charlie Giancarlo:
- I would certainly agree with that. I think you see two phenomena. That is that, on the one hand, to the extent that a customer is putting in an IP telephony system in with an existing network and older networks, generally we see about a 2
- John Chambers:
- Thank you, Jeff.
- Jeff Evenson:
- Thank you.
- Operator:
- Our next question comes from Alex Henderson, Citigroup.
- Alex Henderson:
- So I'm a little confused about the tone of your guidance versus the tone of your comments. Specifically, you have had two quarters in a row of mid-teens type order growth or better; you have had a book-to-bill above 1 in each the last two quarters, a book-to-bill above 1 in the year ago period, yet your guidance for the upcoming quarter is still seemingly implying that you have a reasonable probability of decelerating sequentially year-over-year growth in the July quarter. Your comment about seasonality causing the October quarter to be weaker makes sense sequentially, but does not make sense year-over-year to the extent that a year-over-year comparison by definition does not have seasonality in it. The year-over-year number would have a same seasonal period in both timeframes. So I don't understand why you're implying that that growth rate would be at the lower end of the band of growth of the 10% to 15% vicinity. It sounds like your visibility is eroded, not improved. What am I missing here relative to those factors?
- John Chambers:
- Okay, Alex, taken in sequence
- Betsy Rafael:
- The one thing I would add to that, John, and I think we're talking about a sequential rise throughout the quarter in terms of our growth rates. So if you take the 10% to 15% as the base range, generally speaking it would start at the lower end of that range in Q1 with an acceleration throughout the fiscal year; with the thought being that then we would return to that same sort of cycle in the next year.
- Alex Henderson:
- If I could intercede there just for a second, because that's the question. I do not understand why a year-over-year growth rate has seasonality.
- John Chambers:
- It doesn't, year-over-year does not.
- Alex Henderson:
- So why are you saying that your annual pattern of growth would be low in the first quarter and higher in the back half? It makes no sense that there would be a differential between the growth rate.
- John Chambers:
- Okay, Alex, I hear what you're saying. Bear with me. If you look at the guidance as we move forward in terms of Q4 year-over-year growth, as you begin to look at it without Scientific-Atlanta, the higher range is 12.5%. If you compare that to Q4, Q3, you clearly are seeing an increase both sequentially with Cisco only, not including Scientific-Atlanta, and in terms of the year-over-year numbers at the high end of our guidance. In terms of Q1, as we go into it with any direct sales organization, there tends to be a reset for Q1. But we're talking about being lower than Q4, not in terms of year-over-year type numbers. Did that explain it more?
- Alex Henderson:
- So you're not suggesting that the Q1 is down in revenues, you're just saying it would be down in orders, which is normal.
- John Chambers:
- Which is normal, versus Q4.
- Alex Henderson:
- But the year-over-year growth rates does not have any implication to that.
- Betsy Rafael:
- Year-over-year growth would be, let's say, at the low end of the 10% to 15%.
- Alex Henderson:
- Why is there seasonality on a year-over-year growth rate? It's still back to the same question.
- John Chambers:
- There isn't much.
- Alex Henderson:
- We'll take it offline. Thank you.
- Operator:
- Our next question comes from Mark Sue, RBC Capital Markets.
- Mark Sue:
- Thank you. Could you just talk about the sustainability of strength in both the commercial and enterprise segments? Everyone seems to be entering the commercial business due to its attractive growth rates. On the enterprise side, if anything, IT budgets are not increasing, but rather, corporations seem to be spending more on networking gear versus PCs for the moment anyway, which may indicate a potential long-term slowdown in networking gear.
