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Thomson Reuters StreetEvents Event Transcript
E D I T E D V E R S I O N

Q2 2016 Cisco Systems Inc Earnings Call
FEBRUARY 10, 2016 / 9:30PM GMT

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Corporate Participants
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* Kelly Kramer
Cisco Systems, Inc. - CFO
* Chuck Robbins
Cisco Systems, Inc. - CEO
* Marilyn Mora
Cisco Systems, Inc. - Director of Global IR

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Conference Call Participiants
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* Jim Suva
Citigroup - Analyst
* Brent Bracelin
Pacific Crest Securities - Analyst
* James Faucette
Morgan Stanley - Analyst
* Pierre Ferragu
Sanford C. Bernstein & Co. - Analyst
* Tim Long
BMO Capital Markets - Analyst
* Jeff Kvaal
Nomura Securities Intl - Analyst
* Ittai Kidron
Oppenheimer & Co. - Analyst
* Vijay Bhagavath
Deutsche Bank - Analyst
* Mark Moskowitz
Barclays Capital - Analyst
* Simon Leopold
Raymond James & Associates, Inc. - Analyst
* Jess Lubert
Wells Fargo Securities, LLC - Analyst
* Simona Jankowski
Goldman Sachs - Analyst

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Presentation
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Operator [1]
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Welcome to Cisco Systems second-quarter and FY16 financial results conference call. At the request of Cisco Systems, today's call is being recorded. If you have any objections, you may disconnect. Now, I would like to introduce Marilyn Mora, Head of Investor Relations. Ma'am, you may begin.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [2]
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Thanks, Kim. Welcome, everyone, to Cisco's second-quarter FY16 quarterly conference call. This is Marilyn Mora, Head of Investor Relations. I am joined by Chuck Robbins, our CEO; and Kelly Kramer, our CFO.
By now, you should have seen our earnings press release. A corresponding webcast with slides including supplemental information will be available on our website in the investor relations section following the call.
Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements, and other financial information can also be found on the financial information section of our investor relations website. Throughout this call, we will be referencing both GAAP and non-GAAP financial results and will discuss product results in terms of revenue and geographic and customer results in terms of product orders, unless stated otherwise. All comparisons throughout this call will be on a year-over-year basis unless stated otherwise.
The matters we will be discussing today include forward-looking statements including the guidance we will be providing for the third quarter. They are subject to the risks and uncertainties that we will discuss in detail in our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements. With respect to guidance, please also see the slides and press release that accompany this call for further details. As a reminder, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.
Please note that during Q2 on November 20, we completed the sale of the customer premises equipment portion of our SP video-connected devices business to Technicolor. As such, all of the revenue, non-GAAP, and product orders information we will be discussing is normalized to exclude the SP video CPE business from both the Q2, FY16, and historical results. We have provided Q2 FY16 and historical financial information for the SP video CPE business in the slides that accompany this call and on our website to help to understand these impacts. As a reminder, the guidance we provided during our Q1 earnings call and today's call have been normalized in the same way.
With that, I would like to go ahead and turn it over to Chuck.

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Chuck Robbins, Cisco Systems, Inc. - CEO [3]
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Thanks, Marilyn. We delivered a strong Q2 in a challenging macro environment. Recently, we've experienced one of the most volatile times in the global markets. This volatility led to a slowdown in spending impacting our business especially during the last few weeks of January as we closed our quarter. Despite this slowdown, we executed very well with total revenue growth of 2% and non-GAAP EPS growth of 8%, strong margins and operating cash flow up 36%.
Our ability to deliver strong profitability in a challenging environment reflects the operating leverage we have created in our business over the last several years. Our portfolio is more strategic than ever to Companies and countries that are digitizing everything. As billions of things become connected creating massive amounts of data, Cisco is playing an increasingly critical role enabling our customers to drive their priorities with industry-leading security.
Cisco is unique in our ability to connect everything for our customers from the sensor to the data center with security and analytics. As a result, our conversations are no longer just in IT. They have become prevalent in the C-suite and the boardroom.
When I took this role two quarters ago, I discussed my focus on accelerating our innovation engine and portfolio transformation to execute on the opportunity ahead of us. I believe we are executing well, and I would like to highlight our momentum in four key areas.
First, we are defining the next generation of networking, beginning with the data center with our ACI platform providing the automation and programmability for our customers most critical business applications with the scale, speed, and security they require. In just two years, we have built ACI to a $2 billion run rate business that grew once again last quarter over 100%. We are aggressively focused on winning in the 10-gig, 40-gig and 100-gig transition and firmly establishing our leadership in the next-generation data center.
Second, security remains the most critical priority for our customers, and as everything connects, it makes the network even more relevant. As the largest security provider, we have been focused on driving the growth of this business while at the same time migrating our model from a primarily hardware business to a software and services business. In Q2, not only did our security business grow 11%, but our security-deferred revenue grew 26%.
Third, we saw double-digit growth in our cloud-based SaaS businesses, specifically WebEx, Meraki cloud networking, and security. You are seeing us move more of our portfolio to be delivered in both on-premise and cloud-based models, and we are aggressively driving this transition.
And, fourth, we are using M&A to augment our internal innovation in key growth areas. In the last 12 months, we have added critical capabilities and talent in the growth areas of cloud, security, SaaS, IoT, and analytics.
Our recently-announced acquisition of Jasper, combined with our other capabilities, is a strong example of how we will play a unique and strategic role in unlocking the value of IoT. We will enable our customers to monetize the data from the billions of sensors and connections with the security, speed, and reliability they have come to expect from Cisco. Our momentum reflects the uniqueness of our business model and our ability to weather volatility while accelerating innovation in key markets to drive our long-term growth.
Now, I will turn it over to Kelly to walk through more detail on our financials.

