Cisco Systems’ (CSCO) CEO John Chambers on Q4 2014 Results – Earnings Call Transcript

All comparisons throughout this call will be on a year-over-year basis unless stated otherwise. As in the past we will discuss product results in terms of revenue and geographic and customer segment results in terms of product orders unless specifically stated otherwise.

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

John Chambers – Chairman and CEO

Mel, thank you very much. I’m pleased with our solid performance in Q4 with non-GAAP earnings per share of $0.55 on revenues of 12.4 billion, exceeding the guidance we gave you and representing a record quarter for non-GAAP earnings per share and our second highest quarter in our history in terms of revenue. We generated over 3.6 billion in operating cash flow and returned approximately 2.5 billion to our shareholders through share buyback and dividends.

FY 2014 was a year with many big wins and several challenges. Our fiscal year began with the number of external headwinds including the federal government shutdown and the possibility of a U.S. default combined with significant slowdown in emerging markets. Even with this backdrop FY14 ended with revenues of 47.1 billion representing the second strongest year in our history and record non-GAAP earnings per share of — I wish 200, $2.06 per share.

We maintained our non-GAAP gross margins, generated strong non-GAAP operating margins and exceeded our capital return target, returning 120% of our free cash flow to shareholders. Our innovation engine dramatically accelerated this year as we brought new architectures to the market with a next generation of networking, security and collaboration. At the same time, the journey we began three years ago to transform Cisco continued at a rapid pace.

Let me take a step back for a moment. In 2011, we saw how rapidly the market was changing and understood that we require transformational change at our company. We saw these market changes earlier than our peers and understood the market dynamics were not unique to Cisco. We required a strategic approach, and not tactical responses to the coming transactions. That is the core of what you have seen from Cisco over the past several years. Even in 2011, we saw a much bigger picture.

We rolled out our transformational plan with two principal objectives. First, drive innovation, speed, agility and efficiencies in our business and second, to transform the company to move from selling boxes to selling first architectures, then solutions and now outcomes. Operationally, we’ve done a very good job against those objectives which has afforded us flexibility today and how we go after market opportunities.

Our results are evident, we created significant operating leverage in the past three years revenue has grown nearly $4 billion while our absolute non-GAAP OpEx expenses virtually unchanged. That is very good execution especially when compared with many of our peers. During the same time period, our U.S. commercial and U.S. enterprise business grew orders over 37% and 28% respectively over these three years. They grew double-digit this last year and closed with a very-very strong in Q4 with both segments growing orders over 15%.

These are the segments that have seen the early stages of our transformation, being this segment’s our most successful selling integrated architecture solutions and outcomes. Those of you who follow us closely and talk with our channels and our customers hear first hand that our strategy is not just gaining traction but most importantly getting results. The changes we’ve made over the three years have enabled us to bring innovative products and solutions to market while at the same time growing non-GAAP earnings per share to record levels and returning 25.2 billion to shareholders including 16.7 billion in share repurchase at the average price of $20.58.

Our innovation this period has secured us the leadership position in cloud and hybrid cloud, made us the recognized leader with our customers and SDN and has driven new opportunities with customers embracing the Internet of everything, but we’re far from finished.

As we head into fiscal year ’15 and beyond, we will continue our industry of innovation, the results of the past three years represents significant poor progress and you should expect that we will continue to take actions to transform Cisco in every possible aspect from how we’re organized, to how we develop products to help customers buy from us. Looking specifically at FY15, we executed well in Q4 and expect our revenues for Q1, revenues for Q1 of FY15 to range from flat to up 1%.

While we’re pleased with our improved performance, I would not extrapolate our improved performance into a more aggressive assumption but what we’re likely to do for the next several quarters. Our focus is on executing through our transitions and to manage that appropriately set this up for the long-term. We are assuming that as the weakness continues for the next several quarters and then not at expected any material rebound in emerging market conditions.

I think the best way to characterize this next year is to fully expect that we will exit Q4 in a stronger position that we’re in today. As we see changes in that view, we would tell you how we see it as we always do consistent with our disciplined approach to growing resources in important area while managing cost. When Frank details guidance later in this call, we will announce our plans to do a limited restructuring across several areas of our business.

