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

Q1 2018 Cisco Systems Inc Earnings Call
NOVEMBER 15, 2017 / 9:30PM GMT

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Corporate Participants
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* Marilyn Mora
Cisco Systems, Inc. - Director of Global IR
* Charles H. Robbins
Cisco Systems, Inc. - Chairman & CEO
* Kelly A. Kramer
Cisco Systems, Inc. - Executive VP & CFO

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Conference Call Participiants
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* Paul Jonas Silverstein
Cowen and Company, LLC, Research Division - MD and Senior Research Analyst
* Mark Alan Moskowitz
Barclays Bank PLC, Research Division - Former Director
* Simon Matthew Leopold
Raymond James & Associates, Inc., Research Division - Research Analyst
* Vijay Krishna Bhagavath
Deutsche Bank AG, Research Division - VP and Research Analyst
* Jeffrey Thomas Kvaal
Nomura Securities Co. Ltd., Research Division - MD of Communications
* Pierre C. Ferragu
Sanford C. Bernstein & Co., LLC., Research Division - Former Senior Analyst
* Jim Suva
Citigroup Inc, Research Division - Director
* Mitchell Toshiro Steves
RBC Capital Markets, LLC, Research Division - Analyst
* George Charles Notter
Jefferies LLC, Research Division - MD & Equity Research Analyst
* Steven Mark Milunovich
UBS Investment Bank, Research Division - Former MD and IT Hardware & EMS Analyst
* Tal Liani
BofA Merrill Lynch, Research Division - MD and Head of Technology Supersector
* James Eugene Faucette
Morgan Stanley, Research Division - Executive Director
* Ittai Kidron
Oppenheimer & Co. Inc., Research Division - MD
* Erik Loren Suppiger
JMP Securities LLC, Research Division - MD & Senior Research Analyst

