Cisco Systems Q1 Earnings Call Transcript

123jump.com Staff
11 Nov, 2008
New York City

Cisco, the networking company revenue increased 8% to $10.3 billion, an 8% from a year ago and net income increased 6% to $2.2 billion or $0.37 per share from $0.35 per share. The Company anticipates fiscal second quarter earnings per share between $0.05 and $0.08 per share.

Cisco Systems Inc. ((CSCO))
Q1 2009 Earnings Call Transcript
November 5, 2008 1:30 p.m. PT

Executives

Blair Christie – Senior Vice President of Corporate Communications
John Chambers - Chairman and Chief Executive Officer
Frank Calderoni – Executive Vice President & Chief Financial Officer
Ned Hooper - Senior Vice President of Corporate Development and Consumer Group

Analysts

Simona Jankowski - Goldman Sachs
Mark Sue - RBC Capital Markets
Etai Kidron - Oppenheimer and Company
Jeff Evenson - Sanford C. Bernstein
Tal Liani – Merrill Lynch & Co., Inc.
Scott Coleman - Morgan Stanley
Ehud Goldblum – JPMorgan
Paul Silverstein - Credit Suisse

Presentation

Operator

Welcome to Cisco Systems first quarter fiscal year 2009 financial results conference call. At the request of Cisco Systems, today''s conference is being recorded. If you have any objections, you may disconnect.

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

Blair Christie

Great. Thank you Kim and good afternoon everyone. Welcome to our 75th quarterly conference call. This is Blair Christie and I’m joined by John Chambers, our Chairman and CEO, Frank Calderoni, Chief Financial Officer, Rick Justice, Executive Vice President of Worldwide Operations and Business Development, as well as Ned Hooper, Senior Vice President of Corporate Development and Consumer Group, and Rob Lloyd, Senior Vice President of Sales for US, Canada, and Japan.

The Q1 fiscal year 2009 press release is on Full National Market Wire and the European Financial and Technology Wire, and on the Cisco website at www.Cisco.com. I would like to remind you that we have a corresponding webcast with slides. In those slides, you will find the financial information we cover during this conference call, as well as additional financial metrics and analysis that you may find helpful. Additionally, downloadable Q1 financial statements will be available following the call, including revenue segments by product and geography, income statements, full GAAP to non-GAAP reconciliation information, balance sheets, and cash flow statements can be found on our website in the Investor Relations section. Click on the financial section of the website to access the webcast slides and these documents.

A replay of this call will be available via telephone from November 5th through November 12th at 866-357-4205 or 203-369-0122 for international callers and is also available from November 5th through January 16th on Cisco’s Investor Relations website at www.Cisco.com/go/Investors.

Throughout this conference call we will be referencing both GAAP and non-GAAP financial results. As is customary with many companies, we have used this Q1 time period to reflect certain immaterial reclassifications to our financial statements and results, which will also be reflected in our Form 10-Q. The financial results in the press release are unaudited. The matters we will be discussing today include forward-looking statements, and as such are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent annual report on Form 10-K and any applicable amendments which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

Unauthorized recording of this conference call is not permitted, and I will now turn it over to John for his commentary on the quarter, John.

John Chambers

Thank you Blair. During the opening comments of the conference call, I will focus on what I view to be the key takeaways for Q1 fiscal year 2009, an update on why we continue to be comfortable with our long term growth goals of 12% to 17%, assuming that the global economy returns to normal growth rates, a very candid discussion about what we are seeing in the market on a global basis relative to Q1 and its effect on our Q2 expectations, then finally our revenue guidance for Q2 with the appropriate caveats.

Frank will follow these opening comments with additional detail on Q1 fiscal year 2009. The third section of the call will focus on business momentum and strategy from a geographic, product, customer statement perspective. Frank will then follow with additional financial parameters around our guidance. I will then wrap it up with some comments in terms of Cisco’s momentum going into Q2, and finally our Q&A session.

Q1FY2009 was a solid quarter for Cisco from a revenue and an earnings per share perspective, especially given the many challenges that we are all seeing occur in the global marketplace. In terms of those areas that we can control or influence, we continue to feel very comfortable with both our progress in the quarter and our long-term vision and differentiated strategy as we move into new market adjacencies.

We exited Q1 with an extremely strong position in the marketplace, approximately $27 billion in cash and investments, solid balance from the product, geographic, and customer segments perspective, perhaps one of the broadest balances across the IT industry, continued success in being the number one and number two player in most of our 20 plus targeted product areas, an innovation engine that results in product leadership across the broadest range of products that we’ve had in our history, combined with a product pipeline of new innovation that we believe is also the strongest we have ever had.

Not only is our end-to-end technology architecture from the device to the data center across any combination of networks enabling the next generation of entertainment and business models, but we have had what we believe to be the strongest position in terms of customer relationships at the enterprise and service provider level, and helping to enable our customers’ business goals.

Just as we led in the first phase of the Internet, i.e. Web 1.0, from both the internal utilization and the expertise we offer our customers to enable this capability, we believe we are now uniquely positioned to provide very similar leadership in the second phase of the Internet, through collaboration enabled by networked Web 2.0 technologies. Once again, we are leading in our terms of our own utilization and partnering with our customers to drive their goals of changing business model enabled by the network.

Now moving on to a summary of our Q1 financials. We were pleased with the following results. Revenue was $10.3 billion, approximately an 8% year-over-year increase. Cash generated from operations was $2.7 billion. Non-GAAP earnings per share were $0.42, a 5% year-over-year increase and GAAP earnings per share were $0.37, a 6% year-over-year increase. Total non-GAAP gross margins were very solid at 65.6%, an increase from 64.9% last quarter. Non-GAAP operating expenses as a percentage of revenues for Q1 were 35.8%.

We continue to drive innovation and product leadership from our core, advanced and emerging technologies. The following is a summary of each of those areas for Q1 in terms of year-over-year product revenue growth. Core technologies and services were solid with switching growing at 8% year over year, routing growing at 1% and service revenues growing at 10% year over year.