These actions are focused on investing in growth, innovation, and talent while managing cost and driving efficiencies. We expect to reinvent — reinvest substantially all the cost savings from our restructuring actions in our key growth areas such as datacenter, software, security, cloud and others. While there are tremendous opportunities for our business and we are moving the resources to capitalize on them, there is also a significant risk as we discussed. This is the technology industry and change is constant and accelerating.

We have navigated this industry successful for almost three decades while nearly every competitor we faced 10 to 20 years ago is either exited or part of the market, stalled in terms of market share or has gone out of business. Our vision is clear and our strategy is working and it has largely played out as we expected, in 2011 I said customers will view the network has the most strategic asset not just in communication but in IT. And this would enable us to become the number IT Company. I am confident that we can make this aspiration a reality.

Now let me move onto business momentum and specifically in terms of our geographies and customer segments, as we reminder geographies are the primary way we win our business. In these areas, I will speak in terms of product orders year-over-year unless otherwise noted. We finished the quarter with product orders up 1%, product book-to-billed comfortably above 1 and a product backlog of $5.4 billion.

Our business in Americas grew 2%, U.S. grew 5%, with U.S. commercial and U.S. enterprise continuing the strong growth up 17% and 16% respectively. I think Robert has numbers I can remember in many years they are just a nice job by Alex and Brian. We are seeing the continuous strength in large deals as an example looking at deals in our U.S. Enterprise pipeline, the number of deals over $1 million increased by 22% and deals in the pipeline over $5 million increased by over 70%.

As we continue to engage strategically with our customers on their business opportunities, our enterprise customers are making more and bigger investment as they partner with us. U.S. public sector Pat Finn’s groups did a very good job. They grew over 6% in the quarter with state and local up 3% and U.S. federal up year-over-year 10% in terms of orders. U.S. service provider declined 9%.

Latin America declined 6% with ongoing pressures in some of the largest emerging countries and including a decline of 13% in our business in Brazil. EMEA grew 2% as we see continued relatively stabilization across Europe. In EMEA, enterprise business grew 8% and commercial grew 7%. Leading the way, the UK grew 6% and within the UK commercial was up 18% and enterprise was up 19%. Germany in this most recent quarter grew 16% and again within Germany we saw the same characteristics, commercial was up 13% and enterprise was up 17%.

In the UK and Germany, we are seeing similar success in these marketplaces as we begin to move to selling architectures, then solutions, then business outcomes. This is the transformation we’re working onto drive more broadly. Just to give you a sense of an emerging country’s impact on EMEA as an example and its growth excluding Russia which declined 30%, EMEA would have grown 4% instead of 2%.

Asia Pacific, Japan and China was down 7% with China down 23% and India up 18% while the remaining emerging countries in Asia actually declined 34%. Those are countries that did not include China and India. Overall emerging countries within the three geographies declined this quarter by 9%. We saw the impact of economic and geopolitical challenges in China, Brazil, Russia, Argentina, Turkey, and Thailand and in a number of emerging markets that many of other peers are seeing. These declines are reducing our growth by several points from what was expected and typically seen. Though the trends were looking better in Q2 and Q3 for emerging markets, the emerging countries lost momentum in Q4, the breakdown continued in double-digit declines and the next 15 emerging countries went from positive growth to mid single-digits in Q2 and Q3 to a 9% decline in Q4. Unfortunately as we look out we don’t see emerging markets growth returning for several quarters and believe it possibly could get worst.

When we see these markets coming back, we will share that with you as we always do. We’ve been on to our customer segments. As we’ve been indicating earlier we saw strength around the globe in our enterprise business up over 9% and similar strength in commercial up over 8%, public sector on a global basis was flat.

The same challenges continue in several IP and the service provider market which declined 11%. Within the service provider market the largest impact came from continue to decline SP Video with orders down 13% and the ongoing decline in emerging markets where service provider is the higher mix of the business. Our service provider customers are dealing with transitions in their own business and have been aggressively consolidating with the transaction volumes of these consolidations over the last 12 months about as much as we have seen in the past four years combined.