- John Chambers:
- Breaking these into a couple of questions. First, the commercial marketplace continues to do very well with growth in the low 20s year-over-year. We're going to continue to develop, Charlie, a lot of products for that marketplace and I think we're just getting started in the last few years with our focus there. So we think we will do well in the commercial marketplace, but I think still good opportunities we'll continue to gain market share in most of the categories. In terms of the enterprise, I think there is a more fundamental change occurring. If you watch what the network does, it enables the change in the business models and also in the productivity models. I think you see more and more if a share of wallet spend that we referred to over the last several quarters, in each of our momentums in the enterprise customers. So both in terms of how they view Cisco, in terms of the role we play in helping them achieve their productivity and flexibility need for the future, as well as the consumption of technology. I would not necessarily draw the correlation at all between the number of PCs that may be sold and the networking load that grows in the marketplace. That's true in the service provider environment where we're seeing growth probably in the 8% to 9% sequential monthly loads on service provider networks, which is obviously over 100% growth year by year and starting to accelerate; and that's before video really begins to take hold. In terms of the Enterprise segment, as you began to play in the quad play within the enterprise as well with unified communications, I think you see Cisco not only playing in our traditional routing and switching market, but playing in everything from security to the data center as well. So I do not think that's a cycle that you're running through. There's always a chance we would be getting this wrong, but again, reiterating the issue. There is no change in our guidance in terms of what we've been saying for almost two years now. We thought the growth would be in the 10% to 15% range. And then reiterating the points which I think Alex asked earlier, if you're reading any caution into what I'm saying, we're just being more transparent and telling you what our order rates are; which by the way, has been exactly what they've been relative to a Q4 before. So I think the right comparison is to focus on year-over-year and we're not sending mixed signals in that. We're very comfortable based on what we see today with our year-over-year growth rates for this next quarter. The only reason we mention Q1 is so we don't surprise anyone when we finish up with Q4, and then we say by the way, here's what we have traditionally seen in the reset of Q1, which we allude to for several quarters.
- Mark Sue:
- Thank you, John. Get well, Dennis.
- John Chambers:
- Dennis, by the way if you're listening on that end, we thank you very much for your many contributions. Your team has done a great job. So next question please.
- Operator:
- Our next question comes from Tal Liani, Merrill Lynch.
- Tal Liani:
- Maybe you can discuss the issue of sales force efficiency. You recruited many salespeople in the last two years and you haven't provided much information about the sales efficiency of a new salesperson. When do you expect it to impact sales? Is it what we are currently seeing? Last quarter, this quarter are good quarters. Also if you can discuss, where did you add these new salespeople? What areas, regions?
- John Chambers:
- Rick, this sounds like a good one for you to take.
- Rick Justice:
- Tal, thanks for the question. First of all, we measure very closely the productivity of new salespeople and we expect them to get up to full productivity in four to six quarters. We're finding with the people we have hired over the last six quarters, that in fact continues to be the case. Of course we watch that very closely because if we saw a trend, a diminishing return in that productivity, it might indicate to us that we're reaching a point where we shouldn't continue to add more capacity in the market. We're not seeing those trends at this point in time. In terms of where we're adding the salespeople, and of course when we say salespeople, we're adding SEs as well as supporting people. Of course, the first priority is commercial. That's about coverage, and of course that is why you see the productivity being strong because as you go into new territories that don't have the coverage, you would expect that. We're also adding quite a number of people to the low end of enterprise where companies, again, it's a coverage issue. There are thousands of those companies, particularly in the United States, but we see them all over the world. Then we're also adding geographically aggressively in the emerging markets. And here, we mean emerging countries, both in what we call the emerging markets theater, but also in Asia-Pacific where the countries are emerging. So it's in line with our priorities, it's in line with our growth rates. We are adding a service provider as well, but when you have the infrastructure coverage, when you have big opportunities and you have momentum in the market, it may not be directly related to a coverage issue, and so you wouldn't see as great an increase on the service provider side. So that's how we're approaching it, Tal, and we keep a very close look at it from the time someone comes on board to one quarter out, two, three, four, five, six, and so far the trend looks very positive for us.
- Tal Liani:
- Thank you.
- John Chambers:
- Thank you, Tal.
- Operator:
- Our next question comes from Jiong Shao, Lehman Brothers.
- Jiong Shao:
- Actually I wanted to ask a question, I think I asked it last quarter. Your booking growth year-over-year has been above your revenue growth for several quarters in a row now. John, what do you think your revenue growth is going to match the booking growth? Is that going to happen this quarter or October quarter? Could you provide some comment on that?
- John Chambers:
- Without getting tied too closely down, Jiong, you've asked the right question. Are we increasing the backlog while still maintaining our customer satisfaction lead times? The answer is yes. And if you look within that as the changes that Angel Mendez is making and Randy are making in manufacturing, it gives us more flexibility to run our operations effectively across product lines where literally our advanced technologies are rapidly approaching the same volume as our routing business is. Getting that mix right, as we've seen from quarter to quarter, is challenging. So the key is, how do you keep your lead times where customers want it and be able to run your operation as effectively as you want within it? So to the second part of the question, we are not at all forecasting nor should it be interpreted as a slowdown in the order growth rates based on what we have seen. We are, however, going to run our business very effectively and conservatively given a market condition which some people view with uncertainty which we have not seen, but we want to make sure that we are able to meet our customers' needs within that guidance. So to the point that several of you have asked, I just want to reiterate. We're not in any way indicating that we see a slowing in terms of the order rates as we do Q4, Q1 into next year. We will only forecast one quarter at a time, and again, only in the interest of just being very transparent, we wanted to share with you what our order rates in Q1 are versus what Q4 traditionally is, not making a revenue forecast at this time.