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Kelly Kramer, Cisco Systems, Inc. - CFO [4]
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Thanks, Chuck. I am pleased with our continued execution on our financial strategy of delivering profitable growth, managing our portfolio and strategic investments, and delivering shareholder value.
Starting with delivering profitable growth, total revenue was $11.8 billion, up 2% with product revenue growth of 2% led by growth in security, routing, and collaboration. In switching, as Chuck mentioned, we are driving the next-generation data center architectures and are very pleased with our ACI momentum. The 4% decline in switching was largely driven by macro weakness in our campus business something that we have observed in the past during volatile times as customers pause spending decisions.
We saw our routing business grow 5%, driven by double-digit growth in our CRS platforms with particular strength in mobility and web-scale service providers. Collaboration grew 3%, driven by a 17% growth in WebEx, partially offset by some slowdown in our unified communications business. Deferred revenues showed continued strength growing 15%.
Our data center decline of 3% was also driven by a slowdown in spend. In addition, we have tough comparisons from Q2 2015 when revenue grew 40%. UCS continues to be a strong franchise for us and is a foundational piece of our next-generation data center stack.
Wireless was flat as result of declines in our access [plane] controller business offset by strong growth in our cloud-based Meraki platform. SP video grew 37% larger driven by strength in China. Security grew 11% with deferred revenue growth of 26%.
We had strong growth in our advanced threat security and web security solutions which grew over 180% and 40%, respectively. We added over 2,000 customers on our amp advanced malware solution bringing the total customer base to over 10,000. Services revenue grew 3%, and we continued to show very good progress against our goal of driving more recurring revenue.
Deferred revenue had a solid growth of 8% in total with product up 11% and service up 7%. The portion of our product-deferred revenue which is related to our recurring software and subscription businesses grew 34%. In total, product orders grew 2%. Our book to bill was approximately 1.
Looking at our geographies, which is the primary way we run our business, Americas was flat. EMEA declined 1%, and APJC grew 17%. Total emerging markets grew 7% with the BRICs plus Mexico showing strength at up 70%. With China up 64%, and India up 23%. Total emerging minus the BRICM countries was down 3%.
In terms of customer segments, enterprise declined 2%, and commercial grew 4% -- both of which were impacted by macro uncertainty. Public sector was flat, and service provider grew 5%. We drove strong profitability with discipline and rigor on gross margins and operating expense.
Non-GAAP gross margin was 64.2% with non-GAAP product gross margin of 63.3%, and non-GAAP service gross margin of 66.7%. Non-GAAP operating expenses were 33% of revenue, and non-GAAP operating margin expanded to 31.2%. We will remain disciplined with our operating expenses and portfolio management.
From a profitability perspective, we delivered non-GAAP EPS of $0.57, up 8% with $0.015 attributable to a lower non-GAAP tax rate resulting from the permanent reinstatement of the federal R&D tax credit. From a GAAP perspective, EPS was $0.62.
In addition to the typical reconciling items between GAAP and non-GAAP EPS, there were three material items to call out which we excluded from our non-GAAP results; The gain on the sale of the SP video CPE business, the impact of the settlement of federal tax audit, and prior-year fiscal-year impact of the reinstatement of the federal R&D tax credit. The total impact of these and other immaterial items was a benefit to GAAP EPS of $0.13. Q2 non-GAAP net income was $2.9 billion, up 8%. GAAP net income was $3.1 billion.
Moving on to shareholder value. In Q2, we delivered operating cash flow of $3.9 billion, up 36%. Total cash, cash equivalents, and investments at the end of Q2 were $60.4 billion with $3.9 billion available in the US. In the first half of FY16, we have returned $4.6 billion, or 75% of our free cash flow to our shareholders, comprised of $2.5 billion of share repurchases and $2.1 billion of dividends.
Today, we announced a 24%, or $0.05 increase to the quarterly dividend to $0.26 per share. This represents a yield of approximately 4.6% based on today's closing price. We also announced a $15 billion increase to the authorization of the share repurchase program raising the remaining share repurchase authorization to approximately $16.9 billion. This significant dividend increase and additional share repurchase authorization reinforces our commitment to returning capital to our shareholders and our confidence in the strength and stability of our ongoing cash flows.
Overall, Q2 was a solid quarter in a volatile macro environment. We saw good top line growth, strong profitability, and operating leverage. We continue to shift our business model to more software and subscription recurring revenue.
Let me now reiterate the guidance we provided in the press release for the third quarter of FY16. This guidance includes the type of forward-looking information that Marilyn referred to earlier.
Q3 does include an extra week which occurs every five to six years for us. We have factored this extra week into our guidance for both revenue and expenses. Although it is difficult to forecast the impact of the extra week, we have assumed roughly a 2% year-over-year impact on total revenue growth along with approximately $40 million of incremental cost of sales and $110 million of operating expenses.
The guidance for Q3 is as follows. We expect revenue growth to be in the range of 1% to 4% year-over-year, normalized to exclude the SP video CPE business from Q3 FY15. We anticipate the non-GAAP gross margin rate to be in the range of 62.5% to 63.5%. The non-GAAP operating margin rate is expected to be in the range of 28.5% to 29.5%, and the non-GAAP tax provision rate is expected to be [22%].
Non-GAAP earnings per share is expected to range from $0.54 to $0.56. We anticipate our GAAP EPS to be lower than the non-GAAP EPS by $0.08 to $0.12. Further details to this range are included in the slides and press release that accompany this call.
I'll now turn it back over to Chuck to summarize the call.

