Cisco Systems, Inc. (CSCO) Q2 2012 Earnings Report, Transcript and Summary

Welcome to Cisco Systems Second Quarter and Fiscal Year 2012 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 Melissa Selcher, Senior Director, Corporate Communications and Investor Relations. Ma'am, you may begin.

Thanks, Kim. Good afternoon, everyone, and welcome to our 88th quarterly conference call. This is Melissa Selcher, Senior Director of Analyst Investor Relations, and I'm joined by John Chambers, our Chairman and Chief Executive Officer; Frank Calderoni, Executive Vice President and Chief Financial Officer; Rob Lloyd, Executive Vice President of Worldwide Operations; and Gary Moore, Executive Vice President and Chief Operating Officer. The Q2 fiscal year 2011 press release is on U.S. high tech Marketwire and on the Cisco website at http://newsroom.cisco.com. I would like to remind you that we have a corresponding webcast with slides. In those slides, you will find financial information that we cover during this call, as well as additional financial metrics and analysis that you may find helpful. Additionally, downloadable Q2 financial statements will be available following the call in the Investor Relations section of our website, including revenue and gross margin by geographic segment, as well as revenue by product categories. Income statements, full GAAP to non-GAAP reconciliation information, balance sheet and cash flow statements can also be found on our website in the Investor Relations section. Click on the Financial Reporting section of the website to access the webcast slides and these documents. An audio replay of this call will be available from February 8 through February 15 at (866) 493-8039 or (203) 369-1749 for international callers. A webcast replay is available from February 8 through April 20 on Cisco's Investor Relations website at investor.cisco.com. Throughout this conference call, we will be referencing both GAAP and non-GAAP financial results. 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 discussed in detail in our documents filed with the SEC, specifically, the most recent reports on Form 10-Q and 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. I will now turn it over to John for his commentary on the quarter.

Mel, thank you very much. Over the last several quarters, we've continued to make consistent major progress on our comprehensive action plan to position ourselves for the next stage of our growth and profitability. Q2 was a very solid quarter in terms of this continued progress, with record revenues and earnings per share, both GAAP and non-GAAP. We grew profits faster than revenues, and we achieved our $1 billion expense reduction targets one quarter ahead of schedule. Our value to our customers continues to increase as we focus on catching the major market transitions occurring in our industry sector. By focusing on our 5 foundational priorities of core networking, data center cloud, video, collaboration and business architectures, we are positioned to lead across the most significant market transitions in our industry that our industry is facing today. These market transitions represent our customer's most important care-abouts, including mobility, cloud, BYOD or bring your own device, and the reality of pervasive video driven by new collaboration and social networking solutions. Each of these transitions require the increased value of intelligent networks, along with technology architectures, that enable both better performance and integrated products, software and services. By building on Cisco's intelligent network, our customers are innovating and solving their toughest business problems. We believe our vision and strategy are working and Cisco's value to customer is -- our customers are -- is increasing. We appear to also be gaining that increasing share of our customers' total spend on IT, as evidenced by our revenue growth versus many of our peers and competitors. The bottom line for Cisco is simple: innovation, speed and agility is in; costs and complexity are out. In the initial part of this call, I will first provide a high-level financial review, then cover our progress and results…

Thank you, John. We had a very solid second quarter, with record revenues of $11.5 billion, which grew 11% year-over-year. Along with a number of other strong financial metrics, we had record profitability with non-GAAP net income of $2.6 billion, up 23% year-over-year. These results are encouraging, given the ongoing market dynamics and reflect our commitment to the 3-year model we shared with you last September, which includes growing profits as measured by earnings per share faster than revenue. Again, our total Q2 revenue grew 11% year-over-year. Our total product revenue was $9.1 billion, up approximately 11% year-over-year. Let me highlight a few of the areas within our total revenue -- product revenue. Switching revenue was $3.6 billion, up 8% year-over-year. Next generation networks or NGN routing also grew 8% to $2.1 billion. Collaboration revenue was $1 billion, an increase of 10% year-over-year, and we saw good growth in service provider video, which was up 23% to $1 billion and in data center, which grew 88% year-over-year to $333 million. Services revenue was $2.4 billion, up approximately 11% year-over-year. Our year-over-year revenue grew across all geographic regions, with increases of 9% for the Americas, 15% for EMEA and 11% for APJC. Our total product book-to-bill for Q2 was approximately one. Q2 FY '12 total non-GAAP gross margin was 62.4%, which was flat quarter-over-quarter and year-over-year. For product only, non-GAAP gross margins for the second quarter was 60.9%, a slight decrease of 0.4% quarter-over-quarter. This change was primarily driven by strengths in lower-margin data center and service provider video products, as well as pricing, discounts and rebates, partially offset by higher volume and lower overall manufacturing costs. On a year-over-year basis, non-GAAP product gross margin was down slightly by 0.2%. We continue to see solid momentum and positive impact from our…