Let me now move on to products. I’ll discuss our product momentum in terms of year-over-year revenue but we will share order information where it adds important color. Routing declined 7% we saw a continued strength in the ASR 9000 growing in double-digits with strong penetration among the Web 2.0 customers offset by softness in MOB and optical and mobile business.

Our new product platforms the NCS 6000 and the CRS-X continue to ramp with each of our products crossing 100 million in orders for the year, with approximately half of that coming in Q4. In these markets we’re a relatively small number of customers due to majority of the volume, we added non-new customers for our NCS product line and 39 new customers for CRS-X during the last two quarters of the fiscal year.

Switching, overall switching declined 4% similar to the last quarter our campus switching business declined specifically at the high-end with a notable exception of Catalyst 3850 continuing to grow very well at over 80% growth. In the datacenter our momentum with the Nexus 9000 and application-centric infrastructure continues to be very strong. Since the end of last quarter, the number of customers has tripled to over 580 customers, last quarter it was 180.

We continue to deliver on a application-centric infrastructure roadmap and during the quarter we began shipping to application policy infrastructure controller which we call APIC this industry first innovation provides a central place to configure, automate and manage an entire network based upon the needs of applications. In less than one month of availability we have over 60 paying customers using the APIC with very positive feedback.

We continue to see the strong growth for the Nexus 9000 and our application-centric infrastructure portfolio with key wins across all major verticals including cloud providers, hosting, financial services and technology providers. We believe, we are leading this SDN transition and you would hear to saying from many of our customers. As we discussed, we’re continuing to manage the transitions with the Nexus 7000 and Nexus 9000 and we are seeing some impact on our numbers.

As we said last quarter we expect the negative impact to continue for a few more quarters. Datacenter, datacenter continued to be very strong. Growth of over 30% year-over-year, demonstrate that customers continue to embrace our architecture approach in this critical space. I’m very proud of the success we do into the datacenter market. In 2009 many questions about Cisco was entering the traditional server market. UCS was far from a traditional server and while we have displaced many of our traditional competitors, we did it with an innovative architectural approach to the market.

This quarter Cisco UCS grew 30% with more than 36,500 UCS customers and this quarter we grew our repeat business by 49%. In a market many thought we would exit, we gained share for the 18th consecutive quarter to gain the number one position in revenue share for the X86 blade servers in the U.S. with 41% market share, six points above our nearest competitor and currently we have the number two position worldwide, which I expect us to close to the number one if we execute the way I believe we can run.

Our UCS business now has a run rate of over $3 billion and we continue to lead the converged infrastructure market with FlexPod, with NetApp and with Vblock to VCE. The innovation pipeline is very strong and you should expect to see announcements in the fall that we’ll continue to accelerate our momentum with UCS and add to our competitive advantage. Wireless, wireless grew 1% with orders up 8% while we experienced softness in the service provider segment we saw continued adoption of 802.11AC portfolio in both our enterprise and cloud managed network business.

In this business Meraki had another amazing quarter with growth of 116% year-over-year and subscriptions growing approximately 80%, accelerating our software and reoccurring revenue business. Collaboration declined 4% as we transitioned our portfolio in this space. We saw declines in TelePresence and Unified Communications as we introduced additional new products including our cloud family of solutions, DX70 and DX80 which are incredibly cool desktop collaboration endpoints at dramatically lower price points. Collaboration remains a top priority for our customers wanting to drive employee productivity. We are confident our new portfolio would drive the next stage of productivity that is yet to be delivered by collaborations through this market.

We did see continuous strength in conferencing and an increased customer shift towards software based models with enterprise license and agreements ELAs while our collaborative solutions up 42%. SP Video revenues declined 10%.Video soft and solutions grew driven by deployments by satellite customers and growth in the control playing business, but this was offset by a decline in video infrastructure due to lower CPE business and consolidation among our major service providers. We have made key top leadership changes in both of these areas.