Our first wave of advanced technologies grew 15% year over year, unified communications within that group grew at 22%, wireless grew at 21%, security grew at 19%, the networked home decreased 2% and storage decreased 4%. Our second phase of advanced technologies had a very strong quarter with revenue growth year over year of 22%. Application networking services grew 25% and video systems grew 21%.

Our early stage internal start-ups that we call “Emerging Technologies” were also solid in Q1 in terms of year over year order growth. Our strategy is to develop a reasonable percentage of these emerging technologies into what we categorize as advanced technologies, with a realistic probability of becoming $1 billion plus in sales and the number 1 market position in their respective product categories.

Overall progress was again very strong in this quarter. While these numbers are not material financially at this point in time, we believe that with proper execution they can become very significant to our long term growth rates in the longer run. The Emerging Technology Group orders in total grew approximately 180% year over year. We had strong year over year order growth from the mid-teens to the low 30s in the following countries - China, Canada, Japan, Russia. While we find some of our largest countries such as the US, UK and Italy with negative order growth year over year in Q1. We’ll provide additional details on geographies and customer segments later in the conference call.

In summary, for those areas that we can control and influence, we feel we are doing reasonably well. The key market transitions relative to collaboration and digital networking, which will drive productivity for the next decade, are evolving even faster than we thought one quarter ago. However, all of us are seeing the same financial and global economic challenges that have occurred over this last quarter, especially in the month of October. At this point in time, I would like to share with you some of the detail about how we will approach the current challenges and our underlying assumptions regarding our short-term strategy by taking these challenges into consideration.

First, we start with a culture and track record of using economic challenges to gain market share and profit share and move into new market adjacencies. Our long term growth goals, assuming reasonable global balance and GDP growth have not changed and will remain in the 12% to 17% range. Third, it was one year ago when Cisco was among the first to indicate we were seeing some challenges in orders from our US financial and global accounts. We do believe that these challenges we have seen in the US have expanded to Europe, as well as many of the emerging market countries and finally into Asia. But if there is one lesson learned during the preceding economic challenges that Cisco faced in 1993, 1997, 2001 and 2003, it is the importance of taking action early and while not losing track of long-term objectives.

We also want to use this call, as we have done in the past, to share very transparently what we are seeing in terms of order momentum and feedback from our customers, with the appropriate caveat that we could be wrong in our assumptions and strategies. Our approach to all of the economic slowdowns that have occurred over the last two decades has remained very similar. We will follow this approach in dealing with the current challenges. When we see these market transitions occurring, we go through our playbook, if you will, for economic downturns where there are four basic guidelines that we follow.

The first is to determine is it the macro-environment or your strategy. Candidly determine if the slowing of your business is due primarily to market forces, and that your strategy is working well or was your challenge largely self-inflicted? If your strategy was working well, stay focused on its implementation.

Second, length and depth of a downturn. Determine the magnitude of the slowdown and your best estimate on the length and depth of the slowdown, then adjust and realign your asset utilization appropriately.

Third, prepare for the upturn. Start preparing as soon as possible for the upturn and how you are going to gain share and differentiate yourself from your peers as it relates to profitable growth.

Fourth, expand customer relationships. Use the slowdown to take advantage of building even stronger relationships and differentiation with your customers.

Just as we’ve done in prior challenges, we will also implement our game plan or action plan, if you will, for dealing with these challenges while following our playbook with the four basic guidelines outlined above. The game plan for the current downturn will have six major points and will be called our six-point plan.

Point one of the plan is our vision, strategy and execution model and it’s the fabric for implementation success. First, we believe our vision of how the industry will evolve is being driven by the increasing role intelligent networks will play as all forms of communications and IP are enabled by the network. This transition is occurring as we expected. Our differentiated strategy enabled by the network collaboration is allowing us to move into market adjacencies with tremendous speed, scale and flexibility. Cisco will remain focused on both the technology and business architectures to enable our customers’ objectives. In short, our vision, strategy and execution approach is working well and we plan to stay focused on continuing to expand this approach.

Second, collaboration/Web 2.0 driving the future growth and productivity. We will continue our rapid expansion of collaborative technologies and new business models in both our product architectures and our own internal IT implementation. We plan to quickly realign resources to focus on over two dozen market adjacencies that will loosely, then tightly, come together with our core technologies, and we will be the best example of using Web 2.0 technology such as TelePresence, WebEx, Wikis, blogs, discussion forums, C-Visions, widgets, etc. in an architectural process driven approach that drives productivity and new business models.

Third, resource management and realignment – through our councils and board structures, we have already realigned over 500 million of resources through these opportunities. Beginning in Q2, our goal is to realign another 500 million of resources while at the same time reducing our expenses for fiscal year ’09 by over 1 billion from our original budget. Our goal is to achieve these changes by the end of Q4 of fiscal year 2009. This includes a pause in hiring as well as reductions in travel, off-sites, outside services, equipment, events, prototypes, marketing and other activities.

Fourth, we intend to be aggressive in our strategy, prioritize and then execute. We will also be bold in taking good business risks during this downturn to build our market transitions, opportunities, and put our many assets to use in existing and new markets as the recovery occurs. We will prioritize the top five objectives of both the company and then each of our councils and boards. The top five objectives for the company are - next generation company and next generation relationships, what we call Cisco 3.0 and Rob you’re leading of course. Second - collaboration/Web 2.0. Third - data center virtualization. Fourth - video, and fifth, globalization. We will then align our resources to these top priorities, both as a company and within each of the councils and boards.

Fifth - investment in the US and selective emerging countries. We intend to invest aggressively in two geographic areas – the US and selective emerging countries. In our opinion, the US will be the first major country to recover. Therefore, we will make many of our market adjacency adjustments in the US. On the other hand, we believe countries like China and India are the best positioned among their emerging country peers to minimize the effect of global challenges on their own economy. We are also optimistic that we will continue to see strong support by many governments around the world to minimize the effects of these major changes.