Frank, thank you very much. Moving forward, I would like to provide some perspective on Q2 and our momentum going into the second half of FY '12. We believe our vision, strategy, financial strengths, broad architectural approach, as well as our culture that accepts change, positions us well for growth. We have always used these market transitions to make bold and tough decisions, and then to execute in a way that further extends our leadership over our peers. For several quarters in a row, our business orders appear to be growing faster than many of our comparable industry peers. Rob, I just want to say a great job by you, by Chuck, by Nick, by Edzard and Chris, very, very solid and Paul. So across-the-board nice job and we're expecting it again.

Of course, John. Thank you.

We also want to continue our focus on operational excellence, driving productivity and making Cisco a simpler place to work and for our customers to do business with. At the same time, organizing Cisco in a way we believe our customers will buy and our products will need to be developed, given the major market transitions that are occurring and creating the opportunity that we discussed earlier. Gary, I did just want to congratulate you on the services group. I think what you've done and the team's focus on gross margins, the overall operational excellence, the customer ease of doing business, you see it across the board. So doing a super job. I want to thank you for that, what Angel's doing is really great. Well done.

John, thank you. It's a real team effort.

It really is. Good progress but a long way to go, good journey. In every major market transition over the last 20 years, we have historically emerged stronger and with more market share and with intense target focus. In our opinion, we are on our way to doing the same once again. But it is a journey, and we are still in the early stages. You will continue to see us move aggressively to pull away from our competitors as they adjust to these market challenges, having already made these changes well ahead of our competition. This is also a competitive advantage for us, in our opinion. Industry challenges and our own challenges this year cause us to make needed changes. But as we said last quarter and I'm repeating this quarter, we will not stop here. We will aggressively continue to change and transform and drive our Cisco entrepreneurial spirit through the combination of innovation and operational excellence. At the same time, we will maintain our laser focus on creating value for our shareholders, customers, partners and employees. You will continue to see us a very focused, innovative, agile, aggressive and lean Cisco moving forward. The major transitions from an information technology to business technology are accelerating in our enterprise, service provider, public sector and commercial accounts, and across most industries and geographies. Although we are only in the early stages of this transformation, our ability to use innovative solutions and intelligent networks to enable our customers to achieve their goals and their growth, productivity, cost savings, new consumption and business models is increasing and achieving increased customer acceptance. These are, in many ways, unusual times. On one hand, the business feels good. The demand for Cisco products and services is healthy, and our relationship with our customers are the strongest they have ever been. On the other hand, there is significant uncertainty in the broader macro environment, and as such, it is prudent for us to remain conservative in our outlook for the second half of the fiscal year. For the remainder of FY '12, you can expect us to make the required investments to advance our market leadership and drive innovation while holding to our financial model. I want to thank our employees, our Cisco family for the speed and willingness to change that has positioned us to move with our customers and drive value for our shareholders. I know it has not been easy, but you all have executed and adapted to these challenges and opportunities extremely well. And that, more than anything else, embodies the Cisco franchise: our ability to merge quickly, stronger and more focused and more driven, as we have in the past. Our Q1 and Q2 results certainly reflect that. I want to thank our shareholders, employees, customers and partners as we've transitioned to the reinvigorated Cisco, the aggressive, focused and simplified Cisco you have come to expect over the years. Mel, with that, let me turn it over to you.

Great. Thanks, John. We will now open the floor to questions and answers. [Operator Instructions] Operator, please open the floor to questions.

Our first question comes from Jess Lubert with Wells Fargo Securities.

My question is on your operating margins, which are above your long-term target in the mid-20% range. So I guess I was hoping you could help us understand how you plan to balance spending versus sales going forward. Is it right to think that operating expenses basically grow in line with your revenue forecast, with the top line performance dictating the direction of operating margins? Or do we see you start to ramp expenses more aggressively here in order to take advantage of what appears to be an improving environment?

I'm going to have Frank handle the difficult part of that. Just let me say that we are extremely disciplined in terms of our financial model, and that while we will make investments, we're going to make those with the proper productivity focus. Just as a reminder, this last quarter versus a year ago, our productivity is up to a record 724,000 per employee. That's almost a 20% increase. So you will see us continue to focus on the combination of the end as opposed to one at the expense of the other. So with that guidelines, Frank, well, you had a chance to think about it?

