Cisco Systems, Inc.
Q1 2009 Earnings Call Transcript

Published: 6 Nov 2008

[Operator:]

(Operator instructions). Now I would like to introduce Ms. Blair Christie, Senior Vice President of Corporate Communications for Cisco Systems, ma’am you may begin.

[Blair Christie:]

Than you Kim, and good afternoon everyone, welcome to our 75th quarterly conference call. This is Blair Christie, and I’m joined by John Chambers, our Chairman and CE0, Frank Calderoni, Chief Financial Officer, Rick Justice, Executive Vice President of Worldwide Operations and Business Development, as well as Ned Hooper, Senior Vice President of Corporate Development and Consumer Groups, and Rob Lloyd, Senior Vice President of Sales for US, Canada, and Japan. The Q1 fiscal year 2009 press release is on full national market wire and the European Financial and Technology Wire, and on the Cisco website at www.cisco.com. I would like to remind you that we have a corresponding webcast with slides. In those slides you will find the financial information we cover during this conference call, as well as additional financial metrix and analysis that you may find helpful. Additionally, downloadable Q1 financial statements will be available following the call, including revenue segments by product and geography, income statements, full GAAP to non GAAP reconciliation information, balance sheets, and cash flow statements can be found on our website in the Investor Relations section. Click on the financial section of the website to access the webcast slides and these documents. A replay of this call will be available via telephone from November 5 through November 12 at 866-3574205 or 203-369-0122 for international callers. It is also available from November 5th through January 16th on Cisco’s investor relations website at www.cisco.com/go/investors. Throughout this call we will be referencing both GAAP and non GAAP financial results, as is customary with many companies, we have used this Q1 time period to reflect certain immaterial reclassifications to our financial statements and results, which will also be reflecting in our Form 10-Q. The financial results in the press release are unaudited. The matters we will be discussing today include forward looking statements, and as such as subject to the risks and uncertainties that we discussed in detail in our documents filed with the SEC. specifically, the most recent annual report on Form 10-K 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, and I will now turn it over to John for his commentary on the quarter, John.

[John Chambers:]

Thank you Blair. During the opening comments of the conference call, I will focus on what I view to be the key takeaways for Q1 fiscal year ’09. an update on why we continue to be comfortable with our long term growth goals of 12 to 17%, assuming that the global economy returns to normal growth rates, a very candid discussion about what we are seeing in the market on global basis relative to Q1, and its effect on our Q2 expectations, then finally our revenue guidance for Q2, with the appropriate caveats. Frank will follow these opening comments with additional detail on Q1 fiscal year 2009. The third section of the call will focus on business momentum and strategy from a geographic, product, customer statement perspective, Frank will them follow with additional financial parameter around our guidance. I will then wrap it up with some comments in terms of Cisco’s momentum going into Q2, and finally our Q&A session. Q1FY2009 was a solid quarter for Cisco from a revenue and an earnings per share perspective, especially given the many challenges that we are all seeing occur in the global marketplace. In terms of those areas that we can control or influence, we continue to feel very comfortable with both our progress in the quarter and our long term vision and differentiative strategy as we move into new market adjacencies. We exit Q1 with an extremely strong position in the marketplace, approximately 27 billion in cash and investments, solid balance from the product, geographic, and customer segments perspective, perhaps one of the broadest balances across the IT industry. Continued success in being the number one and number two player in most of our 20 plus targeted product areas, and innovation engine that results in product leadership across the broadest range of products that we’ve had in our history, combined with our product pipeline of new innovations that we believe is also the strongest that we have ever had. Not only does our end to end technology architecture, form the device to the data center across any combination of networks, but also of next generation of entertainment and business models. So we have had what we believe to be the strongest position in terms of customer relationships at the enterprise and service provider level, and helping to enable our customers’ business goals. Just as we led in the first phase of the internet, i.e. Web 1.0, from both the internal utilization and the expertise we offer our customers to enable this capability, we believe we are now uniquely positioned to provide very similar leadership in the second phase of the internet, through collaboration, enabled by Network Web 2.0 technologies. Once again, we are leading in our terms of our own utilization and partnering with our customers to drive their goals, a changing business model enabled by the network. Now moving on to a summary of our Q1 financials, we were pleased with the following results. Revenue was $10.3 billion, approximately an 8% year over year increase. Pace generated from operations was $2.7 billion. Non-GAAP earnings per share were $.42, a 5% year over year increase and GAAP earnings per share were $.37, a 6% year over year increase. Total non-GAAP gross margins were very solid at 65.6, an increase from 64.9% last quarter. Non-GAAP operating expenses are a percentage of revenues for Q1 with 35.8%. We continue to drive innovation and product leadership from our core, advanced and emerging technologies. The following is a summary of each of those areas for Q1 in terms of year over year product revenue growth. Core technologies and services were solid with switching growing at 8% year over year, routing growing at 1% and service revenues growing at 10% year over year. Our first wave of advanced technologies grew 15% year over year, unified communications within that group grew at 22%, wireless grew at 21%, security grew at 19%, the network home decreased 2% and storage decreased 4%. Our second phase of advanced technologies had a very strong quarter with revenue growth year over year of 22%. Application networking services grew 25% and video systems grew 21%. Our early stage internal start-ups that we call “Emerging Technologies” were also solid in Q1 in terms of year over year order growth. Our strategy is to develop a reasonable percentage of these emerging technologies into what we categorize as advanced technologies, with a realistic probability of becoming 1 billion plus in sales and the number 1 market position in their respective product categories. Overall progress was again, very strong in this quarter. While these numbers are not material financially at this point in time, we believe that with proper execution they can become very significant to our long term growth rates in the longer run. The emerging technology group orders in total grew approximately 180% year over year. We had strong year over year order growth from the mid teens to the low thirties in the following countries

[Frank Calderoni:]

Thanks, John.