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Presentation
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Operator [1]
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Welcome to Cisco's First Quarter of Fiscal Year 2018 Financial Results Conference Call. At the request of Cisco, 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, Mark. Welcome, everyone, to Cisco's First Quarter Fiscal 2018 Quarterly Earnings Conference Call. This is Marilyn Mora, Head of Investor Relations, and I'm 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 made 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 in the Financial Information section of our Investor Relations website.
As a reminder, effective in Q1, we began reporting our revenue in the following categories: Infrastructure platforms, Applications, Security, Other Products and Services. As discussed in our Q4 earnings call and in our October 23 press release, this change better aligns our product categories with our evolving business model.
Our segments will continue to be based on geographies, which consists of the Americas, EMEA and APJC. So this change only impacts how we report revenue by product category. We've included quarterly reclassified revenue amounts for the last 3 fiscal years on our website. Click on the Financial Reporting section of the website to access these documents.
Throughout this conference 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 made 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 second quarter of fiscal 2018. They are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent report on Form 10-K, which identifies 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.
With that, I'll turn it over to Chuck.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [3]
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Thank you, Marilyn, and good afternoon, everyone. Our results this quarter demonstrate the continued progress we're making on our strategic priorities.
In Q1, we delivered a solid quarter with revenue of $12.1 billion and non-GAAP EPS of $0.61. We are seeing great traction with our new intent-based networking solutions, delivering accelerated innovation across our portfolio and offering a broader range of new consumption options to our customers, resulting in strong increases in our software and subscription revenue. The progress we've made resulted in all 3 of our geographic regions returning to orders growth during Q1.
Cisco has always been about connecting people, information and machines at scale. Today, the network is becoming more pervasive and critical to business success as billions of new connections are added. We expect these new connections will become increasingly automated, intelligent and secure, delivering unprecedented insights and intelligence to our customers.
Cisco's vision is to deliver highly secure, intuitive technology across our portfolio that is designed to constantly learn, adapt and protect to drive business outcomes with greater speed and agility. This extends to the network, next-generation data center architectures, advanced IoT applications, end-to-end analytics and our collaboration technologies. Our vision is resonating with customers and partners around the world as we help them build more secure, intelligent platforms for their digital businesses.
Today, most of our customers are operating in complex, multi-cloud environments, and Cisco is well-positioned to provide them with networking capabilities, enterprise-class security and support, together with cloud scale, agility and economics. Our new partnership with Google is a good example of this. Over the last few months, our engineering teams have been working closely together to jointly develop a new hybrid cloud solution that is designed to enable applications and services to be deployed, managed and secured across on-premise environments as well as the Google Cloud Platform, bringing the best of cloud to the enterprise.
This partnership is an example of the work we are doing with all of the large web scale providers. We are also investing to develop and acquire new technologies to extend our multi-cloud portfolio. This includes ACI Anywhere, which we announced this quarter; and acquisitions such as CliQr, OpenDNS, CloudLock, AppDynamics and Viptela.
Now I'd like to cover some key business highlights in our new product reporting categories. First, let's start with Infrastructure Platforms. Our launch of the network intuitive in June is an example of the investment and innovation we're driving in our core business. These new intent-based networking capabilities are providing customers unparalleled insights and intelligence, together with highly differentiated security and programmability.
Our new subscription-based Catalyst 9000 Switching platform has been adopted by more than 1,100 customers in just over 3 months. We expect continued momentum throughout fiscal 2018, and we're pleased that the vast majority of Catalyst 9000 customers are buying our most advanced software subscription offer.
Additionally, we saw good performance in our next-generation data center switching platforms, as customers continue to shift to 10-gig, 40-gig and 100-gig architectures and embrace multi-cloud adoption. We continue to advance our intent-based networking for data center and private cloud environments with the latest software release of ACI. Over 4,000 ACI customers are benefiting from increased business agility with network automation, simplified management and improved security.
Going forward, we see a tremendous opportunity to benefit from a shift in customer demand from standalone products to integrated platforms with our intent-based infrastructure portfolio providing unmatched benefits.
Now turning to Applications. Applications are absolutely essential to every digital business strategy. To maximize their effectiveness, companies require a highly secure network that closely monitors applications and workload performance across a complex multi-cloud environment. Our acquisition of AppDynamics is core to our capability of providing end-to-end analytics from the network to the data center to the application.
Within our Applications business, we are enabling new capabilities based on advanced AI and machine learning across our portfolio. An example of this is our acquisition of Perspica, providing deep machine learning, driven analytics to further extend AppDynamics' leading capabilities in application intelligence. Additionally, we announced our latest innovation on the Cisco Spark platform, Spark Assistant, which is the world's first enterprise-ready, AI-powered voice assistant to further enhance our customers' meeting experience.
Our intended acquisition of BroadSoft will enhance our subscription and cloud-based business. BroadSoft has 19 million subscribers in the growing cloud voice and contact center space and will enable Cisco to offer an even broader portfolio of collaboration solutions to our customers, on-premise and in the cloud. We expect this acquisition to accelerate the pace of innovation in our collaboration business, and we see many opportunities to extend the reach of the BroadSoft portfolio.
Moving to Security. With an expanding threat landscape, cybersecurity is the #1 priority for businesses worldwide and is at the heart of every company's digital strategy. In a multi-cloud world, as our customers' environments become increasingly distributed, security requirements only increase. At Cisco, security continues to be a strategic imperative and fundamental to everything we do.
As customers adopt and advance intent-based networking, our end-to-end security is the foundation to keep our customers protected from advanced threats. This architecture, combined with the best-of-breed portfolio across the network, endpoint and cloud, enables our customers to reduce the time to detection as well as complexity and cost.
As a result, we believe Cisco is delivering the most effective and comprehensive security solutions in the market. This differentiated strategy drove the 8% revenue growth in our Security portfolio, and we also saw continued momentum in our Security deferred revenue with 42% growth.
To summarize, we delivered a solid quarter as we continue to execute well against our strategic priorities. I firmly believe that Cisco is well positioned to capture long-term growth opportunities ahead. We remain focused on providing our customers with the most innovative portfolio of offerings in the industry, powered by intent-based capabilities and delivered through a range of consumption models, providing more flexibility than ever before.
Now I'll turn it over to Kelly to walk through more detail on our financials.