Maturity grew 29% driven by strength across our product portfolio with network security up 35% and content security up 12%. Product orders grew faster than revenue as we continue to see solid momentum with our advanced threat solutions including Advanced Malware Protection Everywhere, Sourceware, ThreatGRID.

Additionally we also saw improved growth from our core business including our high-end firewalls and ASA. A key part of our software growth strategy security ELAs grew by 250% year-over-year. We are pleased to see revenue from our Sourceware acquisition accelerate even faster than before they were acquired, which speaks to the power of our combined security architecture in the marketplace today. We have taken security from a lower single-digit growing business to a business that we expect to grow comfortably in double-digits growing forward. Chris Young that one’s yours that I know you’ll bring home for us a little bit of pressure Gary you think that is ok.

Gary Moore – President and COO

It is perfect.

John Chambers – Chairman and CEO

Services revenue grew 5%, up from 3% last quarter and it is trending very well. Strong renewals large multiyear service wins strong technical services performance and growth in new businesses such as consulting, cloud and managed services. And security services drove our growth in the quarter. We continue to deliver our strongest margins of this business well above the industry norms. We are focused on the continued integration of our services and product sales teams to accelerate our ability to drive integrated solutions and business outcomes. We are also investing with more focus on our renewal engine while these multiyear journeys we see both efforts as creating more opportunities over the long-term.

There is strong interest in our InterCloud approach which again we bet Rob Lloyd to lead for the entire company. Customers and partners view our approach to the cloud as differentiated and unique recognizing that we offer the only solution to federated, private, hybrid, and public could that enable them to move their cloud workloads across heterogeneous private and public clouds with the necessary policy, security, and management. Over the last quarter, we expanded our InterCloud ecosystem with partners who are embracing the Cisco ACI Vision and Cisco’s open approach to differentiating their cloud offers through the value of the network. We announced that NTT the Dimension Data and SunGard Availability Services will both use Cisco InterCloud architectures to deliver cloud services to customers and resellers. You will see us announce additional partnership soon.

In the quarter, we entered into a three-year go-to-market program with Microsoft to build InterCloud-ready integrated infrastructure solutions leveraging Cisco UCS, Nexus switching, and the Microsoft cloud operating system. We are growing a developer network to build applications on top of InterCloud and that work is gaining momentum. We believe we can grow debt net developer community to at least a million developers by 2020.

We feel that our focus on delivering enterprise class hybrid cloud solutions along with growing InterCloud ecosystem is resonating with customers and our partners around the world. Cloud as an example of an area where we are making significant investments to fuel our future growth. In FY14, we allocated over 2,000 employees to our InterCloud organization including several of our top leaders. These investments will drive our leadership and opportunity to results — though the results will not show up in our numbers in a meaningful way for a number of quarters.

I would now like to turn the call over to you Frank for additional financial details.

Frank Calderoni – EVP and CFO

Thank you, John.

John Chambers – Chairman and CEO

You are welcome.

Frank Calderoni – EVP and CFO

I will start with Q4 results and later discuss our full fiscal year results. In Q4, we continue to manage through the transitions in our business and markets resulting in our financing performance at or above our expectation. From a top and bottom line perspective, total revenue was $12.4 billion flat on a year-over-year basis. Non-GAAP net income was $2.8 billion and non-GAAP EPS was $0.55 per share. Our GAAP net income was $2.2 billion and GAAP earnings per share on a fully diluted basis was $0.43 a share.

Product revenue declined 2% and service revenue increased 5% with product book-to-bill comfortably above 1. We ended the year with product backlog of approximately $5.4 billion as compared to approximately $4.9 billion at the end of fiscal 2013. Overall non-GAAP operating margin was 28%. In Q4, our total non-GAAP gross margin was 61.8%. Non-GAAP product gross margin was 60.3% as compared to Q3 product gross margin was negatively impacted by pricing and product mix partially offset by productivity. Non-GAAP service gross margin was 66.8% consistent with historical levels.

Our non-GAAP operating expenses were $4.2 billion or 33.8% as a percentage of revenue compared to 33.9% in Q4 of fiscal year ’13. Operating expenses were up 5% quarter-over-quarter due to seasonality and down 1% year-over-year.