[John Chambers:]

You're welcome.

[Frank Calderoni:]

As John stated earlier Cisco has a strong history of successfully navigating market transition. And I remain confident that our financial model enables us to execute in both good and tough environments. For today's call I will provide a recap of our solid financial results for the first quarter of Cisco 2009, and then I will discuss what I believe our financial strength positions us well to manage during the uncertain economic environment we saw - especially in the second half of the quarter, but also more importantly going forward. The total revenue for the first quarter was $10.3 billion, an increase of approximately 8% year over year, in line with our guidance. Searching revenue was $3.6 billion an increase of 8% year over year, driven by growth in both our modular and (unintelligible) port folio. Routing revenue was $1.9 billion up 1% year over year - against technologies revenue totaled $2.7 billion representing an increase of 17% year over year with strong performance in unified communications of 22% year over year growth. The video systems growth of approximately 21% year over year, securities with growth of approximately 19%, wireless land growth of approximately 21% and application networking services growth of approximately 25%. Other product revenue totaled $442 million, a decrease of 13% year over year - related to our obstacle and cable businesses quarter. Total service revenue was $1.7 billion up 10% year over year with solid growth in emerging markets. We are pleased with our growth and advanced services of approximately 15%. Total revenue by geography ranged from 1% year over year in the US and Canada to a high of 41% in emerging markets. Emerging markets revenue growth for the quarter were higher than the order growth rate that John reported due to some increased shipments - recognition of previously deferred revenue and the affect of our reserves from Q1 of fiscal 08. We want to remind you that revenue growth in emerging markets may experience variability and order growth may provide a better indication of future revenue performance. Q1 total non-GAAP gross margin was 65.6% up 7/10ths of a point quarter over quarter and up 4/10ths of a point year over year. For product only non-GAAP gross margin for the first quarter was 66.2% up a percentage point quarter over quarter and up 6/10ths of a point year over year. The quarter over quarter improvement was driven by higher cost savings partially offset by product mix. The year over year improvement was driven by higher cost savings partially offset by higher product discounts as well as mix. Our non-GAAP service margin for the first quarter was 62.4% down from 63.1% last quarter and 63.5% in Q1 fiscal year 08. The service margin will typically experience some variability over time due to various factors, such as the changes in mix between our technical support services and advanced services as well as the timing of support contract initiations as well as renewal. Total gross margin by geography range from 63.4% for emerging market to 69% in Japan this quarter. Across the geographies the margins have remained relatively stable over the last few quarters. Non-GAAP operating expenses as a percentage of revenue for approximately 35.8% in Q1 fiscal year 09 relatively consistent with the 35.7% we had in Q1 fiscal year 08. Foreign exchange impact for the quarter was $46 million when compared to the same period last year which added approximately 4/10ths of a point to this ratio. Excluding foreign exchange our non-GAAP operating expenses for Q1 were at 7% year over year. Interest and other income $123 million Q1 which includes the recognition of realized gains, losses, as well as impairment. We remain very pleased with our diversified high quality cash and investment port folio. I will provide more detail on investment port folio in just a few moments. Our Q1 fiscal year '09 non-GAAP tax provision rate was 22% down approximately 2 points from fiscal year '08. This decline in the affected tax rate was driven primarily by the renewal of US Federal R&D tax credits which occurred last month in a more favorable mix of foreign earnings at lower tax rates. Non-GAAP net income for the first quarter fiscal year 2009 was $2.5 billion which was flat year over year. As a reminder in Q1 fiscal year '08 we did record a onetime tax benefit of $162 million. Non-GAAP earnings per share on a fully diluted basis for the first quarter were 42 cents per share up from 40 cents per share in the first quarter of fiscal year 2008 - a 5% increase year over year and our highest earnings per share to date. The onetime tax benefit in Q1 fiscal year '08 was approximately 3 cents per share. Non-GAAP net income for the first quarter was $2.2 billion dollars flat compared to $2.2 billion dollars in the first quarter - in fiscal year 2008. GAAP net earnings per share on a fully diluted basis for the first quarter was 37 cents per share that was up from 35 cents per share in the same quarter of fiscal year 2008. Now moving onto the balance sheet - the total of cash, cash equivalent and investments at the end of Q1 was $26.8 billion up $528 million from Q4 fiscal year '08. During Q1 we generated $2.7 billion dollars in cash flow from operations as well as $224 million in proceeds from stock option exercises. For the quarter we re-purchased $1 billion of common stock or 46 million shares of our stock at an average price of $21.95 cents per share. We ended the quarter with approximately $7.4 billion remaining in the current stock re-purchasing authorization. Moving onto accounts receivable - we ended the quarter at $3.3 billion which was down 14% on Q4 fiscal year '08. At the end of Q1 days sales outstanding or our DSO was 29 days compared to 34 days in Q4 fiscal year '08 driven by lower service billing due to seasonality as well as improved collection. Total inventory at the end of Q1 was $1.2 billion that was flat quarter over quarter. Non-GAAP interim returns for 11.6 this quarter which was also flat from last quarter. Our inventory purchase commitment and the end of 2/1 were $2.9 billion up 5% from the end of Q4 fiscal year '08. Deferred revenue was $8.8 billion at the end of Q1 an increase of approximately 24% year over year. The