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Chuck Robbins, Cisco Systems, Inc. - CEO [5]
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Thanks, Kelly. Let me quickly summarize. While macro growth has clearly slowed, the speed with which technology is changing every industry and every country has not slowed, and we are moving full speed ahead. This speed, coupled with our innovation, strategic partnerships, and our M&A capabilities will allow us to meet the expectations of our customers and lead into the future. On this front, I feel very confident, and that conviction about our future business is what led us to increase our dividend by 24%.
My confidence in our future is confirmed every day by CEOs, Boards, and country leaders as we preview our strategy and road maps. They see the next-generation data center and cloud architectures we're building on UCS and ACI. They see our extensive security portfolio that protects them before, during, and after an attack.
The see the IoT and analytics platforms that will enable them to act on and monetize data and connections, and they want us to be their strategic partner as they drive their digital agendas. They trust us. They value our innovation, and they believe our portfolio is critical to their ability to execute on their vision.
Our customers and countries around the world know this move to digital is real, and it is happening now. As we help them through this transition, you will see us operate on two fronts. In the near term, you will continue to see us to be a well-run Company that executes even in challenging markets. Longer term, we will continue to make the right investments that will accelerate our growth as our customers embrace and adopt this next wave of technology.
Marilyn, I will turn it back to for questions.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [6]
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Great. Thanks, Chuck. Kim, let's go ahead and open the line for questions. While Kim is doing that, I would like to remind the audience that all analysts -- we ask you to please ask one question.

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Questions and Answers
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Operator [1]
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Pierre Ferragu, Sanford Bernstein.

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Pierre Ferragu, Sanford C. Bernstein & Co. - Analyst [2]
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Chuck, what I would like to understand is your perspective on the macro environment? So, first of all -- you, of course see Bloomberg TV and read the Financial Times as we all do. But, what can you see through Cisco if you get feedback from your channel? From your sales force? Your country managers? What do they really tell you about and what color can you bring us that we do not necessarily see from where we are? And also, on the same front on the macro environments, your guide for next quarter -- what kind of macro scenario have you baked in? Would you qualify that as prudent -- very prudent? And, if you can take us through the thought process of how you came up with that guidance that would be very helpful?

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Chuck Robbins, Cisco Systems, Inc. - CEO [3]
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Pierre, thanks for the questions. Good to hear from you. On the macro front, I think the thing that I can tell you is that as we began last quarter, we certainly have a set of expectations as we have run our business for a long time and really know what to expect, and our expectations were obviously based on the discussions we had with all of you at the end of our first quarter. I would tell you that through the first 10 weeks of the quarter that was very much in line with what we expected. We were executing very much in line with how we would have expected the quarter to go.
Our week 10 -- just so you have the data point was the end of the calendar year. So, while a number of companies have reported earlier this year, not many have actually had their quarter end in January. So, we ended at the end of the third week of January which we all know those first three weeks were reflective of the uncertainty that occurred in a lot of the financial markets. What I will tell you is that after week 10 through those three weeks, we saw customers as they were trying to digest what was going on. They paused a bit, and you see customers say -- I want to just wait and see what is going on. Let me take a look at this. We want to understand this a little better. I think to Kelly's point when she talked about the switching business, the campus refresh opportunities that have been actually pretty consistent for us over the last few quarters, we saw customers say, hey, our infrastructure is working so we're going to hold on that for some period of time and let's see where things go.
That is probably the extent that I can add to what we all know from what we're seeing every day. What I would tell you -- and I will ask Kelly to comment on our guidance -- is I would say that we took that feeling of those first three weeks into consideration as we built our guidance. And, that is what we based it on. Is what the last three weeks of last quarter led us to relative to this level of uncertainty. Kelly, any comments?