- Jiong Shao:
- Thanks.
- Operator:
- Our next question comes from Paul Silverstein, Credit Suisse.
- Paul Silverstein:
- I was hoping for a clarification and question. Clarification -- with respect to the UK, when you look at that region, are you seeing a continued pickup, or is the modest strength of last quarter up to this point, is that kind of steady-state?
- John Chambers:
- If you look at it, I would anticipate it to continue to grow in the UK. A lot has to do with revenue recognition issues for customers like BT, et cetera. Also, I want to be very upfront. The only area that we have seen a concern in terms of current momentum, was in Western Europe. So we see Japan leveling out, we see Asia-Pacific very strong at about the 20% range, we see North America unusually strong. Remember, that is 50% of our business there. Europe, which represents 23% at 22%. UK is doing okay at low double-digits growth rate. Germany is looking better. France we were pleased with the numbers, given what was going on economically there. The issues with Europe were more Central Europe and Southern Europe, in terms of the momentum areas, like Italy, et cetera. So I view the UK as good, not great, remembering again that our team there had two great years of growth in the mid 20's year-over-year. I think this is also pretty typical of what we're seeing from most of our peers when I talk to our industry peers, either in IT or communications. So if you take out revenue recognition issues, I think most people see Europe in terms of their big theaters being the slower growth versus the others in total, Paul.
- Paul Silverstein:
- Okay. And John, [iPic]'s and the other new ATG products area. I trust that they don't factor meaningfully in your guidance for either ATG or for overall revenues?
- John Chambers:
- I think that's fair. As you introduce most new introduced most new advanced technologies from scratch, it is usually several years before they really begin to be material in terms of their revenue. That doesn't mean that they aren't material in terms of customers making architectural decisions for you and beginning to say, here's the vendor that I want to have as my preferred vendor, or perhaps standardize on, which we are seeing an increasing trend on today.
- Paul Silverstein:
- But even '07 would be too soon to look for meaningful impact in those new areas?
- John Chambers:
- Charlie?
- Charlie Giancarlo:
- Yes, I would say so. They're early in their phases. Obviously, video systems is a new one, but it's off of a big base, so that can make a meaningful impact. I would say both [iPic]'s and Linksys 1 should be reasonably small and not truly meaningful from a revenue basis in FY07.
- John Chambers:
- Paul, that's the way all of them are built for us. Each of the advanced technologies, the first couple of years in shipments have been fairly small, and then it usually takes us five to seven years to get to the billion-dollar run rate, if they get on that.
- Charlie Giancarlo:
- Just to be clear, I don't want to let those teams off of their commitment next year, John. So from their standpoint, it's very important.
- Paul Silverstein:
- Thank you.
- John Chambers:
- Thank you, Paul.
- Operator:
- Our next question comes from Ehud Gelblum, JP Morgan.
- Ehud Gelblum:
- First of all, I do want to echo what Alex said earlier when you come to the answer to his question I think we all would like to hear it, because what I understand from his question and from what you said earlier was that the year-over-year growth rates go the lower end of the 10% to 12%, which they shouldn't necessarily be doing in the first quarter, regardless of what order rates go to. So when you resolve that, I think we would all love to hear the answer to that and that would be great. I kind of agree with the premise that he was saying. My question, actually I have a clarification on Scientific-Atlanta as well. Can you give us the number of set-top boxes that Scientific-Atlanta sold in the quarter? Any kind of mix or information you have in there that the Company used to give out? And when I back into what Scientific-Atlanta's gross margin was this quarter by starting off with the core Cisco gross margin, I get 35.1%. Your guidance had been 36% to 38%. I'm wondering where the delta happened there, did that have something to do with acquiring them and somehow the OpEx trend or the COGS didn't translate exactly? Where do you see the trend? Does that mean that we're going to be below that 36% to 38% going forward, or do we move back into that and continue going higher as time goes on?