third product revenue was $2.9 billion up approximately 18% from last year. While the third service revenue was $6 billion up approximately 28% year over year. At the end of Q1 our head count totaled 67,647 a net increase of approximately 1,518 from Q4 fiscal year '08 of which more than 50% were college hires which we normally experience in Q1 each year. Separate from our college hires we added 722 to head count this quarter which were mostly engineering, sales, and services. In mid October we did implement a pause in our external hiring while we did assess the changing macroeconomic environment. Now I'd like to discuss how we are managing Cisco Financial positions. In both good times and challenging times and why we believe this is a competitive advantage and positions us to manage our business well and continue to lead in the future. We do understand that during turbulent economic times like we are currently experiencing our investors would like a solid understanding of key areas we believe allow us to perform well. I would start by saying with nearly $27 billion in cash - cash equivalents and investments, a solid balance sheet, visibility into our supply chain, strong investment port folio management, and our fiscal capital financing arm - all of which provide a key competitive advantage we believe we are well positioned to manage our business through any type of market condition. For example, take the key items that influence our results this quarter. First, we continue to have very high quality receivables as evidence by our DSL 29 days. We continue to conduct regular assessments of the quality of our receivables given the current market conditions and we remain comfortable with our portfolio. Second, our strong supply chain management continues to be a key lever in our ability to maintain strong growth margins whilst at the same time providing visibility and management of our demand planning. Over the last several years we are significantly enhanced our supply chain capabilities to better anticipate and manage our demands. Our lean manufacturing model allows us to more fully optimize our supply chains inventory and investment. We have enhanced processes and systems to provide increased visibility inventory management and better responses to fluctuations in demand. Over time this has resulted in better lead times, on-time shipment predictability, and improved inventory management across our supply chain. While there is always inherent risk given the current economic environment we have enhanced the monitoring of our supply base to identify potential issues so that we can take appropriate measures on a timely basis. Key metrics such as inventory returns, purchase commitments, and on-going review of excess and obsolete inventory remains strong. And again contributes to Cisco's consistent margin performance. Our investment strategy has served us well in the turbulent environment. The overall credit quality of our port folio is extremely strong with our cash and fixed income port folio invested in securities with an average credit rating of double A or better. In light of more challenging market conditions over the last six months we have more conservatively managed our $27 billion diversifies port folio, which has resulted in slightly less than 1% mark to market impact on a cash, and fixed income port folio valuation compared to last quarter. Finally, our financing arm, or Cisco Capital - continues to provide financing to our customers and our channel partners, which enables incremental sales of Cisco's products, services, and networking solutions. In fiscal year '08 fiscal capital originated or facilitated approximately $4.3 billion dollars in lease and longer term loan arrangements. While the number of credit requests for enquiries has increased in the current environment we have adhered to our consistent methodology and prudent financing practices. Our thorough review process for monitoring a variety of risk metrics has enabled us to affectively balance risk reward as well as sales enablement. We believe there has been no material impact to the quality of our port folio. Broadly speaking we believe our port folio has on average an investment grade profile. We remain comfortable with the credit profile and the way we're deploying our capital. With respect to our accounting policies we remain conservative in how we account for our Cisco capital financing business. Specifically this comprises gross receivables, loan receivables, finance service contracts, and financing guarantees. To update the numbers previously disclosed like Q1 fiscal year '09 we have a combined balance sheet and contingent liability position of approximately $4.4 billion. Of this $4.4 billion we have a net reserve and deferred revenue position of $2.5 billion, this represents an overall reserve and revenue deferral position of over 50% of the financing portfolio position. Again, I would like to remind you that we believe this portfolio maintains an average or around investment grade. We believe that Cisco capital on board lease and loan port folio remains an excellent use of our own cash. We have not accessed any capital market for funds to finance this element of our operation. In summary we have long stated that our financial management and position are a competitive advantage for Cisco, and that belief has not changed even in light of the current economic condition. In fact, it is precisely during a difficult environment like we are currently experiencing that the strong financial foundation that we have allows us to focus on the things that we believe will grow our company and capture market transitions in the industry. I do believe our performance this quarter reflects our ability to manage profitability during a period of uncertainty, and I expect through continued prudent expense management, along with calculated investments in certain areas we will be able to balance the parties of growth and profitability as we move through the current environment. Through our unwavering focus on customers, a strong financial foundation and the power of a very talented global work force I believe Cisco will emerge stronger coming out of this period and enhance its position as a global business leader. I'll now turn the call back over to John.