So Jess, let me start by just reiterating what we talked about back at the Financial Analyst Conference in September. So the model that we've put in place is really over a 3-year period of time, and we're looking at clearly with the overall objective of growing profits faster than revenue. And from a model standpoint, and I know I've talked about this a lot over the last couple of months, we're looking at, over that extended period of time, revenue growth, 5% to 7% and EPS in the 7% to 9%, growing faster. Within that, we're looking at operating income, as I talked about, in the mid-20s and getting that right balance. Now I did say back then and we've continued to say that we feel that, that model is -- we want to make it conservative so that it's realistic and achievable and we have the ability to continue to have an opportunity to overachieve where we can. In this past quarter, in Q2, our non-GAAP operating margin was 28.4%, and we also had our expense of -- at -- achieving ahead of schedule, $3.9 billion, which is 34% of revenue, and we talked about trying to get to that $1 billion expense reduction. We were going to get there in Q3. We did it a quarter earlier. That early achievement gave us operating leverage, clearly, significant operating leverage in the second quarter. But it's one quarter, and I want to make sure that we again look at this over a longer period of time and really focus on that long-term model. And the key thing here for us going forward -- and a lot of the groundwork that we laid in the last couple of quarters is being able to make sure that we've continue to drive productivity, and we expect to do that. I mean, if you ask anyone here and around the company, that's #1 focus for all of us. And we know...

While we increase margins.

Yes, well, that's a big part of it, too. And we want to make sure that we can continue to invest in the portfolio to drive innovation. And that's -- in our business, that's also with M&A. John talked about M&A. And we want to make sure that when we do this, we're supporting the 5 foundational priorities. So it's that balance, staying with that long-term model and working that operating margin, making necessary investments to continue to drive productivity, knowing that investors are looking for that operating leverage that we've talked about with growing profits faster than revenue.

Our next question comes from Ittai Kidron with Oppenheimer & Co. Ittai Kidron - Oppenheimer & Co. Inc., Research Division: I wanted to tie, John, some of your individual segment margin commentary. You've talked about improvements in your switching business with gross margins back to where they were 2 years ago, then you talked about routing and service providers as well, areas where your gross margin has been improving. Yet this quarter, your product gross margins have now hit a low of 60.9%. So maybe can you give us a little bit more color as to what's still not working right from your standpoint on the product side? And maybe a little bit more color on the mix that has been impacting your gross margin here? And how should we think about that evolution over the next quarter or 2?

So Frank, I'm going to ask you at the end to summarize our guidance that we did at the Financial Analyst [ph] Conference, which is right in the middle of our -- actually a hair better. It's primarily a mix issue in terms of this quarter, but I don't want to dodge that issue. We saw improvement in routing margins. We're continuing to put focus on that as well. We still have some of the overflow from some of our large wins in Asia, where, as you heard from Frank's comments earlier, our margins are not as high as they are in Europe or in North America. In terms of the continued improvement, the Nexus was probably the best example, 800 points in a year. And it had a way to go -- ways to go on that, but pleased with the results that we're seeing there. You'll find each of our groups, even the emerging technologies, with new start-ups such as emerging video. Even if it's relatively small revenue per year, under $200 million, you see them focusing on major, major improvements in gross margins. So you see it in every category. Services, Gary, we're obviously at a very high gross margin, probably one that you can't stay quite that high on, but to say that every element of the company is focused on it. So it's not a question of not working. I'm actually pleased with how it's working. And it's an area of mix in terms of the approach. But even reminding the comments about our Nexus 2000, 5000 I made before, the margin improvements on those were very good in the first year that we are actually shipping. So we are all over this. You will see it fluctuate it up and down. And I think your guidance actually was up a hair from last quarter's guidance, Frank. If I remember right, last quarter was 61% to 62%. This one was 61.5% to 62%. But the guidance for the longer term, just as a reminder, what we said at the analyst conference?

So John, if I add to that. I think that's a good question. The key thing they want to put on this is managing the portfolio. We've been managing this portfolio now for 2 decades, and we're always going to have different dynamics from a quarter-to-quarter standpoint. I think clearly, what we've emphasized over the last number of quarters, especially the last 4 or 5 quarters, is this whole portfolio approach and really kind of making this a very systemic focus item across the company, really driving across company as a major initiative, making sure we have the right incentives in sales and engineering, make sure we're driving margin and cost improvement and also making sure that these cost improvements are not just short term, that we continue to have them ongoing and that we continue to make emphasis. So we'll continue to do all that and balancing the portfolio. And I think the success that we've had in the past will be also the ability to kind of balance this going forward. Yes, we did have some mix dynamics, as you talked about, primarily with strength in data center as well as SP Video. The pricing was relatively stable this quarter, as we've seen in the last couple of quarters, and that's a good thing. And we've got cost improvements to offset that. We'll continue to work those cost improvements, and we have some other opportunities as we go forward. The guidance I gave for this coming quarter, Q3, is 61.5% to 62%. We try to kind of work that and have that conservative so we can do better than that as well, and I think that kind of allows us to have this continuity that we've seen in the last couple of quarters continue for the rest of the year.