Also, built into our assumption is the view that many companies will use network technology for innovation, productivity, speed and skill, both during the downturn and positioning for the upturn. The strategy on emerging countries is simple – over time we expect the majority of the world’s GDP will come from these emerging countries. In expanding these relationships during tough times, our goal is to be uniquely positioned as the market turnaround occurs. This is identical to what we did in the Asia 1997 financial crisis.

And sixth, the power of the network as a platform, driving the future of communications and IT. Finally, we will remain focused on our stretch goal of evolving into the top communications and IT company, which will be enabled by the expanding role of intelligent networks. This could be the definition of a very success implementation of our six-point plan, looking three to four years out, after the inevitable upturn occurs.

Now at this time, I would like to give you some additional data and customer feedback for you to understand why we are moving rapidly to realign our call structure after a solid Q1 fiscal 2009. There were a number of positives in the quarter, such as our financial results, balance product revenue growth, advanced technology growth and solid momentum from some of our developed and emerging geographies such as Latin America, China, Germany, Japan, Canada and Russia. There were, however, even more challenges from an order perspective as well as global customer feedback on the health of their businesses, especially in the US and Western Europe.

Over 70% of our business comes from the US and Western Europe today. Both experienced negative year over year order growth in Q1. We are seeing customers, not just in the financial, automotive or retail sectors, but across most of our enterprise industries facing what they view as a very challenging business environment. This started in the US, it then in our opinion expanded to Europe, then to emerging market theater, and now to Asia. Total year over year product order growth varied dramatically during the quarter from August to October. In August our order growth increased by 7% year over year, while in October our order growth decreased by 9% year over year. Overall for Q1 year over year product order growth decreased by 3%. While revenue growth in Q1 was a solid 8%, book to bill was below 1.

In summary, we were one of the first high-tech companies to report our quarter that included October. These challenges that we saw in the US did spread globally in our opinion. The environment has changed dramatically in the last two months with the financial crisis in September and the economic crisis becoming more apparent on a global basis in October.

Cisco is uniquely compared to many of our peers in that approximately 84% of our business is non-recurring each quarter, and therefore is a good indicator of new spending patterns. Also, our balance across all major geographic areas, four major customer segments, and over two dozen product families normally works to our advantage. But when you are the number one player in many of these categories and the slowdown has truly gone global across all of these industry segments, geographies and product families, we will be impacted.

It is very difficult, given all of the uncertainties going on in the market to provide a forecast, give the dramatic variability and it is probably the second most difficult time in my career in terms of my comfort level with the forecast. It would not be a major surprise to see these numbers vary on either the positive or negative side of revenue guidance that we provided for Q2. In providing our revenue guidance for Q2 fiscal year ’09, we are going to assume that what we saw in October in terms of order momentum challenges will continue into the next quarter. This is also what we are hearing from our global customers as our field rolls out their forecast for Q2.

As we have said in conference calls over many years, Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors and our ability to execute or not on our strategy and other factors, as discussed in our SEC reports. For purpose of our long-range goals, as well as our quarterly guidance, we are also assuming that our vision of how the industry and the market will evolve will be accurate and we will effectively execute on that vision. With this in mind our revenue guidance for Q2 fiscal year 2009 including our usual caveat as discussed earlier and in our financial reports is for revenue to decrease in the 5% to 10% range year over year.

Again, as a reminder during each of the past economic slowdowns Cisco has always navigated through them very effectively. We did this in 1993, 1997, 2001, 2003, and in each scenario we gained both wallet share and in my opinion profit share. As a result, we were better positioned coming out of these transitions versus our peers.

We will also continue to be aggressive in our investments during this slowdown. Cisco will use this time as an opportunity to expand our share of our customer spend and we will be aggressive about moving into market adjacencies during the slowdown.

As we approach both the opportunities and challenges in front of us, we bring a very experienced and broad leadership team that has been through these challenges together over the last decade. We also bring a culture that adjusts very quickly to change and has consistently continued to execute effectively, regardless of the opportunities or challenges, and as we have done before, leveraging market slowdowns to move into many new market adjacencies.

While we all wish these challenges would not occur, it is during these times that we have consistently gained the confidence of our customers, partners, shareholders and employees, to be even stronger versus our peers following these challenges.

In summary, we believe that we are very well positioned in the industry from a vision, differentiated strategy and an execution perspective. We believe we are entering the next phase of the Internet as growth and productivity will center on collaboration enabled by networked Web 2.0 technologies. We would do our best to provide the product architectures and the expertise to help our customers in the implementation of these collaborative capabilities from a technology and a business perspective. We will also share with our customers how we''ve done this internally. In short, we are going to attempt to execute a strategy over the next decade that is similar to what we did in the early ''90s, and as we said before, it powered our growth for the next decade, except with the obvious differences of being a Company that is now at a run rate of approximately 40 billion with over 67,000 employees focused on our opportunities.

Now, I''d like to turn it over to you, Frank.

Frank Calderoni

Thanks John.

John Chambers

You''re welcome.

Frank Calderoni

As John stated earlier, Cisco has a strong history of successfully navigating market transitions and I remain confident that our financial model enables us to execute in both good and tough environments. For today''s call I will provide a recap of our solid financial results for the first quarter of fiscal 2009, and then I will discuss why I believe our financial strength positions us well to manage during the uncertain economic environment we saw, especially in the second half of the quarter, but also more importantly going forward.

Total revenue for the first quarter was $10.3 billion, an increase of approximately 8% year over year, in line with our guidance. Switching revenue was $3.6 billion, an increase of 8% year over year, driven by growth in both our modular and our Switch Fix switching portfolio. Routing revenue was $1.9 billion, up 1% year over year. Advanced Technologies revenue totaled $2.7 billion representing an increase of 17% year over year with strong performance in unified communications of 22% year-over-year growth, video systems growth of approximately 21% year over year, securities with growth of approximately 19%, wireless LAN growth of approximately 21% and application networking services growth of approximately 25%. Other product revenue totaled $442 million, a decrease of 13% year over year related to our obstacle and cable business this quarter.