[John Chambers:]

Thank you, Frank. In this section of the call we will cover our geographies, customer segments, and products for Q1 in more detail. The products review will be in revenue growth terms while they geographic and customer segments will be discussed in terms of orders unless indicated otherwise. First, from a geographic and a customer segment point of view in terms of Q1 year over year order growth - Japan. Japan continued their solid momentum in Q1, with growth of approximately 20%. Leading the way was service provider with growth of approximately 45% year over year, which represents approximately half of our total business in Japan. Public sector grew in the mid-teens, enterprise and commercial were relatively flat. Overall given all the challenges we feel good about our momentum in the Japanese market. Now, moving on to Asia-Pacific - year over year order growth in Asia-Pacific was in Q1 very dramatically by country. China grew in the mid teens while India was down in the mid single digits. From a customer segment perspective service provider and the commercial market grew in mid single digits. While enterprise was down in the high teens, Asia in total was down approximately 4% year over year in terms of orders. Europe , after maintaining growth in our Q4 fiscal year 2008 in the low double digits, we saw Europe's growth slow to negative mid single digits in Q1. Germany continued to do reasonably well, but the UK, Italy, Spain and the Netherlands were challenged, all with double digit decreases in orders year over year. From a customer segment perspective, commercial and the consumer were relatively flat in Europe, Public sector grew in the mid single digits, enterprise was down in the Mid single digits while service provider was down in the mid teens year over year. Moving to the US, excluding Canada. For the US, orders in Q1 were down approximately 8% year over year. From a customer segment perspective, enterprise growth, not including public sector, was down in the high teens. Commercial, service provider and public sector were down in the mid-single digits in Q1 year over year. The emerging market theaters, not including our emerging Asian countries, were down slightly in terms of orders. Enterprise in the emerging markets was down in the high single digits while the commercial grew in the mid-single digits, service provider was down slightly Q1 year over year. In summary, from a customer segment perspective, enterprise year over year order growth across all of Cisco was down approximately 11%, while the service provider, commercial and public sector were approximately flat from the year over year orders perspective. Products – Q1 year over year product revenue growth was up approximately 8% and detailed and/or individual product areas were covered in the opening section of our call. In summary, although we all would like to avoid the downturns, our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe our differentiated strategy is also achieving the benefits both to Cisco and our customers that we thought were possible. And finally, our execution is on target in terms of the results as measured by our customer partnership perspective, market share and share of our customer’s total communications and IT expenditures, as the network becomes the platform for revenue capabilities. Now I’d like to turn it back over to Frank for additional detail of the financial guidance and other financial highlights. Frank, back to you.

[Frank Calderoni:]

Thanks, John. 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. The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP. It is very difficult to provide a forecast given the dramatic variability and the uncertainties going on in the market. These events increase the potential that our actual results could vary materially from our expectations. To reiterate John’s earlier note, our revenue guidance for Q2 makes the prudent assumption that the order momentum challenges that we saw in October will continue into Q2. Therefore, we anticipate total revenue for the second quarter to be down approximately 5-10% year over year. At this point, let me remind you that in light of regulation FD, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. Now let me give you additional details on the Q2 financial guidance. As we have said in the past, forecasting gross margins has always been challenging due to various factors such as volume, product mix, variable component costs, customer and channel mix as well as competitive pricing pressures. That being said, we believe that total gross margins in Q2 will be approximately 64%, reflecting the revenue guidance I just shared with you. We believe Q2 operating expenses will be approximately 39-41% of revenue, as you would expect in this environment, and as John outlined earlier, we are focused on managing our expenses through a pause in hiring, further decreasing travel and discretionary related expenses as well as deferring certain capital related projects. Also as John mentioned, our goal is to reduce our expenses for fiscal year ’09 by over $1 billion from our original budget. Considering the expense control actions I previously mentioned, this means we are targeting our Q4 fiscal year ’09 quarterly expense run rate to be reduced by about $200 million - $300 million as compared to our Q1 fiscal year ’09 quarterly expense run rate. While we will undertake appropriate expense management initiatives in the current environment, we will also make some calculated investments into areas where we believe we can accelerate development and Cisco’s leadership. We expect the areas will be adjacencies to our current markets, where we feel it is possible to extend the network as a platform, such as next generation companies, globalization, virtualization of the data center, video and collaboration architecture. We expect interest and other income to be approximately $130 million in the 2nd quarter. Our tax provision rate for Q2 is approximately 22%. While we expect to continue our share repurchase program, it is difficult the exact weighted average shares outstanding. We are modeling share counts to be down $50-$100 million in weighted average shares outstanding for EPS purposes. In this estimate of share count, we are not taking into consideration any further change in stock price that could occur in the second half fiscal year ’09. At the point of reference, a $1 movement in our average stock price would change the calculated shares outstanding for the purposes of determining EPS by approximately $10 million. Regarding cash flow from operations, we would expect to generate $500-$700 million per month. For our Q2 fiscal year ’09 GAAP earnings, we anticipate that Q2 GAAP EPS will be $.05 per share to $.08 per share lower than non-GAAP EPS, primarily due to acquisition related charges and stock compensation expense. Please view the slides that accompany this web cast for more detail. Other than those items noted above, there are not other significant differences between our GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax and other events which may or may not be significant. Again, I’ll turn the call back over to John.