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Kelly Kramer, Cisco Systems, Inc. - CFO [4]
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I think -- to your question, Pierre. I think Chuck summarized it well. When we do our guidance, we look at everything we know at the time which is our funnel, the momentum we see, and everything else. I would say to put it in the words you use, I would say that our guidance is prudent. I think you see that we expanded our range to 3 points of range versus our normal 2 because I think it is more volatile than normal. So, I would go with prudent based on what we see right now.

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Operator [5]
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Vijay Bhagavath, Deutsche Bank.

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Vijay Bhagavath, Deutsche Bank - Analyst [6]
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My question is around is Cisco a tale of two cities here? We're seeing enterprise products turning light versus consensus while your service provider product -- routing, video et cetera -- are beating expectations. I would like to get your view on this enterprise versus service provider dichotomy, if any?
And then, you have a bigger picture strategy around software and your cutting services fully believing that strategy and model. My question is really around do you see IT spending queuing quickly toward OpEx versus the traditional CapEx model of spending? How would Cisco [deliver] to this higher than usual OpEx IT spending moving forward?

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Chuck Robbins, Cisco Systems, Inc. - CEO [7]
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Thanks, Vijay. I would say the initial question you asked relative to the difference between the enterprise and the service provider space, I think what we saw was that our customers were spending in areas that are incredibly mission-critical for them even in these times where there is uncertainty. So, you see them continuing to spend in security. You see them continuing to spend in the next-generation data center evolution which was indicative of the 100% growth we saw in that portion of our portfolio. And, I think we saw customers where they had the option to wait, they chose to wait a bit. So, I don't view it as -- I don't see any fundamental issues relative to the enterprise portfolio or things like that. I think that it was largely a prioritization effort that we saw within our customer base on the enterprise side.
The service provider side, I think if you go back a couple of quarters, what I said was that our teams have been working hard to really get to alignment with our customers around the future of the industry, the future of their architectures. How they were going to evolve to position them for the opportunities ahead, and I think we did that. And, I would say that our teams have really executed well over the last couple of quarters as they align with our service providers on those priorities across the portfolio. We are pleased with where we are. I don't think that if you really unpack those numbers over two or three quarters that you are going to see -- you'd be able to delineate a whole lot between what went on with the exception of the enterprise customers prioritizing where they spent their money.
As it relates to the OpEx versus CapEx move, I will ask Kelly and maybe she can comment on the software part of the question. But, I didn't see any fundamental change this quarter in how our customers look at that versus what they have been doing for the last three, four, five, six quarters. It's something that we deal with as it relates to -- as an example, our collaboration portfolio, we made announcements last quarter that all of that portfolio, the entire portfolio, is now available. Or, we announced that it will be available to our customers from both an on-premise and a cloud-based perspective. And, in many cases, it will be a hybrid model. To the extent that our customers would like to procure our solutions in that way, then we will make that available to them. Kelly?

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Kelly Kramer, Cisco Systems, Inc. - CFO [8]
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I think you summarized it well. On the software shift, Vijay, we are making great progress. Whether it is internal -- we talk about how we're driving that in our software and SaaS businesses within collaboration and security. But also, in other parts of our portfolio, we are really developing new offers. There are ways to monetize our services and software along that way so we will continue to disclose more especially as we look at our business and it becomes a bigger part of that. So, I'd say it is progressing well, and we're adding to our models with acquisitions like OpenDNS and Jasper which are both SaaS models. We will continue to build that out as it becomes a bigger part of our portfolio.
On the IT to OpEx, just to add to what Chuck said, I would say one thing that we have tremendous flexibility on is leveraging our great balance sheet to help provide solutions for whatever it is. So, whether it is our Cisco capital offers or for the ability of us to build managed service as a service -- those kind of offers. We are very active working with our customers that want different ways to consume our products and services differently that we're coming up with all kinds of new solutions for different ways of consumption. And, we have that flexibility because of our strong balance sheet. I'd say we're making a lot of progress on both of those accounts.

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Operator [9]
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Simona Jankowski, Goldman Sachs.