- John Chambers:
- Okay. Starting with, Ehud, a little bit on the Scientific-Atlanta, then Betsy, you will take the second part, if that's alright? Okay. In terms of Scientific-Atlanta, repeating what we've said a little bit earlier, the increase versus last year in terms of the two months that we were aligned was in the 11% to 12% range, which means probably just about the middle of that in terms of direction. Set-top shipments growth for the two months were about 22% in terms of the approach. We seem to do a little bit better in the high-end of the high-definition DVR set-top shipments in terms of market share within that. Total set-top shipments were in the 434 category in terms of total shipments. Charlie, is that right?
- Ehud Gelblum:
- 434? That's way too low -- should be well over 1 million.
- John Chambers:
- 1.004 million, I'm sorry, in terms of shipments for the two months. Thank you on that, Ehud.
- Ehud Gelblum:
- That's for two months?
- Charlie Giancarlo:
- 1.004, right.
- Ehud Gelblum:
- For two months only?
- Betsy Rafael:
- Correct.
- John Chambers:
- So we will on the next call invite one of the Scientific-Atlanta members, probably Jim, to come in and we will specifically focus on Scientific-Atlanta. It's tough when you have two months of data with your quarters not overlapping and the first month of the quarter not overlapping to get the alignments as crisp, in terms of the numbers.
- Betsy Rafael:
- The other question with respect to OpEx growth. So we have been talking for certainly the last several quarters about the increase in sales head count, which is targeted to drive the top line growth, and we have also been making some longer-term investments in the engineering organizations. Clearly. the expectation is that over time, the percentage, the OpEx percentage, if you compare to revenue, is going to go down closer to the 35% range. But we do feel that it's appropriate to make the investments in these both as John has often talked about a shorter payback on the sale side with a longer-term payback on the engineering side. But if we don't make those investments at a time when we need the top line growth, we won't really be ready to do that.
- Ehud Gelblum:
- Sorry -- I was talking gross margin.
- Betsy Rafael:
- I apologize.
- Ehud Gelblum:
- Sorry, I didn't mean to cut you off, but the 35.1% is what you got on the gross margin Scientific-Atlanta?
- Betsy Rafael:
- We said that the gross margin impact from Scientific-Atlanta was approximately 2 percentage points.
- Ehud Gelblum:
- Right, but when you back into Scientific-Atlanta's gross margin, you get a 35.1% gross margin for SA's 407 in revenue. Your guidance had been 36% to 38%, and I was wondering what was the reason for that?
- Betsy Rafael:
- The primary driver for that is certainly with an acquisition, we had some kind of minor conforming policies related primarily to inventory, as well as some of the normal activity that happens in an acquisition where you mark up the fair value of the assets, et cetera. So it was not significant, but relative to the size of the revenue, it translates into that from a gross margin percentage.
- Ehud Gelblum:
- So you expect it to really be 36% to 38% next quarter?
- Betsy Rafael:
- We don't have any reason to believe that it wouldn't be in the range we've provided, and certainly consistent with their historical performance.
- Ehud Gelblum:
- Excellent. That's very helpful, thank you.
- Operator:
- Our next question comes from Tim Daubenspeck, Pacific Crest Securities.
- Tim Daubenspeck:
- Thank you. My question is involved with carrier revenue recognition and video. Obviously, you announced a nice win with Deutsche Telekom, you have some work going on globally. When do you think we could see some of this, as you point out, some of the revenue recognition issues worked out? Do you expect fiscal 2007 to be the year where we really start to see acceleration in home networking, edge routing, core routing, driven by video initiatives at carriers?
- John Chambers:
- Charlie, do you want to take that one?
- Charlie Giancarlo:
- I will take the second part of that John. We expect that FY07 is going to be a very busy year in terms of early engagements and early rollouts of video activity with major carrier partners. I would expect it to be an extremely important timeframe from the standpoint of getting the technology up and running and working and proving out the business models and proving out the content and customer satisfaction with these networks, but I really would expect scaling to occur in the FY08 timeframe for those networks. That's not to say that there isn't some very real wins and some very real revenue that will be solidified in the FY '07 timeframe. But in terms of the real strong buildouts, I'd say that, that would wait until the FY '08 timeframe.
- Tim Daubenspeck:
- Thank you very much.
- John Chambers:
- In terms of carrier recognition for video, obviously we have an ongoing process for the cable companies that is going very, very smoothly. As you do some of these new contracts for example in BT or DT or AT&T or others, there is an issue in terms of when recognition occurs on that. So you would probably be into next year before you would begin to recognize most of the revenue. So orders that we receive now in most cases are not booking through and definitely not revenue.
- Operator:
- Our next question comes from Jason Ader, Thomas Weisel Partners.