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [4]
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Thanks, Chuck. I'll start with a summary of our financial results for the quarter followed by the Q2 outlook.
Total revenue was $12.1 billion, down 2%. We continue to focus on driving margins and profitability with non-GAAP operating margin of 30.4%. Non-GAAP EPS was $0.61, and operating cash flow was strong, growing 13% to $3.1 billion.
The rule of enterprise IT is dramatically changing with the move to an application-centric focus and adoption of hybrid cloud architectures, with customers increasingly seeing the value of integrated platforms over standalone products. Cisco's intent-driven architecture with a focus on simplicity, automation and security allows enterprises to manage and govern the interactions of users, devices and applications across the environment.
Starting in Q1, to better reflect this shift, we've changed our product reporting categories, which are now Infrastructure Platforms, Applications, Security, Other Products and Services.
So let me give you a little bit more detail on our Q1 revenue.
Total product revenue was down 3%. Infrastructure Platforms declined 4%, with the vast majority of the decline driven by routing products. This was driven by continued weakness in Service Provider and a slowdown in enterprise routing.
Our Switching revenue was down modestly, but we saw good momentum on orders and Campus Switching with the network intuitive launch. Additionally, we did see continued strong wireless revenue performance and solid uptake of our HyperFlex data center offering.
Let's move on to Applications. To remind you, applications is made up our collaboration portfolio of Unified Communications, conferencing and TelePresence as well as our IoT and application software businesses such as AppDynamics and Jasper. Applications increased 6% in total, with collaboration up modestly and AppDynamics driving most of the increase. We did see strong growth in deferred revenue of 18%. There was also a strong increase in the unbilled deferred, which is not on the balance sheet, bringing the combined total of deferred revenue plus unbilled deferred up 32%.
Security was up 8%, with strong performance in unified threat, advanced threat and web security, and deferred revenue grew 42% as we continue to drive more subscription-based software offers.
Service revenue was up 1%, driven by growth in software and solution services. During the quarter, we introduced a new portfolio of subscription offers called Business Critical and High-value Services, powered by AI to predict future IT failures before they happen. We drove good growth in deferred revenue, which was up 10% in total, with product up 16% and services up 5%. Deferred product revenue from our recurring software and subscription offers was up 37% to $5.2 billion.
We continue to transform our business, delivering more software offerings and driving more subscriptions in recurring revenue. In Q1, we generated 32% of our total revenue from recurring offers, an increase of over 3 points from a year ago. Revenue from software subscriptions was 52% of our software revenue.
In terms of orders in Q1, total products orders grew 1%. Looking at our geographies, Americas grew 1%, EMEA was up 2% and APJC grew 1%. Total emerging markets declined 6%, with the BRICs plus Mexico also down 9%.
In our customer segments, enterprise declined 5%, commercial grew 12%, public sector was up 3% and service provider declined 6%.
From a non-GAAP profitability perspective, total Q1 growth margin was 63.7%, down 1.5 points; product gross margin was 63.0%, down 1.8 points; and service gross margin was 65.6%, down 0.6 points. We continue to be negatively impacted by higher memory pricing, like we've discussed over the past several calls, which we expect to continue in the near term.
Our operating margin was 30.4%, down 1.2 points.
When we look at the impact of acquisitions on our results year-over-year, there has been a 60 basis point positive impact on revenue, no impact on gross margin, a 3-point increase on non-GAAP operating expenses, all resulting in a negative 70 basis points impact on our non-GAAP operating margin rate and a negative $0.01 year-over-year impact on our GAAP EPS.
In terms of the bottom line, our Q1 non-GAAP EPS was $0.61, while GAAP EPS was $0.48.
We ended Q1 with total cash, cash equivalents and investments of $71.6 billion, with $2.5 billion available in the U.S. Q1 operating cash flow had very strong growth of 13% to $3.1 billion. And free cash flow was also very strong with growth of 19% to $2.9 billion.
From a capital allocation perspective, we returned $3.1 billion to shareholders during the quarter that included $1.6 billion of share repurchases and $1.4 billion for our quarterly dividend.
To summarize, in Q1, we continued to make progress on our strategic growth priorities while maintaining rigorous discipline on profitability and cash generation. We continue to prioritize our key investments to drive long-term profitable growth.
Let me reiterate our guidance for the second quarter of fiscal year '18. This guidance includes the type of forward-looking information that Marilyn referred to earlier. And also, as Chuck mentioned, we announced a definitive agreement to acquire BroadSoft. The acquisition is expected to close after completion of the customary regulatory reviews, and therefore, it is not included in the guidance.
We expect revenue growth in the range of 1% to 3% year-over-year. We anticipate the non-GAAP gross margin rate to be in the range of 62.5% to 63.5%. And the non-GAAP operating margin rate is expected to be in the range of 29.5% to 30.5%, and the non-GAAP tax provision rate is expected to be 22%. Non-GAAP earnings per share is expected to range from $0.58 to $0.60.
I'll now turn it back to Marilyn so we can move into Q&A.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [5]
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Thanks, Kelly. Mark, let's go ahead and open the line for questions. (Operator Instructions)

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Questions and Answers
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Operator [1]
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Our first question comes from the line of Pierre Ferragu with Sanford C. Bernstein & Co.