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Simona Jankowski, Goldman Sachs - Analyst [10]
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I just wanted to clarify first, Kelly, in terms of the 2-percentage-point bump that you've embedded into the guidance for the extra week that compares to 4 to 5 points that you saw last time you had this kind of pattern back in 2010. I just wanted to understand if there's anything different this time? Or, if that is just an extra measure of conservatism? And then, just more for the substantive question, Chuck. I heard your comments on the pause on the campus-switching side of the business. I wanted to also ask what is happening on the data center side of your switching business? Is that returning to growth in the first half of this calendar year as you had expected it to? Any update there would be helpful.

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Kelly Kramer, Cisco Systems, Inc. - CFO [11]
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Simona, on the 2%. Great question. Let me give a little context there. Back -- the last we had this was in Q3 of FY10, and it was about a 4% to 5% increase. I would say, what I've baked into my 2% -- so it's roughly about $250 million to $275 million. What I've baked in the guidance is the incremental revenue I know that we will get from things like our services subscription businesses, our SaaS businesses, as well as some product flow-through on the distribution that we're seeing. That is what I baked into the guidance.
I am not assuming there is going to be a lot more because of the current macro environment. The sales guys are out there. The teams driving to a monthly number and a quarterly number and given the spending constraints that we're seeing right now, I'm not being over-bullish in my guidance on that. That is how I built [that] up. Just to remind you, back in Q3 of 2010 -- our growth that quarter was 27% so it was a much different macro environment.

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Chuck Robbins, Cisco Systems, Inc. - CEO [12]
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Simona, the second part of your question. I think the word that we would use relative to how Kelly modeled in that would be the same that we talked about with Vijay which would be prudent. On the switching front from a revenue perspective, it was negative this quarter. We're trying not to give you lots of random pieces of information every quarter so that we can build some consistency in how you look at how we are performing. But, I will tell you that on the new order side on the data center switching business this quarter we did see slightly positive growth on orders. And, I would say in the context of that last three weeks that we felt in enterprise that we are cautiously optimistic.

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Operator [13]
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Jim Suva, Citi.

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Jim Suva, Citigroup - Analyst [14]
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My question is now that it has been a few months with the new partnership in Ericsson, can you let us know if you've actually had any concrete wins or anything you can [point to] showing up in the NGN segment of reporting? Or, is it too early to see? Or, any anecdotes about that new partnership?

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Chuck Robbins, Cisco Systems, Inc. - CEO [15]
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Jim, first of all, thanks for your favorable comments. I appreciate that. On the Ericsson front, we have seen -- I will tell you that we have never seen --. Outside of Apple, we have never seen a partnership that has gotten so much energy and excitement inside the Company. And, as you know on the Apple front, we are actively doing the development. I think Tim alluded to it on his conference call that we are -- both Companies are doing the development that we need to do to actually deliver that join innovation to our customers.
But, the Ericsson partnership has immediate opportunity with it, and we have begun to close transactions together. I would not translate that to a significant impact to any of the numbers that we put out there today because we are literally in the handful stage right now. But, we do see that accelerating. We have a lot of focus on it with our teams. Hans, their CEO and I are going to be together quite a bit. Mobile World Congress in a couple of weeks, and we're also going to have a lot of the next-generation joint solutions that we are putting together for our customers that will be on display in both of our booths there. Hans and I are actually on a panel together at mobile world. That partnership is going probably as well as we thought it would be at this point, and I think you will really see the acceleration over the next 12 months.

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Operator [16]
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Mark Moskowitz, Barclays.

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Mark Moskowitz, Barclays Capital - Analyst [17]
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Just wanted to see if you can give us a little more context about how we should think about the routing glide path going forward in the next few quarters given the nice growth you generated this past quarter. How much of it is related to the CRS cycle continuing? Does it have to do with more vertical penetration or service provider penetration? Any color you can give us? I'm trying to understand, can you still be in the 3% to 4% or 5% bogey for that business for the next couple quarters from a growth perspective?

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Chuck Robbins, Cisco Systems, Inc. - CEO [18]
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I will speak to some of the areas of strength, and I will let Kelly talk about the numbers and how we think about it going forward. We did see strength in our core routing, and we saw strength in enterprise access routing this past quarter. We have some new products in our portfolio that are very early. One of them was the co-development effort that I had talked about over the last couple of calls that we would expect to see some positive momentum out of over the next few quarters. We have got some virtualized routing capabilities that our teams are working on. I think the portfolio looks good. The pipeline looks good from an innovation perspective. And then, Kelly, any comments on how we think about the numbers going forward?

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Kelly Kramer, Cisco Systems, Inc. - CFO [19]
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I think you summarized it well, Chuck. I think we feel fantastic about the portfolio, and we feel good about what it looks like. But, I don't really give guidance by business unit because there's a lot of volatility. But, I would say we feel really good about how the portfolio is sitting and the new products that we have launched on that -- in that platform.

