Cisco Systems Inc

NASDAQ:CSCO

Earnings Call Transcript 2024-Q2

[Operator]

Welcome to Cisco's Second Quarter Fiscal Year 2024 Financial Results Conference Call. At the request of Cisco, today's conference is being recorded. If you have any objections, you may disconnect.

Now I would like to introduce Sami Badri, Head of Investor Relations. Sir, you may begin.

[Ahmed Sami Badri, executive]

Welcome, everyone, to Cisco's Second Quarter Fiscal Year '24 Conference Call. This is Sami Badri, Cisco's Head of Investor Relations, and I'm joined by Chuck Robbins, our Chair and CEO; and Scott Herren, our CFO. By now, you should have seen our earnings press release. A corresponding webcast with slides, including supplemental information, will be available on our website in the Investor Relations section following the call.

Income statements, full GAAP to non-GAAP reconciliation information, balance sheets, cash flow statements and other financial information can also be found in the Financial Information section of our Investor Relations website. Throughout this conference call, we'll be referencing both GAAP and non-GAAP financial results, and we'll discuss product results in terms of revenue and geographic and customer results in terms of product orders unless stated otherwise. All comparisons are made throughout this call will be on a year-over-year basis.

The matters we'll be discussing today include forward-looking statements, including the guidance we will be providing for the third quarter and full year of fiscal 2024. They are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent report on Forms 10-K and 10-Q, which identify important risk factors that could cause actual results to differ materially from those contained in the forward-looking statements.

With respect to guidance, please feel free to see the slides and press release that accompany this call for further details. Cisco will not comment on its financial guidance during the quarter unless it is done through an explicit public disclosure.

I will now turn it over to Chuck.

[Charles Robbins, executive]

Thanks, Sami, and thank you all for joining us today. We delivered a solid Q2 performance with revenue coming in at the high end of our guidance range. Strong operating leverage across our business drove our margins, which exceeded the high end of our expectations and allowed us to deliver better-than-anticipated earnings per share. In Q2, we once again returned a total of $2.8 billion in value through dividends and share repurchases.

We also announced today another increase to Cisco's dividend payout rate, reaffirming our ongoing commitment to returning significant value to our shareholders through consistent capital returns. Overall, our Q2 results continue to advance our strategic business transformation around driving higher levels of software subscriptions and annualized recurring revenue or ARR, both of which showed performance gains in the quarter.

Our pending acquisition of Splunk also further supports our transformation strategy by fueling stronger growth, expanding our portfolio of software-based solutions and generating higher levels of ARR with roughly $4 billion in additional ARR expected upon closing and will make us one of the largest software companies in the world.

Before turning to our performance in the quarter, I'd like to start by commenting on the demand environment. First, in terms of the macro environment, we are seeing a greater degree of caution and scrutiny of deals given the high level of uncertainty. As we're hearing this from our customers, it's leading us to be more cautious with our forecast and expectations. Second, as we discussed last quarter and subsequently saw in other technology provider results, customers have been taking time since the start of our fiscal 2024 to deploy the elevated levels of products shipped to them in recent quarters, and this is taking longer than our initial expectations. Third, we also continue to see weak demand with our telco and cable service provider customers. This industry has seen significant pressure, and they are adjusting deployment phasing, which is weighing on our business outlook.

Given these factors, we are adjusting our expenses and investments to reflect the current environment. That said, for the product categories in which we can measure customer inventory absorption through connections to the cloud, we are seeing steady progress. However, based on conversations with customers, we still believe we are 1 to 2 quarters away from full implementation of their inventory, which, as I mentioned, is longer than we expected. We continue to track Meraki activations, which are moving slightly faster in wireless and slightly slower in switching. Using our Meraki business as a proxy for our wider enterprise networking portfolio, we expect the current implementation of shipped products to be broadly complete by the end of fiscal 2024.

Looking at our wireless business as an example, we are encouraged by the number of orders of $1 million or more, which increased approximately 50% sequentially in Q2. This indicates that many wireless customers have finished absorbing what we've shipped to them and are preparing for larger deployments in the coming months. Our team is also partnering closely with customers to assist with this heightened focus on deployments of Cisco equipment on hand, contributing to our services revenue increase year-over-year. It's also worth noting that nonhardware-centric revenue in areas such as Security and Collaboration increased, and our Observability offerings grew double digits year-over-year. Finally, despite the near-term challenges, our win rates are stable and on a rolling 4-quarter basis, our market share remained steady in 3 of our 4 largest markets.