Total service revenue was $1.7 billion, up 10% year over year with solid growth in emerging markets. We are pleased with our growth and advanced services of approximately 15%. Total revenue growth by geography ranged from 1% year over year in the US and Canada to a high of 41% in emerging markets. Emerging markets revenue growth for the quarter was higher than the order growth rate that John reported due to some increased shipments, recognition of previously deferred revenue, and the affect of our reserves from Q1 of fiscal year ’08.

We want to remind you that revenue growth in emerging markets may experience variability and order growth may provide a better indication of future revenue performance.

Q1 total non-GAAP gross margin was 65.6%, up 7/10ths of a point quarter over quarter and up 4/10ths of a point year over year. For products only non-GAAP gross margin for the first quarter was 66.2%, up a percentage point quarter over quarter and up 6/10ths of a point year over year. The quarter-over-quarter improvement was driven by higher cost savings partially offset by product mix. The year-over-year improvement was driven by higher cost savings partially offset by higher product discounts as well as mix.

Our non-GAAP service margin for the first quarter was 62.4%, down from 63.1% last quarter and 63.5% in Q1 fiscal year ’08. Service margin will typically experience some variability over time due to various factors, such as the changes in mix between our technical support services and advanced services as well as the timing of support contract initiations as well as renewals.

Total gross margin by geography range from 63.4% for emerging markets to 69% in Japan this quarter. Across the geographies, the margins have remained relatively stable over the last few quarters. Non-GAAP operating expenses as a percentage of revenue were approximately 35.8% in Q1 fiscal year ''09, relatively consistent with the 35.7% we had in Q1 fiscal year ''08.

Foreign exchange impact for the quarter was 46 million when compared to the same period last year, which added approximately 4/10ths of a point to this ratio. Excluding foreign exchange, our non-GAAP operating expenses for Q1 grew at 7% year-over-year.

Interest and other income was $123 million for Q1, which includes the recognition of realized gains, losses as well as impairments.

We remain very pleased with our diversified high quality cash and investment portfolio. I will provide more detail on the investment portfolio in just a few moments.

Our Q1 fiscal year ''09 non-GAAP tax provision rate was 22%, down approximately 2 points from fiscal year ''08. This decline in the effective tax rate was driven primarily by the renewal of the U.S. federal R&D tax credits which occurred last month and a more favorable mix of foreign earnings at lower tax rates.

Non-GAAP net income for the first quarter of fiscal year 2009 was $2.5 billion, which was flat year-over-year. As a reminder, in Q1 fiscal year ''08, we did record a one-time tax benefit of $162 million.

Non-GAAP earnings per share on a fully diluted basis for the first quarter were $0.42 per share, up from $0.40 per share in the first quarter of fiscal year 2008, a 5% increase year-over-year and our highest earnings per share to date. The one-time tax benefit in Q1 fiscal year ''08 was approximately $0.03 per share.

Non-GAAP net income for the first quarter was $2.2 billion, flat compared to $2.2 billion in the first quarter of fiscal year 2008. GAAP net earnings per share on a fully diluted basis for the first quarter were $0.37 per share. That was up from $0.35 per share in the same quarter of fiscal year 2008.

Now moving on to the balance sheet. The total of cash, cash equivalents and investments at the end of Q1 was $26.8 billion, up $528 million from Q4 fiscal year ''08. During Q1, we generated $2.7 billion in cash flow from operations as well as $224 million in proceeds from stock option exercises.

For the quarter, we repurchased $1 billion of common stock or 46 million shares of our stock, at an average price of $21.95 per share. We ended the quarter with approximately $7.4 billion remaining in the current stock repurchase authorization.

Moving on to accounts receivables. We ended the quarter at $3.3 billion, which was down 14% from Q4 fiscal year ''08. At the end of Q1, days sales outstanding or our DSO, was 29 days compared to 34 days in Q4 fiscal year ''08, driven by lower service billings due to seasonality, as well as improved collections.

Total inventory at the end of Q1 was $1.2 billion. That was flat quarter-over-quarter. Non-GAAP inventory turns were 11.6 this quarter, which was also flat from last quarter. Our inventory purchase commitments at the end of Q1 were $2.9 billion, up 5% from the end of Q4 fiscal year ''08.

Deferred revenue was $8.8 billion at the end of Q1, an increase of approximately 24% year-over-year. Deferred product revenue was 2.9 billion, up approximately 18% from last year, while deferred service revenue was $6 billion, up approximately 28% year-over-year.

At the end of Q1, our headcount totaled 67,647, a net increase of approximately 1,518 from Q4 fiscal year ''08, of which more than 50% were college hires, which we normally experience in Q1 each year. Separate from our college hires, we added 722 to headcount this quarter, which were mostly in engineering, sales and services. In mid-October, we did implement a pause in our external hiring while we did assess the changing macro-economic environment.

Now, I''d like to discuss how we are managing Cisco''s financial position in both good times and challenging times, and why we believe this gives us a competitive advantage and positions us to manage our business well and continue to lead in the future.

We do understand that during turbulent economic times like we are currently experiencing, our investors would like a solid understanding of key areas that we believe allow us to perform well. I would start by saying with nearly $27 billion in cash, cash equivalents and investments, a solid balance sheet, visibility into our supply chain, strong investment portfolio management and our Cisco Capital financing arm, all of which provide a key competitive advantage, we believe we are well positioned to manage our business through any type of market condition.