- Jason Ader:
- Just a question on the revenue growth in Advanced Technologies. Do you expect that to move towards the 20% level that you talked about in Q4? And then maybe if you could just drill down on security and application networking and comment on those areas?
- John Chambers:
- Sure. If you look overall, the Advanced Technologies are beginning to approach our total router business, so it's over 20% of our product business today, and that's without Scientific-Atlanta being a part of it. I would expect the booking growth and the revenue growths to even out over quarters in terms of the momentum within that. Therefore, you can correctly interpret that our orders this quarter came in more in Q3 than traditionally we see in Q3 and a little bit less in Q1. So nobody asked the question about linearity, but if you look at our typical quarters, they often run 25%, 26% in month one, 31% or so in month two, and the delta in month three, let's say 43%. This quarter, the month one was a little bit lighter than we normally experienced and the third month was a little bit stronger than we normally experienced in terms of run rates. So in terms of the total of Advanced Technologies, we feel pretty good with momentum. Security is running in the bookings low-double digits and the revenue is high-single digits. Part of that is being bundled into the products, part of it is still is selling the architecture for it, in terms of the momentum. Charlie?
- Charlie Giancarlo:
- On the application networking side, we actually saw good order momentum quarter over quarter, so we are seeing that on an upswing but it's still a relatively small market overall. It is accelerating nicely and we believe that it's something that we're going to continue to focus on as we go forward and we have high expectations from that market overall. Security was less than what we would like to see on a longer-term basis. Part of that we think is the market, part of it was just the complexion of this quarter. As we've said in the past, AT can be quite lumpy. We think that was the case this quarter with security.
- Jason Ader:
- Thank you.
- Operator:
- Our next question comes from Cobb Sadler, Deutsche Bank.
- Cobb Sadler:
- I have a quick question on the government. I think you talked about the rollout being a little slower than it normally is. When were budgets released, how does that compare with what you would have expected and what you have seen on a historical basis? Could you talk about the revenue ramp throughout the quarter on a month by month basis as far as the federal government goes? Thanks a lot.
- John Chambers:
- The federal government on a month by month basis I don't have, but I do have a pretty good feel in terms of the quarters. We have had a very good year in federal government and we would anticipate, barring a surprise, that we will end up the Q4 with a very good year as well. We saw this quarter growth in the low-single digits in the federal government. Next quarter looks better and both in terms of sequential growth and year-over-year growth in terms of momentum. Cobb, I don't split it out by individual months within that.
- Cobb Sadler:
- But was there momentum throughout the quarter? I guess the first month was probably a little bit lower since budgets were released late than the last month of the quarter I would assume.
- John Chambers:
- Well, it varies. The answer to your general question would be, probably yes. I don't follow it down to that level of detail. I think it's fair to say that the budgets in the civil side of the federal government were fairly typical. The defense tends to go up and down a little bit more, but we are forecasting a good Q4. Rick?
- Rick Justice:
- Of course, the Defense Department, I mean the DOD, has just released a supplemental budget now and we were waiting for that. But you're absolutely right. Civilian and intelligence, the money was flowing. It was not flowing in DOD and we hope to see some improvement there now. Q4 is obviously always a very strong quarter for us seasonally in the federal space.
- Cobb Sadler:
- Is the feel with the supplemental budgets that things will accelerate a little bit, or is it too early to tell?
- Rick Justice:
- We're glad that the supplemental budget was released, we were looking for that, so that good news and we would hope that we get more than our fair share.
- Cobb Sadler:
- Thanks a lot.
- John Chambers:
- But to answer the question very directly, Cobb, we would be disappointed if Q4 were not up over Q3 and we think we'll finish the year in federal government probably in growth in terms of orders in the mid-teens.
- Cobb Sadler:
- Sounds great.
- Operator:
- Our next question comes from Inder Singh, Prudential.
- Inder Singh:
- Thank you. I wanted to ask you about Scientific-Atlanta and the degree of operational integration you expect you will do. I think when you did the acquisition initially, you said you intended to leave it essentially independent and let it run way the way it was. Does that mean that you're intending to do field force integration than? And then what kind of hiring do you think that might entail, along with the quotas you might anticipate for those people?
- John Chambers:
- What we said in the original acquisition, and Charlie feel free to jump in here, is that we were not going to make significant changes in the first year. We want to make sure, and this is what each of our customers said, that they love the acquisition, they want to see that occur. But they said, make sure this goes very smoothly, not just in your field, but in terms of how you go to market with customers, et cetera. So I think you will see us tread lightly in terms of how we bring together just from an efficiency point of view and really focus on how do we meet the customer requirements. And so I think what we will be seeing, Inder, is that is a gradual approach.