Our next question comes from -- okay, our next question comes from Ehud Gelblum with Morgan Stanley.

A couple of quick things, just, I'd say, a clarification on what you started saying, John, before about gross margin. You've thought -- talked a little bit about the overhang from those Asia deals. And in the past, I think you and Frank have been talking about the China routing deals and -- as a reason for gross margin going down. Just if you could just, as a clarification, just say whether they actually came through because gross margin was actually terrific this quarter. So it looks like they didn't. So perhaps that is something -- if you'll describe the dynamic there. But my real question has more to do with the routing market. When you look at routing, both what you're seeing now, your service provider is actually very good, and you look at routing over the next 2, 3 or 5 years, do you -- what is your estimate now on the growth in the routing market? And is this still a double-digit growth market? Or is it kind of decelerating as other technologies are being -- kind of coming in the networks? And is -- are networks moving more towards the application side and in the cloud and other things? Or is routing going to continue to be a strong business and a strong market for you to grow into?

Sure. So in reverse sequence to the way you asked it. If you look at pervasive video and you look at -- and the importance of intelligent networks and you look at how these tie together with routing, switching, the cloud, data center, UCS, Bring Your Own Device, mobility, all these pieces come together. Without intelligent routing, it doesn't work. And so the ability, whether it's on the Edge with the ASR 5000, the ASR 9000, both of which we had very, very good quarters, or the ability in the data center to tie it out or the ability from any device to bring it forward, as you begin to talk about proliferation in video with intelligence underneath that so you can search to it, so you can push it to common communities of interest, the routing, well, switching will actually blur. The lines between service provider and enterprise and commercial will blur, and the consumer. If you don't have an architecture that goes across all of those, you're going to be a piece player, buried somewhere in the cloud, behind the scenes, in my opinion. We're well positioned, although we can improve in each of these categories. And so I see routing continue to be a very important factor. It isn't that it isn't a growth market. The price performance in routing is we keep really setting new challenges for ourself and others just like we did in switching. And yet as you watch, to have routing grow to the high single digits at 8% was pretty solid. I think when we did the financial conference, Frank, the numbers that we gave for routing was actually a little bit below where we are, but in the mid to high single-digits in terms of the approach. Now without me changing…

Our next question comes from Simona Jankowski with Goldman Sachs.

A follow-up also on the carrier side in routing. I think you talked about some uncertainty in carrier CapEx as influencing your guidance. And yet your own service provider bookings were quite strong at 12%. And obviously, your peers, as you pointed out, have had a very difficult period. So can you just give us a bit more color on what you are seeing in the carrier spending environment? Any standout areas of strength or weakness? And then specific to your own routing business, where, as you pointed out, your major competitor had a significant decline, do you think that difference in performance is driven primarily by the timing of your respective product cycles? Or are there any specific major customer opportunities where you think you've actually displaced your competitor?

Okay. So in sequence that you raised it. The 12% was revenue growth, not orders. And if you look at where we're going in the service provider, we are becoming the sweet spot. It doesn't matter if you're talking to Time Warner or Verizon and AT&T, a Sprint, a Deutsche Telekom, a British Telecom, a Telefonica, an NTT, a China Mobile, a Telstra, all of which we have in the last month at multiple levels. Our role in terms of what they're trying to accomplish is changing. And so we are, in our opinion, and Simona, you're pretty good at verifying this, getting a much larger share of their spend. In terms of our ability to provide value way beyond "a router," back to the earlier question that was asked, they don't buy routing. They buy an architectural play from the data center all the way up. And repeating the Korean telecom and what Chairman Lee did there, he's aligned with us all the way from the data center all, the way to smart services that his company delivers across 16 countries. So our role in service providers as they focus on the key elements: mobility. Mobility. The second key element, video. Both for entertainment video and business video. Third key element, cloud. Cloud is it delivers new services, opens up new revenue opportunities for them. Fourth key element: How do you dramatically cut costs in this environment? And how do you balance within it? We're getting a pretty clear lineup in terms of how we play in these categories. Now are we replacing our peers and competitors in here? Rob, I'm going to let you talk about that.

Sure, John. I would love to. I know you would. But I know that Simona was asking indirectly where some of the negative growth and weak outlook at some of our competitors are reflecting on a changing CapEx patterns. We heard one of those competitors claim that their Tier 1 SPs in the United States have reduced their spending, they've seen weakness in Japan and delayed projects in China. In fact, we saw just the opposite. We had high-end routing revenues in both the United States and in China. We're up in the high teens. And actually, our high-end revenues in Japan nearly doubled in the last quarter. So there is a clear change in our position in terms of the market. We're gaining relevance, and we're winning back major franchises in Tier 1 providers around the world. I do agree with you that some of the CapEx right now is being prioritized and that prioritization is going towards mobility and towards cloud. And in that place, I think our service provider customers are very happy where we stand, and I think they feel we're headed absolutely in the right direction.