[John Chambers:]

Frank, thank you very much. I would like to make some summary comments at this point as my view of Cisco’s momentum and opportunities entering Q2 of fiscal year 2009. In areas that Cisco can control or influence, our momentum continues to be solid in the areas of product leadership, innovation and spot leadership. Balance in a very tough environment, given the global challenges, continues to be reasonable across our geographies, products, services and customer segments. This balance normally works to our advantage when there is a slowdown in a product area, a customer segment, or one or two geographies. However, when you are often the number one player across these categories and the challenges truly go global across all these categories, it is almost impossible to avoid the impact. As we said before, even if the market slows, we don’t see this change in our long term growth targets. If we execute the way we have in prior slowdowns, and assuming that the global economy recovers the GDP growth rates similar to those in the middle of the decade, as we continue in the Q2 fiscal year 2009, we plan to aggressively invest in new and adjacent markets for the longer term, assuming global recovery, regardless of how long it takes for the macro-environment to rebound. We would not invest as aggressively if we were to determine that this current slowdown was going to be long in duration, and that we didn’t have a high probability of achieving our 12-17% long term growth objectives and normal economic environment as the market recovers. In terms of major areas where the momentum appears solid and even possibly gaining, would be the following areas

[Blair Christie:]

Great, thank you John. We’ll now open the call to the question and answer session; we do request that the analysts please ask only one question. So Kim, why don’t you open the call to the first question?

[Operator:]

Thank you, our first call comes from Simona Jankowski with Goldman Sachs.

[Simona Jankowski:]

Thanks very much, hi John. The economic situation is clearly very challenging, but at least so far your margins seem to be quite stable, including what you are commenting on in your guidance. Can you just give us a better idea of the impact on your margin structure in the area of declining revenues next year? Especially, sir, I am thinking of the comparison back in ’01 when, obviously, revenues were off quite a bit and margins declined by 13 points on gross margin line, and even more than that on the operating margin line. Is there any reason you expect more resiliency this time?

[John Chambers:]

Ok, Simona, you very creatively asked about three or four questions, but I’ll try to answer them as one. First let me go in reverse order and hit it pretty lightly, but if others of your peers want to discuss it in more detail we will. There are very few comparisons to 2001. 2001 was a different market; it was a high tech driven crisis. Our growth rates went from 50% plus growth rates for nine or ten quarters in a row to minus 45 growth in a period of a month and a half. 25% of our customers disappeared and you were at the end of an innovation cycle, the web 1.0 run, if you will. And Cisco’s PE ranges in that time varied even during the height of the downturn between 20 and 100 in terms of going forward ratios, from fiscal year 2001 to fiscal year 2003. 2008 is a different model. The financial health of the majority of our customers is actually pretty reasonable. This is one driven by consumer and financial challenges, credit and the availability of cash. The role of the network has changed dramatically and it’s a value to our customers, way beyond transport, and that’s on routers and switches, is also increased. Loads on the network will probably grow, what nobody thought was going to occur just a couple of years ago, 2-500% and you are starting the next wave of innovation, dealing with mobility, collaboration, green, smart grid, data center virtualization, video, small businesses, emerging new countries, etcetera. I see this as an entirely different model as it affects Cisco. In terms of the margins, we are not facing any abnormal pressure in terms of from the customers, you will see this in just normal pressures from our peers as markets tighten up, but that’s something we’ve handled very well before. Its too early to say before, but I would say, Frank, the odds are in terms of our components, you will see the component pricing not give as much advantage to us on the margins, perhaps this quarter, but I think if you begin to look at the next quarter or the quarter thereafter, if it plays out the way our supply chain believes, it looks like we will begin to pick up momentum within that. Part of gross margins is dependant upon volumes. We all understand that. It is a nice way of saying we are seeing this play out fairly normally in terms of a little slowing in the market, and that is how we categorize it. Frank do you have anything to add here?

[Frank Calderoni:]

What I would like to add here is something that I mentioned earlier in the call. I think one of the benefits here, which is a key benefit, is all of the work that has been done over the last few years in terms of the supply chain. We have been able to stay close with our suppliers, especially as we have been implementing the lean manufacturing. That has allowed us, as well as our suppliers to be very efficient and very close in what we are seeing. Now from a margin standpoint in the guidance that I have provided for the second quarter, we are seeing a slight decline in margins. This is primary because of the variability that we are seeing on the topline, and taking those volumes down on a quarter-to-quarter is going to have an impact on costs of the particular quarter. From a component standpoint, we saw a significant benefit in the first quarter from a component cost. We are seeing less so in the second quarter, primarily because of the change in volume. Based on what is happening in commodities overall, we do expect to see that continue later in the year. Hopefully we will see this offset some of the other pressures we are having due to lower volume.

[John Chambers:]

Probably more detail than you wanted. Next question please.

[Operator:]

Our next question comes from Mark Sue with RBC Capital Markets.

[Mark Soo:]

Thank you. John, you are cutting about $1.5 billion in guidance from next quarter in absolute dollars, and this is despite the fact there is no excess inventory out there, and customers are relatively healthy. Is this kitchen sink quarter or does the bookings transfer in the second half of October suggest that things can actually deteriorate from here? What does it mean concerning the duration of this recovery if the loads of the networks are increasing?