We ended the year with our headcount at 74,042, an increase of approximately 200 from Q3. For the full year, headcount decreased by approximately 1,000 from a year ago which is net of an addition of headcount from acquisitions during the year of approximately 1,300. As we outlined in our headcount actions last year, we realigned and reinvested in talent to drive key priorities such as cloud.

We continue to executive consistent with our portfolio approach to acquisitions aligned to driving long-term returns. We announced and completed three acquisitions during the quarter: Tail-f, ThreatGRID and Assemblage to bolster our innovation and long-term growth opportunity in key growth areas such as software and security. Looking at our geographic segment results, in terms of total revenue on a year-on-year basis, the performance was relatively balanced across segments with the Americas and EMEA both down 1% while APJC was up 1%. Total gross margins for the Americas was 62.3%, EMEA was 63.5% and while APJC was 57.1%.

Moving on to our full year performance, our total revenue was $47.1 billion, a decrease of 3% from the prior year as we worked through the challenges in the emerging markets and service provider as well as several product transitions. We were disciplined with our cost structure during the year as we addressed those areas. We held our non-GAAP net income flat at $10.9 billion and grew our non-GAAP earnings per share on a fully diluted basis 2% to $2.06 delivering profitability which was slightly above our expectations for the full year.

GAAP net income was $7.9 billion or $1.49 per share on a fully diluted basis. We generated strong operating cash flow of $12.3 billion, free cash flows of $11.1 billion and returned a record $13.3 billion to shareholders through both the buyback as well as the dividends. This represented a 120% of our free cash flow. We are firmly committed to continuing our capital allocation strategy returning a minimum of 50% of our free cash flow to shareholders annually.

Looking back on this past fiscal year, we effectively managed our portfolio and investments which enabled us to invest in our key long-term growth areas such as cloud, data center, software and security. From a balance sheet and cash flow perspective, total cash, cash equivalents and investments were $52.1 billion including $4.7 billion available in the U.S. at the end of the quarter. We generated operating cash flows of $3.6 billion during the quarter and in Q4 returned $2.5 billion to shareholders that included $1.5 billion through share repurchases and approximately $974 million through our quarterly dividends.

Our balance sheet continued to be an area of strength with DSO at 38 days and non-GAAP inventory turns at 12.1. Deferred revenue was $14.1 billion up 5% year-over-year, product deferred revenue grew 12% driven by subscription based offering and deal related deferrals while services deferred revenue grew 2%. We continue to make progress in driving a greater software mix and higher recurring revenues.

Let me now provide a few comments on our outlook for the first quarter. Let me remind you again that our comments include forward-looking statements. You should review our recent SEC filings that identify important risk factors and understand that actual results could materially differ from those contained in the forward-looking statements and actual results could be above our below our guidance. The guidance we are providing is on a non-GAAP basis with also reconciliation to GAAP.

As John mentioned earlier, we expect total revenue to be in the range of flat to up 1% on a year-over-year basis. For the first quarter, we anticipate non-GAAP gross margin to be in the range of 61% to 62%. As we have said in the past, forecasting non-GAAP gross margin has always been challenging due to various factors such as volume, product mix, cost savings as well as pricing. As a result, non-GAAP gross margin may vary quarter-to-quarter by a 1 point in either direction of our guidance range.

Our non-GAAP operating margin in Q1 is expected to be in the range of 27.5% to 28.5%. Our non-GAAP tax provision rate is expected to be approximately 22% in the first quarter. This is up 1 point from the prior fiscal year, largely driven by the exploration of the R&D tax credit. This represents approximately $0.01 of impact on EPS. If the R&D tax credit is reinstated, we would reflect that benefit in our effective tax rate.

Our Q1 FY15 non-GAAP earnings per share are expected to range from $0.51 to $0.53 per share. As John also discussed earlier, we will be taking a restructuring action in FY15 that will be focused on continuing to invest in growth, innovation and talent while managing cost and driving efficiencies. These actions will impact up to 6000 employees representing approximately 8% of our global workforce. We expect to take these actions starting in Q1 FY15 and currently estimate that we will recognize pre-tax charges to our GAAP financial results of up to $700 million. We expect that approximately 250 million to 350 million of these charges will be recognized during the first quarter of FY15 with the remaining amount recognized during the rest of the fiscal year.