Our next question comes from Simon Leopold with Morgan Keegan. Simon M. Leopold - Morgan Keegan & Company, Inc., Research Division: I wanted to see if we could drill down on one particular market, namely that of data centers. In terms of public commentary, we've heard about service providers, talked about cloud initiatives and investing in data centers. And we've seen some of the largest data center spenders', and most notably Facebook, recent disclosures talking about very significant increases. But I appreciate that that's really only a sliver of overall data center spending. So if you could drill down on this end market, not specifically your data center segment, but the data center end market in terms of what it means to you and what these overall trends are.

Okay. So if I look at the data center end market, it is a market that is in tremendous transition at a very fast pace. We bet, and we were lucky, but we also listen to customers, over 6 years ago on this market and developed products and skunk works for 4 years to really address it at the same time we built an architecture that high-end routing would handle billions of videos. In terms of the importance to us, it is major because we believe this will actually be a free flow of data centers and clouds, private and public, coming together and with the capability for enterprise customers, as an example, but the same thing is true for commercials or even consumer to be able to migrate wherever they want to purchase in terms of the capability or invest within the architecture. We do think it will blur completely between server technology and networking technology and storage across applications and across-the-board, and that's where our partnership with VMware and EMC was very, very good. And [indiscernible], she made some very positive comments about our $800 million run rate in that category where we share in terms of the market and the growth. In terms of our numbers, you saw the growth again very close to 100% with the 2 combined, but it is the ability to provide these overall services. Now while I won't particularly talk about an individual customer, but in the massively scalable data centers, we're picking up momentum, Rob, pretty good. And we've been able to track both engineering talent as well as sales talent to go after it aggressively. So key to our future. You see the end user market changing. But this is where the change is taking place, where you're going to reduce your cost in the data center. And data centers as they consolidate are going to have reduced total CapEx. We do the same within ours. I think Rebecca's down by about $25 million as she consolidates the data centers, per year savings and yet delivering dramatically more capability. So this is a share of wallet based on market transitions. Rob, you're looking like you want to jump in.

I was just going to add, John, that there is clearly a segment that we appeal to with our full architecture, and that's the enterprise-class workloads that are migrating to this platform. So we do see general-purpose applications, like Exchange, SharePoint, SAP, migrating to our UCS architecture. The growing one that's very exciting for all of us is the virtual desktop infrastructure moving in this environment. And of course, there's Unified Communications, our own apps. So I think the question is what does the blade server appeal to? It's enterprise-class applications or private clouds. And obviously, for the public services, then, many providers will be delivering based on Cisco architecture.

And Simon, we're expanding on your question because you allow us to hit 3 or 4 areas at the same time. Rob, if I remember right, in terms of both our UCS sales and cloud sales, as well as video, our commercial, and as example in the U.S. territory, had almost half the deals. So it isn't just with the people's focus on massively scalable data centers. Gary, I'm going to ask you to pull this together because if you think about it, what our customers are also asking us is services. They want the whole offer, Rob, that you kind of, I think, invented here for us. And services are playing an increasing role. That's where we actually added headcount this quarter. Kind of bring that home in terms of what you're seeing in terms of how the market's evolving and what role we're trying to play here.

So as it relates to the data center, I think it's in addition to what you've already said and Rob said. The thing that's really pushing this is the opportunity to move applications into the cloud and do that in a way where the ease-of-use and the cost to do that is really controlled. So if you think about the conversion architecture we have with the Vblock as an example, our ability to help a customer turn that up very quickly has to do with the services and the pre-integration of that stack, and then also the automation we put with that relative to the management systems, so that you have a single pane of glass to man these -- that environment. Significant reduced cost there. So services plays a role to help our customers understand the technology and move to it much more quickly. So if we can accelerate how fast they can do this, then they can also accelerate how fast they turn it into revenue. And that's what they want.

It's interesting. We have not done a good job, by we, let's start with me, in terms of really talking about our innovation on almost every product front that we talk about, from collaboration to cloud to video capability to the data center to switching and routing playing architecturally together to business models to the integration of services. When you talk to our customers what they wanted, it doesn't matter if it's a country what they want, such as Canada or Russia or the Middle East or India, or a company, they want us to help them in this transition. And services plays a very integral role in both reducing the risk, being able to take ownership. And that is a transition that is even occurring in emerging countries where while price per port is important or price per user, average revenue per user is important, they also realize the ability to move effectively in this, perhaps is an area that I think we can add a lot more value to. So Simon, thank you for letting us answer about 4 questions, and we reversed it. Normally, we hold to one question, but I thought it was an important area to hit.