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Operator [20]
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Brent Bracelin, Pacific Crest Securities.

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Brent Bracelin, Pacific Crest Securities - Analyst [21]
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One clarification and one question, Chuck. Could you clarify, was the pause you saw with customers the last couple weeks. Was that global, or was that concentrated in the Americas? And, my question is really around APJC, the recovery you are seeing there? The recovery you are seeing in China? What is driving that? Is that sustainable? Is that easy compares? Walk us through what you are seeing in APJC that drove the rebound this quarter? And, I guess -- A, is it sustainable?

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Chuck Robbins, Cisco Systems, Inc. - CEO [22]
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Thanks, Brent. On the pause that we saw, this is typical. When there is uncertainty in the market, we see enterprise customers and they just basically say, let's just wait. Let's see what's going to happen. They may say, let's wait a week. They may say, let's wait a couple of weeks. When you're in the last three weeks of your quarter, those kinds of decisions have an impact. I just want to clarify. Your specific question. We saw it pretty holistically around the globe. And then, the other thing that we haven't really talked about is obviously outside of the United States we saw currency -- we talked about it on the last call -- in Europe and Asia that clearly continued and maybe even get a little worse in some places.
On the APJC recovery, the team there has done a great job. We've talked a lot about what we have seen happening in India. We have seen tremendous success there. That is one of the key countries that we have a country digitization effort that John has been leading for us, and our business there continues to grow very well. In China, which is the crux of your question. I would tell you that as we've navigated our way through the last three years, and I think, Brent, you and I have talked about the amount of time that I spent over there during that window. The team did a great job, and what they really did is they diversified our business strategy across customer segments. So, not only being aligned to state on enterprises but moving out and creating a commercial market strategy. Moving out into second and third-tier cities, so geographic diversification. And, they really focused on their teams being able to sell our entire portfolio.
The good news is what I will tell you is that the growth we saw in China was very well balanced across our portfolio. We saw routing up -- Kelly, keep me honest. But, routing in double digits. Switching in double digits. Wireless in double digits as well as SP video in double digits. It was a very balanced performance for the second quarter in a row. There's clearly a lot of uncertainty out there so we're going to take things a quarter at a time, but we are pleased with where they are.

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Operator [23]
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James Faucette, Morgan Stanley.

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James Faucette, Morgan Stanley - Analyst [24]
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A couple of quick questions. First on acquisitions. You have been fairly active in the last few quarters. Should we expect this type of pace to persist, both in terms of tuck-in acquisitions and maybe more detailed acquisitions? And then, the second question I had was security -- it seemed like there was some acceleration in that business this quarter. Is that just the result of the SaaS model starting to accrue to the P&L? Or, was there underlying improvement in the billings and activity in that business?

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Chuck Robbins, Cisco Systems, Inc. - CEO [25]
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Thanks, James. Let me comment on the M&A activity that you have seen. We have built a strategic framework that is guiding us for what we believe we need to have in our portfolio and the architectures that we need to be able to build relative to cloud security analytics, SaaS, IoT. We have built that framework with our team in the first two or three months that I was in the role. We then stepped back and looked at where do we have R&D activities that are going to fill some of those opportunities and where are there opportunities like what we saw with Jasper where we can move and actually fill a substantive portion of our portfolio. That is what is driving us. It is very much connected to our broader strategy and connected to what I believe our customers care about in the future. I would say that you should expect us to continue the pace, and obviously valuations in today's market -- that is one piece of good news is that they're more attractive.
As it relates to security -- on the security front, I would say that it is primarily -- and Kelly can again keep me honest on the deferred piece of this -- if it is flowing through. But, what we talked about was the integration of the Sourcefire assets as well as the Cisco assets as well as other acquisitions we made along the way plus the other innovation that our teams internally have done. And, that has -- we put all that together about two quarters ago, and we told you that we thought that this would continue to improve. And, our teams have driven that. When you look at that advanced malware portfolio, we added yet another 2,000 customers this quarter. So, we're up to 10,000 which is they've really done a great job of executing on that strategy.
During the quarter, we also launched our next-generation firewall product that we need to get out in the marketplace for obvious reasons. We're hoping for similar success. But, I think primarily it is because of continued improvement in the portfolio and the work our team has done. I wouldn't suggest that there is a significant revenue impact coming back in from the deferred yet although we are seeing -- .

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Kelly Kramer, Cisco Systems, Inc. - CFO [26]
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That is what we expected. What we said a couple of quarters ago. That ramp that we talked about two quarters ago is happening in addition to the growth that you are highlighting in just the core businesses.

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Operator [27]
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Jess Lubert, Wells Fargo Securities.