For example, take the key items that influenced our results this quarter. First, we continue to have very high quality receivables, as evidenced by our DSO of 29 days. We continue to conduct rigorous assessments of the quality of our receivables given the current market conditions and we remain comfortable with our portfolio. Second, our strong supply chain management continues to be a key lever in our ability to maintain strong gross margins, while at the same time, providing visibility and management of our demand planning. Over the last several years, we have significantly enhanced our supply chain capabilities to better anticipate and manage our demand. Our lean manufacturing model allows us to more fully optimize our supply chain inventory investment.

We have enhanced processes and systems to provide increased visibility into inventory management and better responsiveness to fluctuations in demand. Over time, this has resulted in better lead times, on-time shipment predictability and improved inventory management across our supply chain.

While there is always inherent risk, given the current economic environment, we have enhanced the monitoring of our supply base to identify potential issues so that we can take appropriate measures on a timely basis.

Key metrics, such as inventory turns, purchase commitments, and ongoing review of excess and obsolete inventory remains strong and again, contributes to Cisco''s consistent gross margin performance.

Third, our investment strategy has served us well in this turbulent environment. The overall credit quality of our portfolio is extremely strong with our cash and fixed income portfolio invested in securities with an average credit rating of AA or better. In light of more challenging market conditions over the last six months, we have more conservatively managed our $27 billion diversified portfolio. This has resulted in slightly less than a 1% mark-to-market impact on our cash and fixed income portfolio valuation when compared to last quarter.

Finally, our financing arm, or Cisco Capital, continues to provide financing to our customers and our channel partners, which enables incremental sales of Cisco''s products, services and networking solutions. In fiscal year ''08, Cisco Capital originated or facilitated approximately $4.3 billion in lease and longer term loan arrangement. While the number of credit requests or inquiries has increased in the current environment, we have adhered to our consistent methodology and prudent financing practices.

Our thorough review process for monitoring a variety of risk metrics has enabled us to effectively balance risk, rewards, as well as sales enablement. We believe there has been no material impact to the quality of our portfolio. Broadly speaking, we believe our portfolio has, on average, an investment grade profile. We remain comfortable with the credit profile and the way we are deploying our capital.

With respect to our accounting policies, we remain conservative in how we account for our Cisco Capital financing business. Specifically, this comprises gross lease receivables, loan receivables, finance service contracts and financing guarantees.

To update the numbers previously disclosed, at Q1 fiscal year ''09, we have a combined balance sheet and contingent liability position of approximately $4.4 billion. Of this $4.4 billion, we have a net reserve and deferred revenue position of $2.5 billion. This represents an overall reserve and revenue deferral position of over 50% of the financing portfolio position. Again, I would like to remind you that we believe this portfolio maintains on average or around investment grade.

We believe that Cisco Capital''s on-book lease and loan portfolio remains an excellent use of our own cash. We have not accessed any capital markets for funds to finance this element of our operations.

So in summary, we have long stated that our financial management and position are a competitive advantage for Cisco, and that belief has not changed, even in light of the current economic conditions. In fact, it is precisely during a difficult environment like we are currently experiencing that the strong financial foundation that we have allows us to focus on the things that we believe will grow our company and capture market transitions in the industry.

I do believe our performance this quarter reflects our ability to manage profitability during a period of uncertainty, and I expect that through continued prudent expense management, along with calculated investments in certain areas, we will be able to balance the priorities of growth and profitability as we move through the current environment.

Through our unwavering focus on customers, a strong financial foundation and the power of a very talented global work force, I believe Cisco will emerge stronger coming out of this period, and enhance its position as a global business leader.

I''ll now turn the call back over to John.

John Chambers

Thank you Frank.

In this section of the call, we will cover our geographies, customer segments and products for Q1 in more detail. The products review will be in revenue growth terms, while the geographic and customer segments will be discussed in terms of orders unless indicated otherwise.

First, from a geographic and a customer segment point of view in terms of Q1, year-over-year order growth, Japan. Japan continued their solid momentum in Q1 with growth of approximately 20%. Leading the way was service provider with growth of approximately 45% year-over-year, which represents approximately half of our total business in Japan. Public sector grew in the mid-teens. Enterprise and commercial were relatively flat. Overall, given all the challenges, we feel good about our momentum in the Japanese market.

Now, moving on to Asia-Pacific. Year-over-year order growth in Asia-Pacific in Q1 varied dramatically by country. China grew in the mid-teens, but India was down in the mid-single digits. From a customer segment perspective, service provider and the commercial market grew in mid-single digits, while enterprise was down in the high teens. Asia in total was down approximately 4% year-over-year in terms of orders.

Europe. After maintaining growth in our Q4 fiscal year 2008 in the low double-digits, we saw Europe''s growth slow to negative mid-single digits in Q1. Germany continued to do reasonably well, but the UK, Italy, Netherlands and Spain were challenged, all with double-digit decreases in orders year-over-year. From a customer segment perspective, commercial and the consumer were relatively flat in Europe. Public sector grew in the mid-single digits. Enterprise was down in the mid-single digits, but service provider was down in the mid-teens year-over-year.

Moving to the U.S., excluding Canada. For the U.S., orders in Q1 were down approximately 8% year-over-year. From a customer segment perspective, enterprise growth, not including public sector, was down in the high teens. Commercial, service provider and public sector were down in the mid-single digits in Q1 year-over-year.

Emerging Markets. The Emerging Markets Theater, not including our emerging Asian countries, was down slightly in terms of orders. Enterprise in the Emerging Markets was down in the high single digits while the commercial grew in the mid-single digits, service provider was down slightly Q1 year-over-year.

In summary, from a customer segment perspective, enterprise year-over-year order growth across all of Cisco was down approximately 11%, while the service provider, commercial and public sector were approximately flat from a year-over-year orders perspective.

Products. Q1 year-over-year product revenue growth was up approximately 8%. The detail of our individual product areas was covered in the opening section of our call.

In summary, although we all would like to avoid the downturns, our vision of how the industry is going to evolve appears to be playing out very much as we expected. We believe our differentiated strategy is also achieving the benefits both to Cisco and our customers that we thought were possible.