We expect to reinvest substantially all of the cost savings from the restructuring actions in our key growth areas. We anticipate our GAAP earnings to be lower than our non-GAAP EPS by $0.14 to $0.18 per share in Q1 FY15. Please see the slides that accompany this webcast for further details. Other than those quantified items noted previously there were no other specific differences between our GAAP and non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant.

We are executing well in a rapidly transforming market. As we have mentioned, we’re not expecting a significant improvement in the emerging markets or the service provider segment in the near future. With all of these types of uncertainties in mind we will continue to provide our guidance with all the appropriate caveats one quarter at a time. We encourage our shareholders to have the same considerations. As a reminder Cisco will not comment on its financial guidance during the quarter unless it is done through an exclusive public disclosure.

John, I’ll now turn it back over to you for some summary comments.

John Chambers – Chairman and CEO

Thank you, Frank. The dynamics in our business and market continue to play out as we said they would. Our management team is executing well, driving innovation and discipline across the entire company to disrupt our industry and our sales when necessary. I am pleased with our leadership position and the strong receptivity we are getting from customers as we have grown company that delivers architectures, solutions and finally business outcomes. We’ve transformed Cisco over the past three years and remain as focused as ever on the future.

Moving to become the number one IT Company our customers turn to, to enable their innovation, drive their growth, cut their cost and mitigate the risk. What does that mean for our investors? First, we remain focused on shareholder value creation by maintaining the flexibility to make the right long-term strategic decisions with the business driving efficiencies in our cost structure and returning capital through dividends and share repurchase to our shareholders. Second, investors need to remember that change is nothing new for Cisco we embrace it we see opportunities for disruption all around us and in nearly every case Cisco is positioned extremely well.

In this environment companies who use technology for speed and innovation will differentiate themselves. You see it in places never imagined and it happens quickly, things like a new business model, delivering through a network application that disrupts the taxi industry. Every company is becoming a technology company and the common element is the network at the center driven by applications, allowing for rapid introduction of new business models disrupting old models in record time.

We’ve talked about this opportunity for a while and now you are seeing it play out. Every company is increasingly dependent on the network not just for communications but for how they run, analyze and grow their business and disrupt their competitors. In this paradigm, the reliability, scale, speed and application centricity of the network is even more important and this is where our unique strength lies. As the leader trust of our business in governments with 17,000 sales people, approximately 70,000 partners and install base of approximately $200 billion. Cisco is very well positioned to capture this opportunity and I’m more confident than ever that we are doing just that.

As always, we have to deliver the innovation to new business models and value to our customers to win in the market and that requires continually reshaping how we operate. If we do not disrupt ourselves, if we don’t have the courage to change, if we don’t need the change, we’ll get left behind. Disruption is happening amongst our peers and throughout our customer base. Management teams are being tested every day. The question is whether they will make the right investments and take the bold actions in order to move forward.

At Cisco, we are making these tough choices, transforming our company at a rapid pace, whether it is introducing revolutionary new platforms in our core and at a speed where we knowingly disrupt ourselves we’re making long-term bets like we did with UCS and Internet of everything and are now doing with InterCloud and ACI application-centric infrastructure. We are investing in our leadership for years to come. We understand that the results of our strategy and many of the decisions we make may not be evident in a single quarter and in fact at times we’ll create volatility through our results from time-to-time. We also know that some of the investments we are making today would take several years to pay off. Taking a multi-year view, I’m confident that when we look back in time, this transformative period will be a distinguished part of Cisco’s history, where we made both choices, moved aggressively and ensured our long-term strategic value for our customers, shareholders, partners and employees.

Mel, let me now turn it over to you for question and answer.

Melissa Selcher – VP of Corporate Communication and IR

Hey, thanks Don. We will now open the floor to Q&A. We still request that sell-side analysts please ask only one question. Operator, please open the floor to questions.

Question–and–Answer Session

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