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Jess Lubert, Wells Fargo Securities, LLC - Analyst [28]
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Two quick ones. First, for Chuck. I was hoping you could provide some additional details regarding the weakness in the data center business? What changed there? How you expect that to progress moving forward?
And then, for Kelly, with respect to capital allocation. It seems like you have a little bit less than $4 billion in US cash yet you materially raised the dividend and the buyback. I was hoping to understand if we should be expecting a debt raise? And, to what degree this means any acquisitions we may see are likely to be on the smaller side? Thanks.

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Chuck Robbins, Cisco Systems, Inc. - CEO [29]
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Jess, I'm surprised we got this far in the questions before someone asked about data center so I was beginning to worry. We track that business very closely, obviously, and largely what we believe is that it is connected to the broader macro issue. That data center business has a strong buying season that actually runs into the end of December, and while it is a fantastic franchise for us that has contributed and will contribute to not only our success in the data center in the past but also in our success in the next-gen data center as we build next-generation data center stacks going forward. But, it also -- we also believe that in the December quarter that we actually still gained share with that performance. We had a tough comp from a year ago -- 40%. But, I will tell you the other thing that we looked at is even with the lower performance, it still remained the same percentage of our business this quarter that it was last quarter that it was a quarter a year ago which says that it just in my mind it says it suffered at the same rate that the rest of the business did from the macro. Kelly, second part of the question?

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Kelly Kramer, Cisco Systems, Inc. - CFO [30]
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On capital allocations. Overall, our strategy around capital allocation hasn't changed. We want to give a minimum of the 50% back to our shareholders. We've been listening to our shareholders, and the bottom line is we feel very, very good about our business model and our ongoing cash flows. You saw our operating cash up 36% this quarter that we thought we would increase the amount of our dividend sustainably going forward. It is a blend. We also increased our authorization just as we would normally would increase our authorization -- the $15 billion.
In terms of flexibility, yes, we will be accessing debt in the near future. Again, that is one of the benefits of our balance sheet and our access to capital. It is very, very good so we will continue to do that until anything changes with our overseas cash. But, it does not change our flexibility in any way in terms of acquisitions. When we think through these capital allocation decisions, we're playing out what we're thinking about acquisition-wise. How we're building that out as well as our future cash flow. I think, no change to our acquisition strategy. It does not hamper us in any way. We have easy access to capital, and again, wanted to share some of that cash back with our shareholders.

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Operator [31]
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Jeff Kvaal, Nomura Securities International, Inc.

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Jeff Kvaal, Nomura Securities Intl - Analyst [32]
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I have a few margin questions, Kelly, for you perhaps. Can you talk a little bit about the drivers inside of the gross margin structure? It was a little bit ahead of plan this quarter. It seems to be going back to the norm next quarter. What are the moving parts there?
The second part of that is on the operating margins. I know 30% is the target. When should we be thinking about that? How much progress are you making in that regard?

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Kelly Kramer, Cisco Systems, Inc. - CFO [33]
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On gross margins, we continue be very focused on margins, and we look at it as all the different levers in there. As you know, we continually have some price erosion, and we use price as a lever to drive selling. Our price erosion has remained very, very disciplined. You'll see that it has been in the normal ranges that we have been in the last quarter and actually slightly better than a year ago. So, that continues. We're getting real traction -- continued traction from our engineers and supply chain on the productivity side. So, for the price erosion we have, we are more than offsetting it with productivity, and we're continuing to drive those projects to continue to do that so we can have the flexibility to make sure we're taking advantage of all opportunities for growth out there. That is continuing.
On the operating margin side -- again, we're are going to be smart about managing the overall equation. We want to make sure we're taking advantage and investing in the right areas to be able to take advantage of future growth and balancing that equation. There is a bit of good [news] coming through at the OM line because of FX favorability that you are aware of that falls through the bottom line. But, in general, I would say that we're being very disciplined in terms of how we make these trade-offs and balance the bottom line with the investments we're trying to make to accelerate growth.

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Operator [34]
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Ittai Kidron, Oppenheimer.

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Ittai Kidron, Oppenheimer & Co. - Analyst [35]
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I wanted to think a little bit ahead, Kelly, just given this extra week that you had in the guidance. Historically as you move into your fourth quarter, you typically post a solid sequential increase quarter over quarter. As we lose this week, should we assume a little bit more of a flattish performance then into July versus April? And then, regarding the software in SaaS, clearly you're making very good progress over there. Is there a way to quantify from your standpoint how much of growth are you giving up right now as you transition businesses, more and more of your products into those type of purchasing model? How much of a growth headwind this transition is impacting you near-term?