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Pierre C. Ferragu, Sanford C. Bernstein & Co., LLC., Research Division - Former Senior Analyst [2]
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Kelly, I can't help asking you an update on gross margin movements. So can you give us a bit of a sense of how big is memory prices in the 1.5 points gross margin declines that you've seen year-on-year? And then sequentially, your guide for gross margin in -- for Q2 was slightly below what you've been guiding for Q1. Is there still like incremental headwind coming from compound pricing hurting you from the Q1 to Q2?

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [3]
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Yes. Thanks, Pierre. Great question. Yes, so the vast majority of the impact on our gross margin is driven by memory. It is basically 1.3 points of my product gross margin decline year-over-year. Everything else in our gross margin is basically in the normal ranges. So we expect that to continue. When you look at the guidance, we did bring it down 0.5 point to account for that because we are still seeing increases as we look forward -- moving forward. But otherwise, we kind of see everything else in the normal range of things.

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Operator [4]
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Our next question comes from the line of Mark Moskowitz with Barclays Capital.

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Mark Alan Moskowitz, Barclays Bank PLC, Research Division - Former Director [5]
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Chuck, you talked about 1,100 customers have already adopted the intuitive network. I just want to get a sense in terms of how does that underpin, longer term, the steady-state growth? You guys guided to about 1% to 3% growth for the current quarter. But as more and more of those customers adopt and they move beyond the labs and move beyond the proof-of-concept, can we actually see your growth tick higher than 1% to 3% on a steady-state?

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [6]
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Yes, Mark. Thanks for the question. So clearly, we're pleased with where we're going right now with this product portfolio. We're pleased with the early feedback. I'll tell you that our sales teams, our partners and our customers, are very excited about the architecture that we've announced. It's still one quarter, so we have to get a little more time under our belt.
But what I will tell you is that when we look back at a transition like the 3850 years and years ago, it's very much in line. And I think that as more customers have the opportunity to test the automation and programmability and all those software features that they're testing right now, we would hope that the platform continues to accelerate. So one quarter down, but we feel good about where we are.

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Operator [7]
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Our next question comes from Steven Milunovich with UBS Securities.

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Steven Mark Milunovich, UBS Investment Bank, Research Division - Former MD and IT Hardware & EMS Analyst [8]
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To continue along those lines, Chuck, you talked a little bit about the software attach rates. Could you elaborate on that? And particularly the advantage premium, which, I think, has the encryption capability and so forth? Exactly what sort of mix are you seeing? And do you think that customers are going to be willing to pay up for the premium?

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [9]
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Well, thanks, Steve. So what I said in the script is that a vast majority of our customers that are buying these platforms are opting for the advanced. And I would say that it's a vast majority. We knew when we introduced a subscription on a switch that we needed to ensure that there was unique innovation that was available to our customers in order for them to see value in that.
We couldn't just simply shift the capabilities that they had gotten before in a perpetual model. We needed to drive new innovation. So the anchors that are in that advanced subscription are the overall automation capability, which really gets at the OpEx of running these networks; and the second part is the Encrypted Traffic Analytics, where we can determine when there's malware inside encrypted traffic without decrypting it.
And we think that those 2 are phenomenal incremental capabilities that our customers didn't have before, and I think that's why we're seeing such a high attach rate. So we're very pleased with where we are on that as well.

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Operator [10]
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Our next question is from Vijay Bhagavath with Deutsche Bank securities.

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Vijay Krishna Bhagavath, Deutsche Bank AG, Research Division - VP and Research Analyst [11]
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Yes, my question for you, Chuck, and Kelly, please join in, is has anything changed in your sales motion in terms of data center switching? And the reason I ask is we are starting to see this positive news flow, Alibaba cloud recently and, perhaps here in Microsoft as well.
What has changed in your view, Chuck, in terms of the sales motion? Is it the clouds paying attention to things like software automation tools, security? Anything else? Or is it just a sales focus on cloud? Help us understand.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [12]
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Vijay, thanks for the question. We've been talking about this for several calls now, about how we've reengaged with the large web scale providers back -- right after I became CEO, and these are long processes as they made major architectural decisions and they have franchises that you're trying to reenter.
But if you look at whether it's the announcements we've made with Microsoft a couple of quarters ago, the announcement we made with Google, you alluded to Alibaba, which there's a summary of that win on our website, if you want to go see that. It's our first insertion there. And actually, it was before the large sales day they experienced, I think, last week.
And so we continue to make progress, and we're continuing to execute on what I told you that we're executing on over the last 1.5 years, which is trying to go deeper. I think the other thing that has become eminently clear is that these large web scale providers realize that it is going to be a multi-cloud world, and they definitely have come to the conclusion that the Edge is going to be mission-critical for our customers going forward.
And as I think about that, we're a very natural -- we're the very natural partner for them to partner with as the network is the only common denominator across all these cloud environments all the way out to the edge of our enterprise customers' networks. So we're just continuing to execute against what we set out 2 years ago, and we hope to continue to seek success.