[John Chambers:]

In terms of the loads on the networks, which we think absolutely will continue, because of videos and collaboration, and web 2.0 and entertainment and many projects with which we are just getting started, our own networks loads are growing at over 400% a year the current rate. I anticipate that increasing as well as we look out over the next six months. In terms of the kitchen sink question, we do not know. I would like to give you a better answer than that. August felt very good. September was a bit bumpy, but had nothing that was a big surprise to us. October did slow, and we began to hear from customers on a global basis that their business was slowing as well. We felt that the prudent thing to do was to extrapolate October out going forward, but to answer your question very directly; it would not a big surprise to see it on the positive side projection or on the other side of the projection. There is more variability, and I think we will know a lot more in 45 days. Most of the time being on the off quarter, being one month behind our peers on announcements works to our benefit, but this time we did not have as much advantage of listening to what others were seeing, other than what they told us anecdotally. Mark, I think that we are in uncharted waters, but it is something, concerning things which we can control and influence, that we feel pretty good and our role in terms of customer environment is feeling quite healthy.

[Operator:]

The next question comes from Etai Kidron with Oppenheimer and Company.

[Etai Kidron:]

John as you look a little bit further out, what would you need to see in order to say “We need to be much more aggressive on optics cutting?” Frank perhaps you could clarify how much was your budget up on a year over year basis, meaning are we going to see optics in ’09, after your cut plan, versus ’08?

[John Chambers:]

We have a lot of weaknesses in the company and we have a lot of strengths, but one thing that most people give us credit for is how we handle economic challenges. We have been through this four or five times. Sixty-six percent of our leadership team were here in the year 2000. So, it is a team that knows how to handle this very effectively, and we have a culture that accepts change well. Our strategy, if you will, our playbook, around those four basic guidelines; that is what we followed every time, and we executed it remarkably well, and coming out of each of these downturns looking out whether its 6 or 12 or 18 months, you watch us really come back to our financial models even stronger. We are not backing off of our traditional financial models over the longer term. However, part of that playbook is that if your strategy is working well, and you are moving into market adjacency, and you are taking market share, and you are being successful in that, and they are going to play architecturally together, we will bring all 26 of those cross functional priorities together architecturally. This is the chance to break away from our peers, and we eventually intend to do that. So while we use good guidance in terms of taking the expense run rate down from about 3.7 billion plus in this last quarter run rate, and that probably doesn’t count our hires into that number, to in the area of 3.45 billion to 3.5 billion dollars in terms of the current plan. We think that is the right way to go after this. Our game plan being based on that playbook will build on speed, scale and flexibility, and we will adjust along the way. We think that we do this well, and you would probably have to agree that each time that we have done this, we have come out in very strong financial shape, and got our model the way that you would expect. We won’t do anything dumb in the short run, that will affect our long term growth, and long term profitability.

[Operator:]

Our next question comes from Jeff Evenson with Sanford Bernstein.

[Jeff Evenson:]

I am wondering hot the weaker oil prices might affect your growth rate in the Middle East and other emerging markets.

[John Chambers:]

Jeff, It is a fair question, and I am going to shot from the hip on this one. Countries in the Middle East, such as Saudi Arabia make money on $2.50 oil prices. In countries which have a fair amount of oil, and a reasonable good base in terms of their expenditures, I do not think you are going to see major changes. There will be nations such as Russia, that model their expenditures, in terms of government and others, at a higher run rate than they possess. They will have to make some decisions on programs etcetera, but this last quarter, I believe, Russia grew by over 20% year over year in this last quarter. Our challenge in Russia is actually the reverse. Our problem in Russia is availability of credit and currency. They have 1000 banks, but only a few have credit available at the present time. So this is were we are examining our channels and seeing what we can do to help them in a way that also maintains our fiscal carefulness. That is a nice way of saying that while there will be some impact in some of the countries, overall, I think the benefits of the other countries will far outweigh the disadvantages in terms of the economy and the effects on discretionary spending. Jeff, It will vary tremendously by country, and if you would like ask sometime one on one, I would be happy to go through everything from Azerbaijan to Saudi Arabia to Dubai, to Russia on what we think will occur, but that would probably bore people in the line at the present time.

[Jeff Evenson:]

Certainly oil prices will have impact on the oil producing countries, but they are much stronger in this particular downturn, in terms of reserves, etcetera, and I am talking about financials, and not just oil. They are more prepared to deal with the situation, plus they didn’t bring about this situation in any way. They are reacting to a global situation in a strong position. I think the same thing is true, even in Latin America which often times has had ups and downs. They have strong reserves. That is not to say they can’t have issues when currencies shift, as rapidly as they have been shifting. I think their position is a little bit different.

[Operator:]

The next questions comes from Tal Liani with Merrill Lynch

[Tal Liani:]

I have a question on the trends of the various activities, mainly switching versus routing. What happened this quarter is counter intuitive. Switching grew by 8%, and routing went down. You had stated in your comment that enterprise had seen declining orders, versus surge providers had seen relatively flat orders, or rather better orders than enterprise. That means you should see the opposite trend in switching versus routing. I am wondering if you can shed some light on that. Also, in relation to the guidance, when you look at next quarter, do you expect switching trends to reverse and routing trends to reverse?

