These prepared remarks should be viewed solely in conjunction with the related quarter s conference call webcast and press release, which can be found here. The webcast includes the prepared remarks as well as a question and answer session. Please click here for complete GAAP reconciliation information between our GAAP financial results and our non-gaap financial results. Cisco Systems, Inc. [CSCO] Q3 2016 Financial Results Conference Call May 18, 2016 Introduction Welcome everyone to Cisco's third quarter FY16 quarterly conference call. This is Marilyn Mora, Head of Investor Relations, and 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 fourth quarter. They are subject to the risks and uncertainties that we 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 forwardlooking 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.
As a reminder, in Q2, on November 20th, we completed the sale of the Customer Premises Equipment portion of our SP Video Connected Devices business, and, accordingly, had no revenue or expense from that business in Q3 FY16. 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 our historical results. We have provided 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 Q2 earnings call and today's call has been normalized in the same way. So with that, I'll go ahead and turn it over to Chuck. Opening Remarks Thank you, Marilyn. We delivered strong Q3 results against a backdrop of a macro environment that continues to be uncertain. Despite this uncertainty, we executed very well, with revenue growth of 3% and non-gaap EPS growth of 6%. We continued to generate strong operating cash flow of over $3 billion in the quarter, returning nearly $2 billion to shareholders through dividends and share repurchases. Our commitment to operating discipline continues to yield solid results in spite of the challenging environment. The operational changes we continue to make will further enable our customers to leverage a strategic role of the network as they transform their businesses to become digital. As I did last quarter, I'd like to highlight our momentum in four key areas. First in security, we saw continued acceleration in the third quarter, with revenue growth of 17%, while deferred revenue grew 31% driven by our ongoing shift from hardware to more software and subscription services. Our security business is tracking, as we indicated it would earlier in the year. As one of the largest IT security vendors, we believe our portfolio is the most comprehensive and effective in enabling our customers to protect their businesses. Security is and will remain one of our absolute highest priorities. Second, collaboration - revenue accelerated by 10% and deferred revenue here grew 16%. This is yet another example of a successful transition to a cloud-based platform, increasing our market leadership, which we expect will give us sustainable long-term differentiation.
Third, our next generation data center portfolio is extremely well-positioned to meet our customers' needs regardless of where they place their workloads, enabling public, private, or hybrid cloud deployments. At our Partner Summit, we received a very strong response to our innovations as customers adopt our next generation data center solutions. Our strong position is evident in our installed base of 52,000 UCS customers, and the continued success of our ACI portfolio. In March, we announced a dramatic improvement in price performance. And by this, I mean 100 gig performance for 40 gig pricing, driven by new ASICS, which provide us a time-to-market advantage of 18 to 24 months, while maintaining the same margin profile. In Q3, our ACI platform grew revenue approximately 100% while it exceeded a $2 billion annualized run rate, far outpacing our next closest competitor in both size of business and growth rate. Our entry into the hyper-converged market with HyperFlex, as well as our acquisition of CliQr, an innovator in multi-cloud orchestration, extend our leadership position in the data center. Finally, we continue to make great progress in transitioning more of our revenue to recurring, with increased emphasis on software and subscription offers. Our software subscription deferred revenue balance continues to exhibit accelerated growth, this quarter up 36%. We have a number of strong proof points for how we've executed successfully against our objective, and the potential to apply the same model to the rest of our portfolio. In addition to the success I've highlighted in our security and collaboration businesses, we had double-digit revenue growth again this quarter in Meraki, which stands out as an excellent example of how we've begun to scale our enterprise networking into a subscription model. As I look to the future, you will see us expand the approach we've taken with the success of Meraki, collaboration, and security, and apply it to our data center and core networking for both enterprise and service providers. Our $180 billion of installed base with by far the most widely adopted operating systems for networking, makes us uniquely positioned to lead this migration. While the overall macro environment remains uncertain, we are nicely positioned to benefit from any rebound in the global economy. At the same time, we will continue to manage our business to capitalize on the key growth areas in front of us.