Our next question comes from Rod Hall with JPMorgan. Rod B. Hall - JP Morgan Chase & Co, Research Division: Just a couple of questions. One is on the revenue guidance. Just wondered if you could clarify -- I mean, you're guiding for basically flat revenue in Q3, and we haven't -- in most Q3s you're up on revenues, so -- and I know Frank talked about IT services spending potentially being down in 2012. So I just wondered if you guys could elaborate a little bit on why that guidance -- what is it you're seeing out in the marketplace that makes you maybe a little bit more cautious than you otherwise would be given you've just delivered such a strong quarter. And then on the UCS comments, if you could just clarify. I don't think I heard the gross margin impact on UCS. I'm not sure if I missed that or if you said it. But if you could justify what the gross margin impact from UCS was this quarter given you had such strong growth, that would be helpful, too.

Okay. I'm not sure we're going to be able to answer that last question specifically, so I'm going to give Frank just a second to think about it. And I'm not sure we can answer too specifically without giving away our gross margins on UCS, which we clearly don't want to do, Frank, in terms of [indiscernible]. But if you look at what's occurring in the market, I think we're well positioned in terms of our ability to get share of wallet spend. You all have to make your own decision on that. And there are things that, Gary, we've got to do better as well. But we're making very, very good progress. So I think what you want to look at is the macro issue, kind of the macro issue. I think we're all aware in Europe, although I would split it into 3 categories, Northern Europe, Central Europe and Southern Europe, and with the Northern and the U.K. component part of that going better than most people anticipate. In terms of public sector spending, it's going to be tough. U.S. federal budgets, anybody that thinks that those aren't coming down dramatically this next year? And it will vary by department. So if you're only in a department that happens to be spending money, it might be different. Or if you're part of large projects where your products are automatically built into it, that there's one of my peers reminding us. They said, "John, you're a great leading indicator. We are not. We are lagging because often, it takes almost a year to work through the systems in terms of our direction and power." You are seeing some challenges still in India that we talked about. That's primarily public sector. And I would hope that the business leaders and the Indian Government and the citizens come together on that. But then you're having some bumps like Argentina where their import-exports issues take a major problem. And while it's not a big number, it's a big number relative to Latin America. A nice way of saying there are a number of challenges in the marketplace, not the least of which has been a surprise to us of our peers. And many of our peers have been very conservative, and I think, Frank, the vast majority of those who reported in our industry, I think, 70%, have actually guided down versus expectations already in the market. We clearly are guiding up versus what the consensus was for this next quarter. So I think that's a conservative approach. You would be disappointed in anything else. And given all the variables that are going on, even though we made, in relative terms, positive comments about Northern Europe, I think this is what the better part of prudence would be in terms of the direction, and one that we will focus on again. But it is conservative. Real quick answer on UCS without giving too much detail.

John, overall, if you look at it from a sequential standpoint, overall product gross margins were down, as I said, slightly by 0.4 of a point. If you look at the -- we had a benefit from a cost standpoint, which pretty much offset the -- what we normally would expect from a price range. But the delta, couple of tenths of a point, was related to mix, and the mix was driven by, as I mentioned before, a combination of UCS or data center as well as strength in our SP Video. So I would say a portion of that delta was driven by mix. But as I said before, we're doing many things to kind of look at other cost benefits as we go forward, continue to keep managing and managing that gross margin portfolio.

I just wanted to say, Gary, for what engineering supply chain, what the Cisco transition is doing, the focus on gross margins is world class and couldn't more be more pleased with it. So without going on a line -- in a limb too far, I would say our gross margins feel pretty stable at this point in time. And Frank, would you agree with that?

Yes, absolutely. And the value engineering work, while we've made great progress, is really on the front end of that. So I feel our ability to stay competitive and hit those ranges very clearly.

Our next question comes from Tal Liani with Bank of America Merrill Lynch.

I want to ask a question about something that was asked many times on this call, which is gross margin. When you look at gross margin in Asia, Asia Pacific, Japan and China, the contribution to sales in the last 2 quarters were $142 million, and the contribution to gross profit was minus $20 million, which means the incremental sales came at negative margin. Another way to look at it is just if you give discounts on many other things and not just incremental sales. But the question is that now, there starts to be a measurable gap between the margins in Asia Pacific, Japan and China and between Americas and Europe, which means -- or the question here is what's the risk that the pricing level that you're now introducing to these Far Eastern markets will filter into Americas and the U.S. and will pressure prices there.