[John Chambers:]

Tal, that was the exact question that I asked when I received the data the very first time out watching the trends. Historically routing and surge providers correlate and switching and enterprise correlate. Our enterprise marketplace I was the most challenged, however our commercial marketplace and public sector were relatively flat. We want to look at how you balance within those categories. In terms of the service router side of the house, routing will swing up or down based upon both loads in the networks and where they are in terms of the build out cycles that were varied geography wise in the world, and as we showed in the various theaters, it did vary geography wise. You are seeing service routers as a percentage of CapEx, as a percentage of sales tighten up a little bit on that, and the reason is that service providers actually grew pretty well with the area of video. Our video group grew over 20% year over year, the scientific Atlantic group grew very well, and we also did a pretty good job with set top boxes which were up both bookings and revenue wise in the 100% range, Ned, can you add anything to that?

[Ned Hooper:]

No I think that's exactly right John, and the other thing is the new product launches with the nexus 5000 and 7000 has been extremely well received in the enterprise market even in a tough environment. The focus has been on virtualization and product innovation, increasing the strategic relevance in the conversation.

[John Chambers:]

Thank you

[Operator:]

Thanks Tal. Our next question comes from Scott Coleman of Morgan Stanley.

[Scott Coleman:]

A question about cash. At the end of the last fiscal year, your US cash balance had dipped below $2 billion, can you talk about what level of cash you need in the US and how these levels might impact buybacks particularly since you are guiding for lower cashflow on a monthly basis?

[Frank Calderoni:]

So we'll disclose this further when we send out the Q, but, for Q1 we had cash in the US as $2.5 billion and part of that $27 billion that we talked about. When we look at our cash position, on a global basis, which we look at from a net realizable cash standpoint, that's taking the $27 billion and then netting it for any of the debt that we have, plus the tax effect of the non-US portion. If you look at that from a model standpoint, we try to keep it at a $10-15 billion range. As of the end of Q1 we are around $11 billion, so we are within that range. Within the US we try to also look at a balance, and if you look at how that's been trending at the $2-5 billion dollar range, at $2.5 billion at the end of Q1 we are still within that range. As far as the buyback, I mentioned earlier that we did about $1 billion in the first quarter and we have over $7 billion left that's authorized, and we do expect to continue that buyback and we feel comfortable with the amount of cash that we have and that we generate in the US, and we will be able to continue to do that over a longer period of time.

[Scott Coleman:]

Thanks

[Operator:]

Next question please comes from Ehud Goldblum of JP Morgan

[Ehud Goldblum:]

Thank you. I'd like a clarification here on this. Frank on the tax rate, you did 22%, what brought us down there so that it's lower? Then on the finance receivables, I appreciate the commentary, its been really helpful, There are two kinds of finance receivables, one that you backstop from third party sources and some that you originate your selves. Was there any shift between those two pieces? Finally, the billion dollars of cost savings, that you plan on having by the end of the year, where is that coming from? Is that headcount reduction? Is that facility reduction? Can you give us a sense of the kinds of things that you are going to cut back on, and the headcount if you can quantify that and give us a sense of how you get to the billion dollars.

[John Chambers:]

Frank why don't you handle the first two questions on that in terms of the financial side of the house and I'll do the billion dollars in savings. Maybe if you need to look something up frank, I'll go ahead and answer that question first.

[Frank Calderoni:]

As far as the 22% tax rates, and that's a reflection of what we believe will be on an annual basis for fiscal '09. The biggest change that we had coming from the 24% tax rate that we had last year is the renewal of the R&D tax credit in the US. We had assumed going into the year that that had been scheduled to expire so we were not going to have it. But as you know, tat was approved in the October bill that was passed by Congress. So, the first benefit is that we were able to get that in. The second benefit is our business that is outside of the US that gives us a little bit more of a benefit oon the tax rate, so between those two, we feel comfortable with the full year rate now at 22%.

[Ehud Goldbloom:]

Frank in 06-07 your tax rate was 25-26% even with the R&D tax credit, so I had assumed that it would not get much below 24 when you got that.

[Frank Calderoni:]

It’s the full effect of what we had assumed coming in to this year. We also have some retroactive fee for that credit since it had expired and now it has been renewed. The second point that I had mentioned has to do with the percentage of our business that has been outside the US which has had a lower effective tax rate. So again, the combination of the two make us comfortable with that 22% rate.

[Operator:]

So for time purposes Ehud, can you choose from between Cisco capital and the billion dollars?

[Ehud Goldbloom:]

I'll take the billion dollars and follow up on that.

[John Chambers:]

Look what we've done, in a very short time period, in a week and a half, we went where we wanted to go in terms of cutting expenses. The hiring pause is one area, our attrition runs let's say that on an average year the combination of voluntary and involuntary runs anywhere from 6-8% to give you an idea on that. Some of those will be replaced, but very few. We'll realign the resources within that. We are going to move into the new market adjacencies and we are going to be moving around resources, and that's where the second $500 million will come from. If you watch, we can go down through almost every category, we can go down through travel and meetings and events and you'll see us cut our travel at a faster pace then we had. There will be pressure on telepresence, we'll cut down the number of people traveling to each meeting. We canceled as you would expect, all off-site meetings unless they were with customers. We are looking at events, how we skinny back on those. These are just normal reactions. In fact, its actually healthy to do this every couple of years, to go back through and cut out some of the not so fat but probably not muscle either as you've developed these areas. There are a lot of other related areas in terms of cost and relocation programs and recruiting that will not be as much. We will look at outside services, which is about how much Frank?