I'm very pleased with our demonstrated ability to execute operationally and strategically in virtually any environment. Now I'll turn it over to Kelly to walk through more details on our financials. Financial Overview 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 $12 billion, up 3%, with growth in product revenue of 1% and services of 11%. We did have an extra week in Q3. Consistent with our guidance for the quarter, the benefit to revenue was approximately $265 million, $200 million of which was from our services, subscription businesses, and $65 million from our SaaS businesses like WebEx, as well as some from our product distribution. In switching, as Chuck mentioned, we continue to see good momentum with ACI and the next generation data center. The 3% decline in switching was mostly driven by macrorelated weakness in our campus business, offset by positive growth in data center switching. Routing experienced 5% decline, mostly driven by the high end. We are seeing continued strength with our web scale customers where our co-development continues and our sales to the top 10 web scale customers was up 31%. Collaboration grew 10% by strength across the entire portfolio, and deferred revenue grew 16%. WebEx continued its double-digit growth with solid performance in telepresence and unified communications, driven by our new offerings in those areas. Data center grew 1%, with the slower growth largely driven by continued macro challenges impacting customer spend. We expect that our HyperFlex offering will further expand our growth opportunities in the data center. Wireless grew 1%, led by strong double-digit growth in our cloud-based Meraki platform, partially offset by declines in our controller and access point businesses.
Security grew 17%, along with continued strong deferred revenue growth of 31%. We had great performance in our advanced threat security and web security solutions, which grew over 100% and 50%, respectively. SP Video grew 18%, with ongoing strength in China. Services revenue grew a very solid 11%, which includes the $200 million for the extra week I mentioned. Normalized for the extra week, the growth was 4%. We again saw very good progress against our goal of driving more recurring revenue. Deferred revenue had solid growth of 8%, with product deferred revenue up 9% and service up 7%. The portion of our product deferred revenue relating to our recurring software and subscription business grew 36%. From a orders perspective, product orders grew 3% with a book to bill comfortability above one. Looking at our geographies, which is the primary way we run our business, Americas grew 4%, EMEA was up 2%, and APJC grew 1%. Total emerging markets grew 4%, with the BRICs plus Mexico showing strength up 4%, and China up 22%, and India up 18%. Brazil and Russia continue to be challenged and now combined representing less than 2% of our total product bookings. In terms of customer segments, enterprise declined 2% and commercial grew 8%. Public sector grew 6% and service provider was flat. Similar to Q2, we are seeing pressure in the enterprise segment driven by the macro uncertainties. We drove strong profitability this quarter, especially with gross margins. From a non- GAAP perspective, gross margin was 65.2%, with product gross margin of 64.5% and service gross margin of 67.1%. Operating expenses were 35.2% of revenue and operating margin was 30%. The total impact of the extra week on our non-gaap cost of sales and operating expenses was $150 million. We are being very disciplined in this tough macro and pricing environment, focused on making the right investments while driving operational efficiencies and productivity. From a bottom-line perspective, we delivered non-gaap EPS of $0.57, up 6%, while GAAP EPS was $0.46. Q3 non-gaap net income was $2.9 billion, up 4%, while GAAP net income was $2.3 billion.