Now moving on to our performance in Q2. As I mentioned earlier, our performance in the quarter was broadly in line with or better than our Q2 expectations. Given the trust our customers place in us and the criticality of our technologies to the outcomes our customers are seeking, I am confident about the foundational strength of our portfolio and our future growth opportunities. With our innovation, we deliver and enable our customers to deploy next-generation applications in a highly secure manner.

As part of this, we help facilitate their growth through our products and services so that when our customers adopt new technologies, we grow alongside them. We continue to accelerate our innovation across high-growth areas. Last week at Cisco Live EMEA, we announced new capabilities in networking, furthering our vision for the Cisco Networking Cloud. We also announced several new capabilities across our Security, Collaboration and Observability portfolios, leveraging AI throughout.

We also continue to capitalize on the multibillion-dollar AI infrastructure opportunity. This quarter, we announced the next phase in our partnership with NVIDIA to offer enterprises simplified, cloud-based and on-prem AI infrastructure. This includes both networking hardware and software to support advanced AI workloads. We are clear beneficiaries of AI adoption, and this partnership further demonstrates the central role we play in AI and the overall technology ecosystem. Our combined solution will be sold through our extensive global channel with professional services and support from key partners who are committed to helping businesses deploy their GPU clusters via Ethernet infrastructure.

In webscale, we continue to see momentum with 3 of the top 4 customers deploying our hyperscale Ethernet AI fabric, leveraging Cisco-validated designs for AI infrastructure. While there is tremendous opportunity ahead, we are still in the early stages of adoption of AI workloads.

In Security, we continue to execute against our product road map to deliver the industry's most comprehensive unified platform with end-to-end solutions. This quarter, we introduced Cisco Identity Intelligence, an analytics layer that pulls data from identity infrastructure and performs behavior-based assessments to help protect against identity-based attacks, which are at the forefront of cyber threats today. AI is also becoming more pervasive across the Cisco Security Cloud. For example, our new AI Assistant and Secure Access lets customers create security access policies using natural language prompts, reducing errors and speeding up policy administration by 70%. Our new security solutions like XDR and Secure Access are ramping quickly after being launched this fall with now over 230 Cisco XDR customers. Over the next 6 months, you can expect more meaningful announcements across the portfolio through our accelerated organic innovation and inorganic investments.

In addition, we have now extended our AI-powered ThousandEyes into Cisco Secure Access, joining past integrations with AppDynamics, Webex, Catalyst and Meraki platforms. ThousandEyes allows our customers to understand the digital experience of users, applications and things through billions of daily measurements of the Internet and public SaaS as well as thousands of enterprise customers, creating best-in-class digital experiences for users.

In Observability, we introduced the Cisco Digital Experience Monitoring application, providing deep insights into the performance of browser and mobile applications and efficient resolution of session-level issues. Our continued generative AI innovations build upon our existing platform capabilities, further enabling operations teams to focus on what matters most: minimizing tools for all, improving overall performance and delivering highly secure digital experiences.

Going back to the pending Splunk acquisition, the combination of Splunk's complementary capabilities with ours and AI, Security and Observability will create an end-to-end data platform to enhance our customers' digital resiliency. We are excited that together, we will bring trusted innovation leadership, an outstanding go-to-market engine and a world-class culture that will help our customers achieve their technology outcomes with innovative products and solutions.

I would also like to provide a brief update on timing. While the closing of the acquisition of Splunk remains subject to regulatory approvals and other customary closing conditions, given the positive progress to date on the required regulatory approvals, we now expect to close the transaction late in the first quarter or early in the second quarter of calendar year 2024, which is in our fiscal third quarter.

Before I turn it over to Scott, let me summarize 3 key takeaways. First, we have reset our expectations for the second half of the year given the cautious macro environment, our customers absorbing high levels of inventory and ongoing weakness in service provider. Second, you can count on us to take a disciplined approach regardless of the environment. We remain committed to operating leverage, capital allocation and expense management. Lastly, our portfolio continues to get stronger and stronger every day. While we have work in front of us and despite the current environment, we remain confident in our long-term strategy. We are relentlessly focused on our commitment to driving long-term value for our shareholders and industry-leading innovation for our customers.

I'll now turn it over to Scott to provide more detail on the quarter and our outlook.

[Richard Herren, executive]

Thanks, Chuck. Our Q2 results reflect solid execution again with strong margins and increasing operating leverage. For the quarter, total revenue was at the high end of our guidance range at $12.8 billion, down 6% year-over-year. Non-GAAP net income was $3.5 billion, down 3%, and non-GAAP earnings per share was above the high end of our guidance range at $0.87, down 1%.