[Frank Calderoni:]

It's in excess of $2 billion on an annual basis

[John Chambers:]

So we are looking at outside services carefully in light of the core versus context. If you take a look at where we stand in terms of outside services, look at where we're investing in terms of facilities from a capital perspective, I went through with Frank and Randy Pond, the two people who are leading this program for us, and we identified over a dozen major areas that we made progress in. Headcounts just being one of them. We'll evolve that, Ehud, as you'd expect, but this is something that we know how to do pretty well, and we're pretty disciplined on doing it well.

[Frank Calderoni:]

John one thing I'd add on that, 30% of our spend is [inaudible] from an expense standpoint, so that's the piece that you're talking about that give us the flexibility to manage the billion dollars.

[John Chambers:]

That looks like a pretty reasonable number off the rate for Q4 this year. Next question please.

[Operator:]

Actually we have time for one more question. From Paul Silverstein from Credit Suisse

[John Chambers:]

Paul How are you doing?

[Paul Silverstein:]

I'm well John. I appreciate getting in under the wire. I apologize, I know this question has been asked multiple times throughout the call, John, to the extent that you have visibility, and I realize that's a very fuzzy thing right now, how much of what you are seeing in January off of the month of October, how much is a function of the credit crisis, and how much is fundamental economic downturn? As part of that if I may since I'm the last question, you are talking about January, which I trust is really a reflection of calendar 2009 budgets which is being set as we speak in both enterprise IQ departments as well as carriers, I recognize that you are not giving guidance for calendar 09 on this call, but when you think about budgets being set for next year in light of what has just transpired, do you have any thoughts in terms of what to expect and in terms of what you are looking at?

[John Chambers:]

Its very difficult to separate what might be a problem with credit availability and how much that contributes to both capital purchasing but also to job creation as you look around at the world, and they go hand in hand because many of our channels ask for help in some of these geographies, their issue is as much credit as for headcount as it is on the products themselves. So I have to think about it a little bit Paul If I can break the two apart. I think that credit absolutely contributed to this. Then it becomes a catch-22, did credit contribute to not purchasing the products or did credit slow down the market to where it actually begins to slow down the economy in given geographies, its probably a combination of both those factors going on. In terms of the CEO's and their attitudes overall, they are pretty conservative in terms of the approach. I was at a business ouncil meeting a couple weeks ago where you have some of the top CEOs in the world and some of them are pretty conservative in their business approach. But its different for two reasons both for us and for the market then it was looking back seven or eight years ago most of the CEOs are understanding the leverage they can get in terms of flexibility in the market, productivity, market adjancencies with the technologies, and the CEOs especially of the service providers on a global basis are looking at moving into new markets and they're getting competition in a way that our role with service providers will expand. That's a nice way of saying that if we do this right, we'll probably get a larger share of their budgets over time, and that I think the budgets will probably be more flexible including Cisco's not just for the next quarter, but for the next year, than normal. SO we probably won't have a hard and cold budget for the next calendar year on IT. We'll use IT to enable our capabilities and probably provide some flexibility into that. I know that didn't answer your question quite as directly, if you want to get one last question in under the line I will be happy to do so.

[Paul Silverstein from Credit Suisse:]

So John if I can push you relative to in terms of the discretionary nature of com equipment data networking spin, I hear you saying that you're arguing that its less discretionary today then it was earlier in the decade, albeit that it appears anecdotally that routers and switches and even unified communications gear is something that enterprises find a way to push out and lengthen in periods like this in terms of upgrade cycles.

[John Chambers:]

Yes, but in terms of Unified communications, we do not see that. Actually it was very solid in this quarter, with 20% pipe growth. If there is one area that CEOs literally can do an advertisement for us its in telepresense, and it would shock you how many dozen CEOs actually do that regularly in terms of changes in business models. We're going to use this time to really instill the products that will allow us to dramatically cut our travel expenses as well as the business models that go with it in terms of routers and switches, can they run the networks hotter for a period of time? And the answer is yes. In terms of the environment how long that cycle looks will vary by customer, and will vary by what types of loads and the applications that go with it. We do however, and this is perhaps why we saw all the impact quicker, with 84% of our business being non-reoccurring, in other words, we don't do large outsourcing bids, we don't do large data center buildouts, which, including large software deals, once you commit you have to finish them up, we don't have that buffer on our numbers like some of our competitors do, our roccurring is only about 16% of our business each quarter in terms of the direction. But I would say for most of our customers, if you would ask the large CEOs of enterprise, or the CEOs of service providers, Cisco role is dramatically stronger in those environments than we were just two years ago, and lightyears stronger than we were 7-10 years ago in the last major economic slowdown. So Paul, we'll see how it plays out and when you go into slowdown fast and with the governments around the world putting a lot of resources into it, none of us know for sure how quick its going to come out, we're just going to maintain flexibility to adjust, and I think that's the way most of us will approach our IT budgets as well.

[Blair Christie:]

Ok so Cisco's next quarterly conference call which will reflect our fiscal second quarter 2009 results will be on Wednesday February 4, 2009 at 1