And finally, our execution is on target in terms of the results as measured by our customer partnership perspective, market share and share of our customers'' total communications and IT expenditures, as the network becomes the platform for delivering theses capabilities.

Now, I''d like to turn it back over to Frank for additional detail of the financial guidance and other financial highlights. Frank, back to you.

Frank Calderoni

Thanks John.

Let me remind you again that our comments include forward-looking statements. You should review our recent SEC filings that identify important risk factors and understand that actual results could materially differ from those contained in the forward-looking statements.

The guidance we are providing is on a non-GAAP basis with reconciliation to GAAP. It is very difficult to provide a forecast given the dramatic variability and the uncertainties going on in the market. These events increase the potential that our actual results could vary materially from our expectations.

To reiterate John''s earlier note, our revenue guidance for Q2 makes the prudent assumptions that the order momentum challenges that we saw in October will continue into Q2. Therefore, we anticipate total revenue for the second quarter to be down approximately 5% to 10% year-over-year.

At this point, let me remind you that in light of Regulation FD, Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

Now, let me give you additional details on the Q2 financial guidance.

As we have said in the past, forecasting gross margins has always been challenging due to various factors such as volume, product mix, variable component costs, customer and channel mix, as well as competitive pricing pressures. That being said, we believe that total gross margins in Q2 will be approximately 64%, reflecting the revenue guidance I just shared with you.

We believe Q2 operating expenses will be approximately 39% to 41% of revenue. As you would expect in this environment, and as John outlined earlier, we are focused on managing our expenses through a pause in hiring, further decreasing travel and discretionary related expenses, as well as deferring certain capital related projects. Also as John mentioned, our goal is to reduce our expenses for fiscal year ''09 by over $1 billion from our original budget. Considering the expense control actions I previously mentioned, this means we are targeting our Q4 fiscal year ''09 quarterly expense run rate to be reduced by about $200 million to $300 million as compared to our Q1 fiscal year ''09 quarterly expense run rate. While we will undertake appropriate expense management initiatives in the current environment, we will also make some calculated investments into areas where we believe we can accelerate development and Cisco''s leadership. We expect the areas will be adjacencies to our current markets where we feel it is possible to extend the network as a platform, such as Next Generation Company, globalization, virtualization of the data center, video and collaboration architecture.

We expect interest and other income to be approximately $130 million in the second quarter.

Our tax provision rate for Q2 is expected to be approximately 22%.

While we expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. We are modeling share counts to be down 50 to 100 million in weighted average shares outstanding for EPS purposes. In this estimate of share count, we are not taking into consideration any further change in stock price that could occur in the second half of fiscal year ''09.

As a point of reference, a $1 movement in our average stock price would change the calculated shares outstanding for purposes of determining EPS by approximately 10 million.

Regarding cash flow from operations, we would expect to generate $500 million to $700 million per month.

For our Q2 fiscal year ''09 GAAP earnings, we anticipate that Q2 GAAP EPS will be $0.05 per share to $0.08 per share lower than non-GAAP EPS, primarily due to acquisition related charges and stock compensation expense.

Please see the slides that accompany this webcast for more details.

Other than those items noted above, there are no other significant differences between our GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring, and tax or other events which may or may not be significant.

Again, I''ll turn the call back over to John.

John Chambers

Frank, thank you very much.

I''d like to make some summary comments at this point of my point of view of Cisco''s momentum and opportunities entering Q2 of fiscal year 2009.

In areas that Cisco can control or influence, our momentum continues to be solid in the areas of product leadership, innovation and thought leadership. Balance in a very tough environment, given the global challenges, continues to be reasonable across our geographies, products, services and customer segments. This balance normally works to our advantage when there''s a slowdown in a product area, a customer segment or one or two geographies. However, when you are often the number one player across these categories and the challenges truly go global across all these categories, it is almost impossible to avoid the impact.

As we said before, even if the market slows, we don’t see this changing our long-term growth targets. If we execute the way we have in prior slowdowns and assuming that the global economy recovers to GDP growth rates similar to those in the middle of the decade, as we continue into Q2 fiscal year 2009, we plan to aggressively invest in new and adjacent markets for the longer term assuming global recovery regardless of how long it takes for the macro-environment to rebound. We would not invest as aggressively if we were to determine this current slowdown was going to be long in duration and that we didn’t have a high probability of achieving our 12% to 17% long-term growth objectives in normal economic environments as the market recovers.

In terms of major areas where the momentum appears to be solid, and even possibly gaining, would be the following areas.

First, innovation and product leadership look very solid across our core technologies, first and second wave of Advanced Technologies and our new Emerging Technologies; second, collaboration and networked-enabled Web 2.0 acceptance and Cisco''s leadership role; third, speed, scale and flexibility. As we move into new market adjacencies based upon our collaboration and teamwork approach, our councils and boards'' organizational structure, combined with our vision, strategy and execution model; fourth, Emerging Markets. While some of the countries may be challenged in the short term, we are positioning ourselves especially in the selective emerging countries for the long run in terms of country transformation and partnerships with our customers at both the business and government levels; fifth, Japan and service provider, Next Generation build-out.

While we believe there are more positive areas than there are areas of concern, the areas that we continue to focus on are expanding and include the U.S., Europe and part of the emerging countries. As we stated earlier, we do believe that the challenges that initially affected the U.S. have spread to other countries around the world. On a global and U.S. basis, we see the same challenges and uncertainties from an economic, political and capital spending perspective that many of you continue to witness.

The second area that we are watching closely is service provider CapEx spending. One way to analyze CapEx growth and service providers is capital expenditures as the percentage of total sales. The rate of growth in this area appears to be moderating, although it varies dramatically from company to company and by geography.

While our technology and business partnership relationships in most of the service providers are continuing to get even stronger, there are clearly some very tough comparisons for our service provider business for fiscal year 2007 Q4 and fiscal year 2008 Q1 and Q2, which had very strong year-over-year growth rates in service providers.