- Charlie Giancarlo:
- That's absolutely right, John. And Inder, you and I spoke of at the time of the acquisition. What we said was, we would do a very careful and thoughtful integration over the first two years, right, but that we were going to take our time on the integration so that we made sure that we really were bringing together the best aspects of both companies and we didn't come to any hasty conclusions or actions. And that is our plan and we're proceeding along in that way. Obviously, there are areas where we can get immediate benefits on the supply chain side, as well as on the coordination and presentation to customers, on the integration of advanced services and so forth, and we're clearly doing those things. But we are taking a very cautious, thoughtful approach.
- Inder Singh:
- Thank you.
- John Chambers:
- Thank you, Inder.
- Operator:
- Our final question comes from Ari Bensinger, Standard & Poor's.
- Ari Bensinger:
- Thank you for squeezing me in. Just on product gross margin, you guided down, which I understand reflects another month of Scientific-Atlanta, but do you have any long-term targets for that? And is it fair to assume that as you're focused more on consumer-oriented products that pricing pressure will sort of increase versus historic numbers?
- John Chambers:
- Let me address it first very directly in terms of competition. Our competition is pretty much what we've seen before -- aggressive on pricing but nothing out of the ordinary. Rick's discounts have been very solid, very predictable versus prior quarters. So we are seeing just the normal pricing pressure and that has not changed. You'll want to probably look at our gross margins in three categories. I think you'll want to look at our traditional Cisco gross margins, which clearly at this point in time, we're just seeing the normal pressure and no major surprises there at all. That's more of a mix issue in a given quarter and how those go up or down half a point or so and we were very comfortable with the gross margins for the traditional Cisco products this quarter. In terms of Scientific-Atlanta, obviously they had lower gross margins, but a lower expense model as well. So what we focus on is the profit contribution that they make and it looks like it's very much in line with the guidance that we gave in terms and profit contribution from Scientific-Atlanta being about $0.01 a quarter minus the debt issues that we would be paying interest on. In terms of all the way down to Linksys, Charlie, obviously, gross margins in the mid-20s, an operating expense model at the 10% and that's kind of how we look at it. So the answer directly is, we're seeing very little abnormal competition on pricing that we are comfortable with where we are in our gross margins today versus what we've said in other prior quarters. And actually, I think a large amount of the consolidation that is occurring in the industry and the architectural decisions that are going on and the products' inner workings works to our favor on gross margins, especially when you can help the customers achieve their goals in terms of their own productivity and their cost of ownership. So I would like to summarize at this time, and Blair, I want to thank you very much for running the session. I want to make sure that we're very clear in terms of our view of the quarter, what we're seeing going into Q4 and just a general statement about Q1, reminding everyone that we don't give guidance more than one quarter at a time. But I think it's fair to ask the question. In terms of this quarter, we were extremely pleased with what we view as a very strong quarter. This is true from a financial perspective, a market share gains perspective and acceptance within our customers across all key verticals and across most of our key geographies. That the challenges that we see this quarter aren't any more than what we traditionally see, that our optimism going into Q4 is very solid. Again, I want to make sure that we're not singling anyone in our 10% to 15% growth in orders for Q4 that we expect Q4, barring a surprise, to be a very solid or for us. That Q1 in terms of giving you the data, what we want to just be very clear on is that we see Q1 and we will measure it in terms of year-over-year type of growth numbers. We are not indicating that we see in the segment of the market that we see today a slowdown in times of what our order expectations would be. So bottom line from our side, in spite of what is going on in the market, we see the order growth rates and the revenues in the 10 to 15% range, that Q3 was solid for us at the very high end in terms of order growth range. Q4, we will see how that develops. After Q4, we will be able to get more indication on Q1. Our comments on Q1 related only, related only to our order rate versus Q4, which we've traditionally seen down in the mid-single digits, that our order momentum at this time gives us no reason to indicate that it won't be within the 10% to 15% range that we have traditionally seen.
- Blair Christie:
- Thank you, John. As a reminder, our next quarterly conference call, which will reflect our fourth quarter and fiscal 2006 results, will be on Tuesday, August 8, 2006 at 1
- Operator:
- Thank you for participating on today's conference call. If you would like to listen to the call in its entirety, you may call 866-357-4205. For participants, dialing from outside the U.S., please dial 203-369-0122.
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