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Operator [13]
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Our next question is from Paul Silverstein with Cowen and Company.

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Paul Jonas Silverstein, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [14]
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Chuck and Kelly, recognize you guys are no longer breaking it out, but I'm hoping that you'll throw us a bone and put numbers on the data center switching revenue growth, given how important it is and how stronger growth market that's been. And as part of that, Chuck, related to the previous question, can you give us any quantification of your progress with the Web 2.0 hyperscale customer segment, given the importance of that segment?

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [15]
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Yes. So Paul, yes, I mean, obviously, we're trying to go to new groupings. But just to give you some color. I mean, we continue to see the double-digit growth that we've been talking about of our ACI portfolio, continue in the strong double digits. And overall, data center was certainly up from a revenue perspective.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [16]
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And I think, Paul, from a perspective of the web scale, I mean, it's really just what I described. We're in discussions with all of them. We have made announcements with several of them, and we continue to execute against our strategy. And again, it's -- these are large franchises. There's 2 facets. And if you remember on a call back -- 2 or 3 calls back, I said that we're now expanding our discussions into 360-degree relationship discussions.
The Google announcement was reflective of that comment because not only are we working on their infrastructure, but we're also working significantly on this multi-cloud enablement, hybrid cloud enablement and helping bridge our customers -- their premise-based solutions, their Edge-based solutions, their cloud applications, their SaaS applications. And so we just -- we're continuing to execute on that right now.

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Operator [17]
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Our next question is from Ittai Kidron with Oppenheimer & Co.

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Ittai Kidron, Oppenheimer & Co. Inc., Research Division - MD [18]
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Nice to see growth on the guide. I had a couple of things. First of all, for you, Kelly, can you update us on the number of Cisco ONE customers? Just as a housekeeping. And then for you, Chuck, getting a little bit deeper into the infrastructure part of the business. Great color there on the product lines, but maybe you can help us fine tune a couple of things. One, on the hyperconverged, I think Kelly actually mentioned that you were off to a good start there.
But maybe you can help us understand where you stand on that product line, how good you feel about the platform, how stable it is. And then the weakness in the enterprise routing, I'm just trying to understand how much of it is a secular issue, meaning SD-WAN is starting to make an impact there versus an execution or seasonal element. Is this going to be another part of your business that's just going to be under pressure for a long time as routing has been?

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [19]
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Kelly, you want to...

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [20]
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Yes, I'll just hit the Cisco ONE. Cisco ONE continues to have great momentum. We're over 22,000 customers at this point with that. So still great momentum.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [21]
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Yes, Ittai, just -- so thanks for your comments, by the way. On the hyperconverged offer or HyperFlex offer, I would tell you that it has continued to probably be at the high-end of my expectations. I'd say a couple of quarters ago, it began to exceed what I was expecting, so I changed my expectations. And it's -- but they're doing a great job. The teams are doing well. I think we know the use cases where it's very competitive, and I think that it continues to -- they continue to operate at the high end of what I expected from them. So we're very pleased with that.
On the question relative to SD-WAN, I think you nailed it, right. The -- our customers, and we've talked about this for a couple of calls, our customers have been trying to assess what this SD-WAN architectural transition looks like. And I think that after we acquired Viptela, we have now, at our sales meeting, we provided tremendous clarity to our sales organization and our partner community at the Partner Summit about what our strategy is. We've now taken customers through the road maps of what they can expect and then -- and how to position the different alternatives that we have and how those portfolios are going to come together over the next 12 to 18 months.
So I think that it is a by-product of the SD-WAN discussion. And I would expect that we'll start to see customers move somewhat this quarter. And then in the second half of the year, I think our customers will continue to begin to deploy some of these solutions. So again, happy with where we are relative to the positioning of the different platforms.

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Operator [22]
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Our next question is from George Notter with Jefferies.