Looking at our Q2 revenue in more detail, total product revenue was $9.2 billion, down 9%, and service revenue was $3.6 billion, up 4%. Networking, our largest product category, was down 12%. We saw declines across switching, wireless and routed optical networking driven primarily by weakness in the enterprise and service provider and cloud markets.

Security was up 3% with our Zero Trust offering growing double digits. Collaboration was up 3% driven by growth in collaboration devices and calling partially offset by a decline in meetings. Observability was up 16% driven by growth across the portfolio with continued strength in ThousandEyes network services. As Chuck mentioned, ThousandEyes helps monitor and assure digital experience everywhere, on-premise, Internet and the cloud.

We continue to make progress on our transformation to more recurring revenue-based offerings. We saw strong performance in our ARR of $24.7 billion, which increased 6%, with product ARR growth of 9%. Total software revenue was flat at $4.2 billion, with software subscription revenue up 5%. 88% of our software revenue was subscription-based.

Total subscription revenue increased 6% to $6.4 billion, which now represents 50% of Cisco's total revenue, an increase of 6 percentage points over last year. RPO was $35.7 billion, up 12% year-over-year. Product and service RPO both increased 12%. In total, short-term RPO was $17.9 billion, up 6%. Q2 product orders declined 12%, a significant improvement from Q1 as customers continue to work down product shipments from prior quarters.

Looking at our geographic segments year-over-year, the Americas was down 10%, EMEA down 8%, and APJC was down 27%. In our customer markets, service provider and cloud was down 40%, enterprise was down 6%, and public sector was down 5%. Backlog at the end of Q2 has now returned to normal levels.

Total non-GAAP gross margin came in at 66.7% up 280 basis points year-over-year and above the high end of our guidance range. Product gross margin was 65.2%, up 310 basis points. The improvement was driven primarily by lower freight and component costs and favorable product mix partially offset by negative impact on pricing. Service gross margin was 70.5%, up 140 basis points.

Non-GAAP operating margin came in at 33%, up 50 basis points and exceeding the high end of our guidance range. Strong non-GAAP gross margin and continued cost management drove the leverage.

Further, we are realigning our investments and expenses to reflect the current environment to help maximize long-term value for our shareholders. As part of our announced restructuring plan, we expect to impact approximately 5% of our global workforce with estimated pretax charges of approximately $800 million.

Shifting to the balance sheet. We ended Q2 with total cash, cash equivalents and investments of $25.7 billion. Consistent with our expectations, operating cash flow was $800 million driven in large part by the timing of federal tax payments and the higher annual payment of the TCJA transition tax.

This quarter, we returned $2.8 billion to shareholders comprised of $1.6 billion for our quarterly cash dividend and $1.3 billion of share repurchases. Year-to-date, we have returned $5.7 billion in value to shareholders, and we plan to continue our share repurchases at the current quarterly level throughout fiscal 2024. Increasing shareholder returns through greater operating leverage, maintaining a higher level of annual share repurchases and growing our dividend is consistent with our capital allocation strategy.

Given the confidence we have in our business today, we announced we are raising our dividend by $0.01 to $0.40 per quarter. This dividend increase demonstrates our commitment to returning a minimum of 50% of free cash flow annually to our shareholders and our confidence in the strength of our ongoing cash flows.

To summarize, we executed well with continued strong margins and increased operating leverage as we help our customers complete record deployments and implementations. We continue to progress our business model shift to more recurring revenue. We are strategically investing in innovation to capitalize on our growth opportunities and are committed to delivering long-term shareholder value.

With regard to our proposed acquisition of Splunk, we continue to work through regulatory approvals and closing conditions and as Chuck mentioned, we're optimistic that it will close ahead of what we had originally anticipated. We have not included any impact from the Splunk acquisition in our forward-looking guidance.

Turning to our guidance. As previously mentioned, we have reset our expectations for the second half of the year to account for the caution around macro uncertainty, the continued absorption by our customers of record levels of product shipments they received from us and the weakness of our service provider market. For Q3, our guidance is as follows. We expect revenue to be in the range of $12.1 billion to $12.3 billion. We anticipate the non-GAAP gross margin to be in the range of 66% to 67%. Non-GAAP operating margin is expected to be in the range of 33.5% to 34.5%. Non-GAAP earnings per share is expected to range from $0.84 to $0.86.

For fiscal year '24, our guidance is as follows. We expect revenue to be in the range of $51.5 billion to $52.5 billion. Non-GAAP earnings per share guidance is expected to range from $3.68 to $3.74. In both our Q3 and full year guidance, we're assuming a non-GAAP effective tax rate of 19%. Sami, let's now move into the Q&A.