We've been very active from an M&A perspective, closing five acquisitions in Q3. Jasper Technologies, making Cisco the largest cloud-based IoT service platform, helping enterprises and service providers launch, manage, and monetize IoT services on a global scale. Acano, which provides on-premise and cloud-based video infrastructure and collaboration software. Synata, which enables us to deliver search capabilities for collaboration cloud application. Leaba, a fabless semiconductor company. And CliQr, which provides an application-defined cloud orchestration platform, which is expected to help Cisco customers simply and accelerate their private, public, and hybrid cloud deployment. These acquisitions are clearly focused on our key growth areas, including IoT, software, cloud and collaboration, as well as continuing to strengthen our core. We've also seen solid momentum with our Ericsson partnership, closing 17 deals this quarter. Moving on to shareholder value, in Q3, we delivered operating cash flow of $3.1 billion. Total cash, cash equivalents, and investments at the end of Q3 were $63.5 billion, with $6.3 billion available in the US. We returned $2 billion to shareholders during the quarter that included $649 million of share repurchases and $1.3 billion for our quarterly dividend, which we increased by 24% in Q3. Overall, Q3 was a very solid quarter in a difficult macro environment. We focused on strong operational execution, resulting in top-line growth, strong gross margins, and continued operating leverage consistent with our expectations. We're making the right investments in the growth areas of the business, balancing our decisions with sound portfolio management. Guidance Let me now reiterate the guidance we provided in the press release for the fourth quarter of FY16. This guidance includes the type of forward-looking information that Marilyn referred to earlier. The guidance for Q4 is as follows - we expect revenue growth to be in the range of 0% to 3% year over year, normalized to exclude the SP Video, CPE business from Q4 2015. We anticipate the non-gaap gross margin rate to be in the range of 63% to 64%. The non-gaap operating margin rate is expected to be in the range of 29% to 30%. And the non-gaap tax provision rate is expected to be 22%. Non-GAAP earnings per share is expected to range from $0.59 to $0.61. We anticipate our GAAP EPS to be lower than the non-gaap EPS by $0.08 to $0.11. 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. Summary Comments Thanks, Kelly. So let me quickly summarize before we move to questions. First, I think the number one key takeaway is that we continue to execute well, even in an obviously very tough environment. Secondly, we've proven our ability to transition certain elements of our portfolio, like we've done with Meraki security and collaboration. And we believe we can accelerate long-term growth by bringing this same approach to our core, and this process has begun. And finally, everything we do will be done through a lens of enabling our customers' success while driving value for our shareholders. The prepared remarks set forth above and the related conference call may be deemed to contain forwardlooking statements, which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among other things, statements regarding future events (such as the impact of the challenging macro environment, our ability to transition our business model to software and recurring revenues across our entire portfolio, our ability to deliver profitable growth and maintain strong margins, and our financial guidance) and the future financial performance of Cisco that involve risks and uncertainties. Readers are cautioned that these forward-looking statements are only predictions and may differ materially from actual future events or results due to a variety of factors, including: business and economic conditions and growth trends in the networking industry, our customer markets and various geographic regions; global economic conditions and uncertainties in the geopolitical environment; overall information technology spending; the growth and evolution of the Internet and levels of capital spending on Internet-based systems; variations in customer demand for products and services, including sales to the service provider market and other customer markets; the return on our investments in certain priorities, key growth areas, and in certain geographical locations, as well as maintaining leadership in routing, switching and services; the timing of orders and manufacturing and customer lead times; changes in customer order patterns or customer mix; insufficient, excess or obsolete inventory; variability of component costs; variations in sales channels, product costs or mix of products sold; our ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; our ability to achieve expected benefits of our partnerships; increased competition in our product and service markets, including the data center market; dependence on the introduction and market acceptance of new product offerings and standards; rapid technological and market change; manufacturing and sourcing risks; product defects and returns; litigation involving patents, intellectual property, antitrust, shareholder and other matters, and governmental investigations; man-made problems such as cyber-attacks, data protection breaches, computer viruses or terrorism; natural catastrophic events; a pandemic or epidemic; our ability to achieve the benefits anticipated from our investments in sales, engineering, service, marketing and manufacturing activities; our ability to recruit and retain key personnel; our ability to manage financial risk, and to manage expenses during economic downturns; risks related to the global nature of our operations, including our operations in emerging markets, currency fluctuations and other international factors; changes in provision for income taxes, including changes in tax laws and regulations or adverse outcomes resulting from examinations of our income tax returns; potential volatility in operating results; and other factors listed in Cisco s most
recent reports on Forms 10-Q and 10-K filed on February 18, 2016 and September 8, 2015, respectively. The financial information contained in the prepared remarks and the related conference call should be read in conjunction with the consolidated financial statements and notes thereto included in Cisco s most recent reports on Forms 10-Q and 10-K as each may be amended from time to time. Cisco s results of operations for the three and nine months ended April 30, 2016 are not necessarily indicative of Cisco s operating results for any future periods. Any projections in the prepared remarks and the related conference call are based on limited information currently available to Cisco, which is subject to change. Although any such projections and the factors influencing them will likely change, Cisco will not necessarily update the information, since Cisco will only provide guidance at certain points during the year. Such information speaks only as of the date of the prepared remarks and the related conference call.