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George Charles Notter, Jefferies LLC, Research Division - MD & Equity Research Analyst [23]
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I guess, I was curious about the revenue headwind associated with the move to a subscription model, including Cisco ONE. Can you remind us what you wound up seeing in terms of the headwind in the October quarter, and then also, what you're assuming for January?

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [24]
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Yes, George, thanks for the question. Yes, right now, we're still seeing it around that 2% range. We expect the headwind to grow once the -- once we continue to grow the intuitive network that has a subscription. As that grows, that'll grow. But right now, it's in that 2% range, 1.5% to 2% range. And we expect that to be roughly in that range next quarter as well.

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Operator [25]
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Our next question is from Tal Liani with Bank of America Securities Merrill Lynch.

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Tal Liani, BofA Merrill Lynch, Research Division - MD and Head of Technology Supersector [26]
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My question is almost a follow-up to the previous question. Can you elaborate? I know you started at the beginning of the year to do the Subscription for Switching. Can you elaborate on, first of all, the experience you've had so far, cases where customers took the subscription versus didn't take?
What does it include? Just elaborate on the subscription and kind of the profile of it and also the take rate so far and whether you need to make any changes to it in order to improve take rates, et cetera. I'm just trying to understand the implications for future years.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [27]
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Yes. So Tal, thanks for the question. Let me break it down. So the advanced subscription today is primarily being sold on the new Catalyst 9000, even though it's backwards compatible with a couple of years worth of our, I don't know, 2, 3 years' worth of products that we've shipped in wireless and in routing, et cetera.
But what the customers are doing right now is they're basically becoming accustomed to the platform. They're testing the platform before they make an investment on any sort of backwards compatibility is what I would tell you. I don't think we need to make any changes right now because the attach rate of the most advanced subscription offer is at the very high end of what I would've expected.
So I think we're very pleased with where it is right now. And assuming we execute on the value and the innovation that our customers continue to gain from that, then I think that we'll begin to see them then buy the subscriptions on some of their installed base as well. That would be our intent.

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [28]
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And just to add to that, I mean, just to be clear, 100% of the switches we're selling come with a subscription. It's just a difference on what additional features and security are added between the Advantage and the Essentials. So 100% of the new switches are sold with a subscription, and that's going well.

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Operator [29]
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Your next question is from Mitchell Steves with RBC Capital Markets.

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Mitchell Toshiro Steves, RBC Capital Markets, LLC, Research Division - Analyst [30]
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I wanted to focus on the Security angle. So despite having pretty difficult comparisons last year, still up 8%, so can you maybe provide some color what's going well there? And then secondly, any sort of growth rates or rough numbers with the advanced threat versus web security growth rates?

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [31]
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Thanks, Mitch. So I think that the thing that is resonating with the customer is if you look at the environments that they're all beginning to operate in, they're operating in an environment where they have multiple SaaS providers, multiple cloud providers. They've got their private data centers with applications running. They've got their branch networks. They've got now Edge connectivity with IoT coming in.
And so the robustness of an architecture that they have to have that protects across the network, across the endpoint, across the cloud is really what, I think, is differentiating it. And we've also -- we've been on a multi-year journey of selling software and subscriptions against the threat intelligence and the malware intelligence that we have, and I think that's what's continuing to pay off. So I think it's resonating with our customers, and it's an architecture that we can continue to innovate on. We continue to expand on. And Kelly, any comments on the...

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [32]
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Yes. I mean, I'd just say advanced threat and unified threat as well as even web security, they're all up big double digits. I mean, just really strong growth.

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Operator [33]
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Next question is from James Faucette with Morgan Stanley Investment Research.

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James Eugene Faucette, Morgan Stanley, Research Division - Executive Director [34]
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I wanted to ask a question on capital structure. Can you give us an idea of what your preference is and priorities will be in capital structure in terms of buybacks and acquisitions, et cetera, if the proposed new tax changes pass versus if that change in tax law gets derailed? I'm particularly curious as to how you're thinking about the pacing of acquisitions versus buybacks, et cetera.

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [35]
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Yes, I'll take that one. What I'd say is in terms of acquisitions, the tax policy isn't impacting us either way because we are lucky to have a great cash flow and access to capital. So it hasn't been stopping us from anything from an acquisition perspective, and it won't. So that will continue. I would say we're definitely encouraged by the progress that's going on in the tax reform.
So like we said in the past, when that happens and if we get a repatriation, which most plans currently have, we're going to continue, like we have, growing our dividend with our earnings growth. And where we have opportunity is really to get much more aggressive than we have been on the share buyback. And of course, we want to make sure we continue to have enough firepower to continue to able to do the right acquisitions to help us position Cisco right for the long term.