Again, if the market does continue to slow, we believe this will not dramatically change our long-term opportunities with our vision of how the industry evolves and our differentiated strategy. In fact, it is our intent to expand our share of customer spend during these corrections as we''ve done in the past.

We also believe that our opportunities to expand in our current markets and market adjacencies are actually increasing. This is true from the data center to the home market, from the service provider to the small-to-medium business and consumer. Therefore, you will continue to see us invest aggressively, where appropriate, while maintaining our focus on our financial models.

Once again, with the usual caveats, as discussed earlier, and in our financial reports, our Q2 fiscal year 2009 guidance is for year-over-year revenue to be in the negative minus 5% to 10% range.

We believe our long-term growth opportunities remain in the 12% to 17% range, again, assuming our usual caveats and global GDP growth.

We will focus on what we can control and influence, and attempt to position Cisco to gain momentum and market transitions, whether they are in industry consolidation, product transitions, market adjacency opportunities or economics.

In summary, for those areas that we control and influence, we believe our vision, strategy and execution are in great shape and producing the results.

As always, I want to thank our shareholders, customers, employees and partners for their support and continued confidence in our ability to execute during rapid industry consolidation, market transitions and challenging economic times.

Now, Blair, I''d like to turn it back over to you for some comments and the Q&A.

Blair Christie

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

Question-and-Answer Session

Operator

Thank you. Our first question comes from Simona Jankowski with Goldman Sachs.

Simona Jankowski – Goldman, Sachs & Co.

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

John Chambers

Okay. Simona, you very creatively asked about three or four questions, but I’ll try to answer them as one. First let me go in reverse order and hit it very lightly, but if others of your peers want to discuss it in more detail we will. There are very few comparisons to 2001. 2001 was a different market; it was a high tech driven crisis. Our growth rates went from 50% plus growth rates for nine or ten quarters in a row to minus 45 growth in a period of nearly a month-and-a-half, 25% of our customers disappeared and you were at the end of an innovation cycle, the Web 1.0 run if you will and Cisco’s PE ranges in that time varied even during the height of the downturn between 20 and 100 in terms of going forward ratios, from fiscal year 2001 to fiscal year 2003. 2008 is a different model. The financial health of the majority of our customers is actually pretty reasonable. This is one driven by consumer and financial challenges, credit and the availability of cash. The role of the network has changed dramatically and it’s a value to our customers, way beyond transport not to say routers and switches has also increased. Loads on the network will probably grow, what nobody thought was going to occur just a couple of years ago, 2% to 500% and you are starting the next wave of innovation, dealing with mobility, collaboration, green, smart grid, data center virtualization, video, small businesses, emerging new countries, etc. And so, I see this as an entirely different model as it affects Cisco.

In terms of the margins, we are not facing any abnormal pressure rather in terms of from the customers, you will see this in just normal pressures from our peers as markets tighten up, but that’s something we’ve handled very well before. Too early to say before, but I would say, Frank, the odds are in terms of our components, you will see the component pricing not give as much advantage to us on the margins, perhaps this quarter, but I think if you begin to look at the next quarter or the quarter thereafter, if it plays out the way our supply chain believes is the most likely scenario, it looks like we will begin to pick up momentum within that. Part of gross margins is dependant upon volumes. We all understand that, but it is a nice way of saying we see this playing out fairly normally in terms of a little slowing in the market and that is how we categorize it. Frank, do you have anything to add that I missed here?

Frank Calderoni

What I would like to add is something that I mentioned earlier in the call. I think one of the benefits that we have here is a key benefit, is all the work that has been done over the last couple of years in managing the supply chain. As I mentioned we have been able to stay closely with our suppliers, especially as we have been implementing the lean manufacturing and that has enabled for us as well as our suppliers to be very efficient and very close in what we are seeing.

Now from a margin standpoint in the guidance that I have provided for the second quarter, we are seeing a slight decline in margins. That’s primary because of the variability that we are seeing on the top line and taking those volumes down from a quarter-to-quarter is going to have an impact on costs in that particular quarter. But John I agree with you from a component standpoint, we saw a significant benefit in the first quarter from a component cost. We are seeing less so in the second quarter, primarily because of the change in volume but just based on what is happening in commodities overall, we do expect to see that continue later in the year and hopefully we will see that kind of offset some of the other pressures that we are having due to lower volumes.

John Chambers

Simona, probably more detail than you wanted. Next question please.

Operator

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

Mark Sue – RBC Capital Markets

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

John Chambers

In terms of the loads on the networks, which we think absolutely will continue because of video and collaboration and Web 2.0 and entertainment and many other areas that I think we are just getting started on, our own networks loads are growing at over 400% a year at the current rate and I anticipate that increasing as well as we look out over the next six months.

In terms of the kitchen sink question, we do not know. I would like to give you a better answer than that. August felt very good. September was a little bit bumpy, but nothing that was a big surprise to us on it but October did slow, and we began to hear from customers on a global basis that their business was slowing as well and so we felt the prudent thing to do was to extrapolate October out going forward, but to answer your question very directly; as I said in my commentary it would not a big surprise to see it on the positive side of that projection or on the other side of the projection. There is more variability and I think we will know a lot more in 45 days.

Most of the time being on the off quarter, one month behind our peers on announcements works to our benefit, this time we did not have as much advantage of listening to what others were seeing other than what they told us anecdotally.

So Mark, I think we are in a little bit uncharted waters, but it is something that on things we can control and influence we feel pretty good and our role in terms of our customer environment actually is doing pretty healthy.

Blair Christie

Great. Thank you. Next question please.

Operator

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

Etai Kidron - Oppenheimer and Company

Thanks, I’ll try to be as smooth so let me just ask a couple of questions here. John, as you look a little bit further out, what is it that you need to see in order to say “We need to be much more aggressive on optics cutting?” and Frank, maybe you can clarify $1 billion below your budget is your -- how much was your budget up on a year-over-year basis versus last, so meaning are we still going to see up year-over-year optics in ’09 as of now after your cut plan versus ’08?