Got you. A fair challenge. So going in the sequence you raised it. If you look at the overarching issue across Asia Pacific, Japan and China, while we do it as one region, it is probably 5 or 6 different regions. And the margins in Australia and New Zealand and Japan are more in the developed market type of margins. The margins in China and in India and some of the other countries are more the emerging price points. However, if you don't get this as a land grab, Rob, early on when the franchisers start to get built out, you miss on it for the next number of years. And so as you look at this, I would look and anticipate that we improve our margins by account over time as we earn more and more of their confidence. What is fascinating to me were, Gary, you were just there in India, and Rob, you and I get there regularly, is they -- the service providers in India used to make it entirely on price points. They're now realizing that isn't their core competency. They're realizing we bring value, our peers do not, and looking at it from an architectural. They still, however, beat the tar out of us on the balance of this market, and we will participate aggressively in striking that right balance while still maintaining our financial model. This is why you have to think about the markets different. And Asia is an exploding market. You must play to get across the board with a little bit different business model. Now our ability to compete effectively there is improving. So the ability to not only contain this approach in Asia, as is appropriate, is absolutely being seen in the neighboring countries like Japan and Korea and…

Me, too.

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

And thank you for the dividend increase.

We listen, we listen. And we'll continue to listen. We knew that the honeymoon on doing a dividend would be very short lived and that we must look at that on a regular sequence about increasing it. And our goal is clearly to do that.

I had a question on the service providers. If we look longer term, does it increase inclination by carriers to reduce their CapEx as a percentage of their revenues? And it's also happening at a time when they're also seeing their margins decline. So I guess for Cisco longer term to grow their service provider revenues, you have to gain more share of a shrinking wallet. Does that mean structurally there's a ceiling on margins as you push your architectural approach? Or does the dialogue suggest with your customers that they actually will pay more since they get more?

Okay. So the answer is the last point that you made and set me up with a question. Most service providers will absolutely pay more if they get more. Their problem is very simple, as you articulated very well. Their capital spend was going up, using the U.S. as example for some of those service providers, at twice the rate their revenues were, and the profitability in the revenues were sliding. So this is where you see them get excited about what they can do in cloud and delivering services. This is where you see them getting excited about new mobile capability. This is where you get to see them excited about moving to video into the home, which is why we must be in that set-top box business, going to a hybrid-type approach, growing clearly to the cloud and the data center. And this is where, I think, you see, perhaps more than any other time, Mark, why we had to play across architectures, which we clearly bet on a decade ago, and why we're getting better at operations of them, Gary, in doing better at efficiencies and ease of doing business. These are bets and good execution we've done over a period of time. Nick Adamo and Pankaj are joined at the hips on this, along with Sameer from the services side on it. So I think we have share of wallet opportunities in front of us that will continue way more than a couple of years. But secondly, for any CEO, you turn to them and say, "I can bring you a certain amount of revenue, and I can increase your profits." And if they believe you can do that and you show it a step at a time, then it's a very good model and it plays right into our sweet spot on it. And we don't compete against them like several of our large data center peers. This is a market that we do not compete against them. We enable them as we move forward.

Our next question comes from Nikos Theodosopoulos with UBS.

Can you discuss how comfortable the company is with the $5 billion in U.S. cash balance given the plan to increase the dividend, continue the buyback and now start looking at some M&A? Do you anticipate raising some debt, given the low interest rates, to give you some cushion on the U.S. cash balance? Or not -- and what should we think about as the size of the deals you might do over the next year or so?

I knew that last one is coming. So in terms of sequence, if you look at where we are, we have historically done pretty good job on deals, and the ideal one has not changed. 100 engineers, a product about to come to market and there are customers who say, "Go buy them." And our ability to ramp that through, I would argue, is the best in industry, and our shareholders have really benefited from it. The 2 most recent big deals are Starent and TANDBERG, both of which are growing very well for us, allowed us to expand our footprint in the market and allowed us to integrate it tighter, et cetera. We all know that in an industry where the vast majority of them fail, I personally believe 80% to 90%, our hit rate is much higher than that of our peers. And probably the only other -- one other player, Oracle, is good at the acquisitions of the scale that we're talking about. In terms of our size, we believe you partner big-to-big, you acquire big-to-small. And that's how we approach our market in terms of direction. In terms of the cash balance, we clearly built up a little bit more because it's easier if we buy small company to pay cash for that as opposed to other segments. What I read in the merge -- the M&A activity, we'll play across multiple groups in it. We normally have done very well. I would hold Ned and the engineering team accountable to continue to do well in this space. And in terms of the debt, I still believe that every other country in the world understands you must bring back your profits outside a country into their existing country at 0% to 2%. I think regardless which…

Our next question comes from Brian Modoff with Deutsche Bank.