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Operator [36]
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Our next question is from Simon Leopold with Raymond James & Associates.

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Simon Matthew Leopold, Raymond James & Associates, Inc., Research Division - Research Analyst [37]
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I wanted to see if you could give us a little bit more insight into what you would attribute the outlook to in terms of this is the first quarter with year-over-year growth we've seen in quite some time. So I'm wondering, if we attribute it to an easy comparison or lapping the buildup of deferred revenue or some specific product cycles, if you could help us assess the key elements bringing you back to year-over-year growth.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [38]
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Kelly, you want to...

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [39]
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Yes, sure. I mean, I'll give you some color. I'd say, it's a combination of things, right? I mean, if I go to the amount of revenue coming off the balance sheet from the progress we've been steadily making on growing our software and subscriptions, it's now up to 12% of our product revenue is now coming from recurring offers and off the balance sheet. So that's helping.
I would say also, the launch that we had on the intuitive network and the excitement around the reinvention of the core is having an impact. So we're encouraged. And you heard me mention, we're seeing positive demand on [man or wan] Campus Switching overall, which is great, and that has a big impact because it's one of the biggest pieces of our portfolio.
So that, combined with pretty good orders like we had in Q1, gives us a very good backlog position that allows us to have a good view into what the next quarter looks like. So I'd say, overall, the overall strategy, what we've been executing and talking about for the last couple of years here is we've been making progress, and all of this is benefiting us in the outlook.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [40]
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James, just to clarify one point or just to add to it, actually, when Kelly says 12% of our product revenue is coming from recurring offers, just to put that in perspective, when I became CEO, it was 6%. So we've effectively doubled that. And I think that's certainly helpful. And just we have seen -- we're seeing positive feedback on the launch. So I'm sorry that was Simon. I apologize, Simon.

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Operator [41]
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Our next question is from Jeffrey Kvaal with Nomura Securities International.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [42]
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Jeff?

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Jeffrey Thomas Kvaal, Nomura Securities Co. Ltd., Research Division - MD of Communications [43]
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Oh, sorry. I'm on mute. Pardon me. Yes, I was hoping to ask about competition in the Enterprise Switching space. And we've seen a little bit more out of Huawei perhaps, not in the U.S., of course, but international. I'm wondering if you could put some of that color into context for us, both from them and also from some of your traditional rivals.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [44]
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In the enterprise switches?

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [45]
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Yes, enterprise. Yes.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [46]
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So thanks for the question, Jeff. I think that if you look at some of the performance we saw around the world, to your point, in Europe and Asia, we've talked about Huawei's activity over the last couple of quarters. I would say that our teams have been very focused on it. I think that the intuitive network launch that we did in June really changes the discussion.
And where we compete with competitors who their value prop is upfront cost of the hardware, I think we're changing the discussion, because if you look at the cost of operating this infrastructure over a 5-year period, it's probably 10x the cost of the upfront hardware.
So going and helping our customers really reduced that is a value proposition that helps us change the discussion relative to the competition. So they continue to be very tough, but we think that competing on the price of the box upfront is something that we can shift over the next couple of years.

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Operator [47]
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Our next question is from Erik Suppiger with JMP Securities.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [48]
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It was good to see Security picking up. What are your expectations for Security growth? In the past, you've talked about driving double-digit growth on the Security side. Is that still a goal? And where do you think you are in terms of getting there?

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [49]
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Yes, Erik, thanks for that. So at our financial analyst conference this summer, we articulated a long-range guide in line with what you just described. We're going to have quarters that are going to be -- that are going to vary from that. But that's definitely our long-term objective.
And I think our teams are focused now on what is it we need to do for the next wave of this architecture. Once we have this architecture built, where we can actually defend and apply real-time defense against known threats, we can learn about a threat through malware and e-mail, and we can protect against it in the network and the cloud and the devices at the endpoint all at the same time.
So the teams are working hard to continue to drive innovation there, but also looking at what other elements can we fit into this architecture over time. And I think that's how we think about the long-term guide.

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Operator [50]
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Our last question comes from the line of Jim Suva with Citigroup Global Markets.