John Chambers

Okay. So breaking it into several segments, we have a lot of weaknesses as a company and we have a lot of strengths, but one thing that I know most people give us credit for is how we handle economic challenges and we have been through this four or five times. Our leadership team, I think 66% of the senior VPs and above were here in the year 2000. So, it is a team that knows how to handle this very, very effectively, and we have a culture that accepts change well. Our strategy, if you will, our playbook, around those four basic guidelines; that is what we followed every time and we executed it remarkably well, and coming out of each of these downturns looking out whether it’s 6 or 12 or 18 months, you watch us really come back to our financial models even stronger.

So we are not backing off of our traditional financial models over the longer term. However, part of that playbook and following the game plan is if your strategy is working well and you are moving into market adjacencies and you are taking market share, and you are being successful in that, and they are going to play architecturally together, for example (inaudible) in the environment we will bring all 26 of those cross functional priorities together architecturally. This is a chance really to break away from our peers and we eventually intend to do that. So while we use good guidance in terms of taking the expense run rate down from about 3.7 billion plus in this last quarter run rate, and that probably doesn’t count our hires into that number to in the area of 3.45 billion to 3.5 billion dollars exit in terms of Q4 in the current plan, we think that is the right way to go after this. And so, our game plan if you will, being based on that playbook will build us on speed, and scale and flexibility and we will adjust along the way. But we think that we do this well and I think you would probably have to agree each time we have done this; we have come out in very strong financial shape and got our models the way that you would expect. But we won’t do anything dumb in the short run that will affect our long term growth and long-term profitability.

Blair Christie

Great. Thank you. Next question please.

Operator

Our next question comes from Jeff Evenson with Sanford Bernstein.

John Chambers

Jeff, how are you doing?

Jeff Evenson - Sanford C. Bernstein

Very well, thanks. I am wondering how the weaker oil prices might affect your growth rate in Middle East and other emerging markets.

John Chambers

Jeff, it is a fair question. I am going to shoot a little bit from the hip on this one. Countries in Middle East, like Saudi Arabia, they make money on $2.50 oil prices. So, in countries that have a pretty fair amount of oil and a reasonably good base in terms of their expenditures, I do not think you are going to see major changes. There will be countries like Russia where they model probably in terms of their expenditures of government and others, at a higher run rate than what they’ve got and they will have to make some decisions on programs, etc., but this last quarter, Rob, you might want to look real quick, but I am pretty sure Russia grew by over 20% year over year in this last quarter, 22%, thank you very much. Our challenges in Russia are actually the reverse. Our problem in Russia is the availability of credit and currency. They have a 1000 banks but only a couple of them have credit available at the present time. So that’s really where we are looking at our channels and seeing what we can do to help them in a way that also maintains our fiscal carefulness. I guess that is a nice way of saying that while there will be some impact in some of the countries, overall, I think the benefits of the other countries will far outweigh the disadvantages in terms of the economy and the defects on discretionary spending. But Jeff, it will vary dramatically by country, and if you would like to sometime one-on-one, I would be happy to kind of go through everything from Azerbaijan to Saudi Arabia to Dubai, to Russia on what we think will occur, but that would probably bore a lot of people in the line at the present time.

Jeff Evenson - Sanford C. Bernstein

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

John Chambers

Agreed.

Blair Christie

Thank you Jeff. Next question please.

Operator

The next question comes from Tal Liani with Merrill Lynch.

Tal Liani – Merrill Lynch & Co., Inc.

Hi. I have a question on the trends of the various activities, mainly switching versus routing. What happened this quarter is kind of counter intuitive. Switching grew 8%, accelerated and routing went down while you were saying in your comments that enterprise – you had seen the declining orders versus service providers you had seen relatively flat orders or better orders than enterprise. So that means you should see the opposite trend in switching versus routing and I am wondering if you can shed some light on that. And also, related to the guidance, when you look at next quarter, do you expect switching trends to reverse and routing trends to reverse or vice versa?

John Chambers

So Tal that was the exact question I asked when I got the data the very first time out watching the trends because historically routing and service providers correlated and switching and enterprise correlated.

If you watch our enterprise marketplace was the most challenged on that, however our commercial marketplace and public sector were relatively flat. So we want to look at how you balance within those categories. In terms of the service provider side of the house, well routing will swing up or down based upon both loads in the networks and where they are out in terms of the build out cycles that were varied geography wise around the world, and as we showed in the various theaters, it did vary geography wise around the world. You are seeing service providers as a percentage of CapEx, as a percentage of sales tighten up a little bit on that, and the reason is service providers actually grew pretty well with the area of video. Our video group grew over 20% year over year, the Scientific Atlantic group grew very well, and we also did some pretty good job at the set top boxes which were up I think both bookings and revenue wise in the 100% type of range, give or take 5% or a little bit above that. Ned, would you add anything to that?

Ned Hooper

No, I think that''s exactly right John, and the other thing I would just add is the new product launches with the Nexus 5000 and 7000 has been extremely well received in the enterprise. So, even in a tough environment the focus on virtualization and product innovation is increasing the strategic relevance in the conversation we are having with customers.

John Chambers

Thank you Tal.

Blair Christie

Thanks Tal. Next question please.

Operator

Our next question comes from Scott Coleman with Morgan Stanley.

Scott Coleman – Morgan Stanley

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

John Chambers

Frank.

Frank Calderoni

Scott, just we''ll disclose this further when we send out the Q, but, for the first quarter we had cash in the US of $2.5 billion and part of that approximate $27 billion that we talked about. When we look at our cash position on a global basis, which we look at it from a net realizable cash standpoint but that''s taking the $27 billion and then netting it for any of the debt that we have plus the tax effect of the non-US portion and if you look at that we try to keep that from a model standpoint in the $10 to $15 billion range and as of the end of Q1 we are $11 billion, so clearly within that range.