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Kelly Kramer, Cisco Systems, Inc. - CFO [36]
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On the extra week, this is how I think you can think about it. I tried to be pretty transparent of what we are assuming in there so literally the $250 million or so, the $275 million that we're assuming literally is just the businesses where it is just because we have weekly billing it is going to amortize off our balance sheet. That is basically a guarantee. Just marginally a little bit more for some of the distribution flow business. I would say as you are modeling for Q4, I think you should assume the normal ranges. Take that out -- that $250 million to $275 million and assume the normal ranges of growth in Q4.
On the software and SaaS. I know you and others ask me this question a lot, and it is tough to quantify. Certainly, it is 1 point or 2 easy to say, off the top. Some of the businesses we're growing -- our businesses that we've had that are great like [collaboration] and security. We are adding more to this profile with some of these different offers. These big enterprise ELAs that we have. It is hard to quantify for any one quarter, right, of when it is going to fall in. But, there is certainly something on the top line, but we will see that come back through as we continue to build that out and amortize it.

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Operator [37]
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Simon Leopold, Raymond James.

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Simon Leopold, Raymond James & Associates, Inc. - Analyst [38]
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Quick clarification. Strength in service provider video, I think you highlighted China. If you could just talk to what you think the duration is? And then, in terms of market verticals, I was interested if you could talk a little bit more about your exposure to what we have often called Web 2.0 or web-scale operators? Certainly, there is the idea that they buy white box, but we know you sell to them. I would like to get a sense of your exposure and the trends from that group of customers if we might?

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Chuck Robbins, Cisco Systems, Inc. - CEO [39]
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Simon, thanks. This is Chuck. On the SP video front, I think that the team has done a great job of evolving that portfolio and really building some great solutions. They're engaged with lots of customers. Our strategy when we divested of the video CPE business was to really focus on a cloud-based delivery model, and that is occurring. We're having obviously good success with that platform in China. That tends to be an ongoing -- a longer-term solution that the customers deploy. So, we will see. Again, we're taking things quarter by quarter, but we feel good about where they are there.
On the second part of your question, relative to the web-scale guys. We have talked the last couple of quarters about how we had been having success with them. And, I talked about us really changing our strategy about 18 months ago and moving more into a collaborative, co-development mode with them thinking about what they're very unique needs are. I will tell you that our business with them last quarter grew 17% so we continue to see relatively good strength with those customers.

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Operator [40]
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Tim Long, BMO Capital Markets.

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Tim Long, BMO Capital Markets - Analyst [41]
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Chuck, maybe just to go back to the data center, if we could. I get the macro and the tough compares there. Just looking more broadly at that market, I think though the share gains are starting to normalize a little bit at least in the server market. So, when you think about the continued growth on the hardware side of the data center, do you think we need to broaden the server offering? Maybe get more involved in storage or ADC or some other products that are important to the data center that Cisco might not fully be participating in?

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Chuck Robbins, Cisco Systems, Inc. - CEO [42]
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Tim, it is good to hear from you, and that is a very good question. What I would tell you is that we are currently -- we have a lot of work going on around the future -- the next-generation data center and what the future stacks look like in that data center which will be a combination of infrastructure hardware with a heavy dose of software and orchestration. And, you can assume that we're looking at our role up and down that stack going forward. I would tell you that there was a recent article, I think late last week in InfoWorld where [Barry Sing] actually outlined how we are thinking about this market. So, you are spot on, and we are spending a lot of time thinking through what role we play there and what the opportunity is. But, we believe it is going to be significant. Appreciate the question.
Tim, thanks. That was apparently the last question we have. I'm going to close with some short comments. I am incredibly pleased with how we executed this quarter, as I said, in a very uncertain macro environment. Our teams did a great job, and as we look forward, I think about how we're operating the Company on these two fronts.
The first front is that we will continue to execute and run this Company in a well-managed way even in challenging environments, but at the same time, we're going to move full speed ahead. The second front is that we are going to make the long-term investments and build our strategy and the architectures and the solutions that our customers need, and I believe that our growth will accelerate as our customers embrace and move towards this next wave of technology that is going to fundamentally change every Company and every country around the world. I believe we can do both. I think that will allow us to take advantage of the incredible opportunity ahead of us, and I have a great deal of confidence in our ability to execute against that. Thank you for spending time with us today, and we look forward to talking to you soon.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [43]
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Thanks, Chuck. Cisco's next quarterly call, which will reflect our FY16 third-quarter results will be on Wednesday, May 18, 2016 at 1.30 PM Pacific time, 4.30 PM Eastern time.
Again, I would like to remind the audience that in light of regulation FD, Cisco's policy is not to comment on its financial guidance during the quarter unless it is done through an explicit public disclosure. We now plan to close the call. If you have any further questions, please for free to contact the Cisco investor relations department, and we thank you very much for joining the call today.

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Operator [44]
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Thank you for participating on today's conference call. If you would like to listen to the call in its entirety, you may call 1-888-562-6191. Or, participants dialing from outside of the US, please dial 1-402-280-9986. This concludes today's conference. You may disconnect at this time.

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