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Jim Suva, Citigroup Inc, Research Division - Director [51]
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It's Jim Suva from Citi. On your guidance of up 1 to 3, as talked about earlier, it's the first time you guys have seen year-over-year revenue growth for quite a long time. Kelly and Chuck, you've mentioned strength in orders and also the subscription model taking traction.
Are we now at a point where a shift to subscription is no longer dragging down year-over-year comps? Or that still a bit of a challenge in the orders that Chuck mentioned are just so much stronger? And Chuck, any end market areas we should think about for that order strength?

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Kelly A. Kramer, Cisco Systems, Inc. - Executive VP & CFO [52]
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Yes, I'll take the first part. I'd say no. We're still, I'd say, growing the base of the offers faster and putting it on the balance sheet than it's coming off. But again, both the year-over-year increase of the balance of $5.2 billion was up 37%, and my income statement was up 37% as well. But I'm still putting more and more offers. And as we get scale through the core networking, not just on Switching but the whole DNA Center, I think that'll continue to add.
So it's still going to be a headwind. And as I said before, this 1.5 to 2 points will move to more like a 2 to 3 points in the upcoming years as we get more scale there. So more to come, but again, we're benefiting from -- we're starting to see the benefit of just having more stability and being able to have a better line of sight and less massive fluctuation by having that.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [53]
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And Jim, just a market segment perspective that it's probably pretty clear. We saw service provider pretty much the same as it has been for some period of time. Our largest enterprise customers, which the way we define it, is really just an organizational segment that we have, we did see -- we saw negative mid-single digits there, which you saw on the slides.
In our commercial business, we saw 12% growth on a global basis, and it was double digits in every geography, which is always good to see. Our enterprise customers, what I would tell you is that they are -- they're some of the biggest customers who take the longest amount of time to evaluate new platforms and new capabilities like the network intuitive as well as this whole SD-WAN discussion. So we're actively in those discussions with the enterprise customers.
And our commercial customers tend to just move more quickly than others. And then finally, on the Public Sector side, which we didn't talk about a lot, I think, the big call-out there, I would say, is that 2 quarters ago, we talked about the pressure in the Federal, business. Last quarter, we said we saw it improving. And what I would tell you is that in this quarter, we saw the year end that was -- that seemed fairly normal.
While they still have a lot of leadership roles that haven't been filled and we still have the impending December debt ceiling issue, overall, for this quarter, we saw the federal business pretty much back to what we expected as we closed the quarter. So that's probably commentary I can provide on the market segments.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [54]
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Okay. I think we are...

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [55]
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Well, that's it, isn't it?

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [56]
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Yes. We're going to wrap up.

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Charles H. Robbins, Cisco Systems, Inc. - Chairman & CEO [57]
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Okay. I'll wrap it. Thanks, everyone, again for joining us today. I want to -- I just want to wrap with a few points. First off, we are committed to executing on this vision to deliver a highly secure, intelligent platform for our customers' digital business. And we are laser focused on 5 key elements of that strategy to enable our customer success and drive profitable growth for us and shareholder value as well.
First, we are fundamentally reinventing networking with our intent-based networking platform. We intend to further accelerate our leadership here, extending intuitive technologies across the broad portfolio that we have while increasing application visibility and automation.
Secondly, security is fundamental to everything we do. You can't build a next-generation digital business without a comprehensive security strategy across endpoints, network and the cloud. Third, it is very clear that it's a multi-cloud world, and Cisco is in a unique position to help our customers navigate this by expanding our multi-cloud portfolio and extending our web scale partnerships with strategic cloud providers.
Our Google partnership's an example of the work we are doing with all of the large web scale providers. Fourth, we're unlocking the power of the data with advanced analytics such as our solutions with AppDynamics, Encrypted Traffic Analytics and TELUS threat intelligence.
We are also embedding AI and machine learning technologies across the breadth of our portfolio. And lastly, we will continue to deliver a more enhanced customer and employee experience through our broad collaboration portfolio, including our intent to acquire BroadSoft.
Marilyn, I'll turn it back over to you.

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Marilyn Mora, Cisco Systems, Inc. - Director of Global IR [58]
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Thanks, Chuck. Cisco's next quarterly earnings conference call, which will reflect our fiscal 2018 second quarter results, will be on Wednesday, February 14, 2018 at 1:30 p.m. Pacific time, 4:30 p.m. Eastern time. Again, I'd 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 feel free to contact the Cisco Investor Relations Department, and we thank you very much for joining the call today.

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Operator [59]
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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 (866) 421-0447. For participants dialing from outside the U.S, please dial (203) 369-0803. This concludes today's call. You may disconnect at this time.

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