So a couple of questions actually. Can you talk a little bit about campus versus data center in terms of how you see both of those packing up, that you're -- obviously, you've got carriers, as you mentioned, looking at building private clouds? So how do you feel about campus? Some of us have recently been a little more positive on that area. So can we get a little feedback there? And then specifically on service provider earlier, what specific products are you seeing share gains? And is it CRS-3, ASR 9K, the Starent box? What is it?

Okay. All right, Mel was about to tell me we're going to hold only one question. But since you asked two that I think are interesting, we'll finish the questions with those 2 in terms of the direction. In terms of the campus type of approach, that is obviously dependent upon part on the requirement for the speed of the connections. As video really takes off and as the new products come out from Intel, you're going to see a lot of requirement in terms of increasing port size, capabilities and evolution to the next generation of switching within that. So it's an issue both on employment type of issues, bandwidth requirement, et cetera. And if you watch as our organization changes, we've now organized data center with one group, i.e., primarily Nexus, and Catalyst with another group, primarily with what we're doing on the campus side, and those are being run by Rob and by David, respectfully, within that. In terms of service provider spending in terms of the overall business, I think we're doing -- Rob, you've got to keep me honest here. I think we're doing well in almost every category. We're doing very well in high-end routing, year-end growth there was in low double digits. We've done very well at the Edge with the ASR 5000 and 9000 and big franchise wins at -- well, you might allude to without mentioning the companies, what you're doing in that area. We're doing very well in the data center. There are always a couple of areas that we need to do better, and I think you all and we are very much aware of those and you'll see us continue to focus on it. But I'd say the service provider spend by product category is only part of the question. The real question is: What value do you bring to those, as you're alluding to? And what value do you bring in terms of integrating together with being able to deliver services in a much quicker time frame? What value do you bring together going with a service provider to jointly go to the market? What value do you bring to in terms of innovation, which is why a lot of service providers business with us? And if that's your decision criteria as a CEO, our win rate is extremely high in most all product categories as long as we're just competitive within it. Rob, additional thoughts?

Just to summarize, John. 5 consecutive quarters of market share gains with the CRS-1 and CRS-3, and 3 consecutive quarters of market share gains with the ASR 9000, ASR 5000 and ASR 1000. So I think the answer is in all of those environments, even in challenging CapEx environments, we're winning market share.

So if I were to summarize, Brian, your question and kind of use it as the closing for the call, if you will, Mel, our vision and strategy is working very well. It's a continuous journey, and we're making good progress on it. And Gary, we're making great progress in terms of operational excellence, but that is a multiyear journey and making good steps along the way. Rob, I couldn't be more proud of what the sales force has done. I mean, your momentum and share gains and really taking it to competitors in an aggressive but fun and fair way is going to continue, and that feels very, very good. Record revenues, earnings, growing profits faster than sales. I don't think it could have been a much better quarter in terms of the trends, and I appreciate your comments on that. Five foundational priorities, there are always elements in foundational priorities we want to do better in, and you probably have a feel for those. But they were solid this quarter, and a couple I want to see us do a better job on. Unusual balance in terms of geography, customer segments and products, given what's occurring on a global basis. Our watch-outs and caveats are largely macro or spending within a category type of comment. And I think you'll hear from our customers and you see it by how they view us as opposed to an individual product company, an innovation company with innovative products and innovative way to help them solve their type of business needs and with the core intelligent networks made up of routing and switching and other devices that our peers don't have integrated together. And at the present time, we've done exactly what we outlined in our 2- to 3-year plan for the…

Great. Thanks, John, and thanks, Gary, Frank and Rob. Cisco's next quarterly conference call, which will reflect our third quarter fiscal 2012 results, will be on Wednesday, May 9, 2012, at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. In anticipation of our continued business and geographic growth and increased use of new models -- business models, we are implementing enhanced planning and reporting processes. To accommodate these changes, all future quarterly earnings calls will take place one week later than our historical schedule effective Q4 FY '12. Our Q4 earnings call will take place on August 15. The timing of our Q3 call will not change. Additionally, downloadable Q2 FY '12 financial statements will be available following the call, including revenue and gross margin by geography and revenue by product categories. Income statements, full GAAP to non-GAAP reconciliation information, balance sheets and cash flow statements can be found in our website in the Investor Relations section. Click on the Financial Reporting section of the website to access the webcast slides and these documents. Again, I would like to remind you that in light of Regulation FD, Cisco plans to retain its long-standing policy to not comment on its financial guidance during the quarter unless it's done through an explicit public disclosure. Please call the Investor Relations Department with any follow-up questions from this call. Thank you for your participation and continued support. This concludes our call.

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) 493-8039. For participants dialing from outside the U.S., please dial (203) 369-1749. This concludes today's conference. You may disconnect at this time.