[Ahmed Sami Badri, executive]

Thank you, Scott. [Operator Instructions] Operator, can we move to the first analyst in the queue?

[Operator]

Amit Daryanani with Evercore.

[Amit Daryanani, analyst]

I'll ask both my questions upfront. Chuck, when I think about the lower revenue guide for the full year by about 500 basis points versus 90 days ago, can you just touch on how much of that do you think is the digestion getting extended versus the macro versus the telco weakness? And then how do you sort of think about getting back to a positive revenue cadence organically?

And then as a follow-up, I'd love to just understand this, in media announcement you folks had, there's a bit of a perception that it's more about servers, less about networking. I would love for you to just flesh that out, what that means to Cisco.

[Charles Robbins, executive]

Amit, thank you very much. So obviously, with the lower guide, we talked about the feeling that there's some macro uncertainty. We talked to our teams in preparation for this, and they obviously submitted their forecast. And what we really saw was what they previously told us 90 days ago relative to the second half versus what they told us a couple of weeks ago had changed materially, which means customers are pushing things out and putting a little more scrutiny on them. So that's the difference that we've seen.

As far as trying to break down what percentage comes from each of those -- the 3, including the digestion issue as well as the telco and SP piece, I think it's pretty difficult to do, honestly. However, I will say that we think that the consumption of the elevated inventory levels should be -- we should be through that by the end of our fiscal year. We think that the SP telcos -- the SP telco and cable side of it, we're hopeful that in '25, they will begin investing again. We originally had anticipated that they would begin to invest in the second half of this year, and we no longer believe that to be true.

And I think that -- so I think the consumption issue and the SP thing -- or the consumption issue is temporary through the end of the year. The macro thing is one that we're going to have to wait and see and the SP telco probably similarly. And all of these things led us obviously to reset the second half of the year.

On the NVIDIA partnership, it is definitely Ethernet. I was in the meeting when we first talked about this with Jensen, and he agreed that we would include our Ethernet technology with their GPUs and creating the stack. There will also be servers as well, and there'll be multiple versions of this over time. So -- but it will include our Ethernet technology when they're connecting multiple clusters.

[Operator]

Meta Marshall with Morgan Stanley.

[Meta Marshall, analyst]

Maybe you've mentioned service provider, but I guess -- just getting a sense of whether you're seeing more weakness on data center or edge or if it comes to kind of the 5 investment priorities that you had noted that enterprises had a couple of quarters ago. Are any one of those areas still getting prioritized significantly versus not getting prioritized significantly? And then just maybe as a second question, how are you seeing enterprises think about AI and think about where the budgets for AI are coming from? Just any commentary would be helpful there.

[Charles Robbins, executive]

Yes. Thanks, Meta. So I would say that what we do see customers investing in is clearly cybersecurity. We see Observability as you saw the 16% growth rate. We even saw Collaboration positive this quarter, which was a good sign. They are at various phases of still dealing with this hybrid work situation. We had a very strong quarter with our devices, our video device businesses.

We see customers investing in their customer experience through technologies like contact center. And so we see a lot of that. We see customers continuing to invest in their application rearchitecture, which leads to both Observability opportunities as well as the re-architecture of their networks to deal with the traffic flows that we've been talking about for a couple of years. I think the real issue right now is that we ship so much networking in our core business that, that's where the challenge is, that they're just trying to get all that implemented right now.

As it relates to the enterprise and how they're thinking about AI, what I would tell you is that over the last 90 days, we began to see the pipeline for AI use cases in the enterprise began to emerge. And there's heavy work going on in financial services. I would say it's early in what they're trying to think through, but we are seeing opportunities arise. And I think that there have been some comments, not enough for me to translate this to a massive trend, but there were some comments from some of our field teams that they see customers holding budget back just to be ready to expend it on AI once they get their strategy fully baked. So that's about what I could tell you at this point.

[Operator]

David Vogt with UBS.

[David Vogt, analyst]

So maybe I just want to step back for a second, Chuck, and maybe for Scott also. If I look at your guide for this year, I mean, we're basically back to fiscal '19 revenue levels. So I'm just trying to think about how your longer-term model works in the context of that 5% to 7% guide that you laid out at the investor briefing a number of years ago as sort of customers digest product.

Obviously, it would suggest that maybe there's some more share loss going on in the core networking portfolio, given some of the other parts of the business has grown. So I just want to kind of try to get a sense of how you're thinking about the portfolio today, given we're kind of back to fiscal '19. And then from a profitability standpoint, obviously, you've done a tremendous job, and I would imagine the cost cutting goes along those lines to keep margins higher. But is there an opportunity to use margin and maybe price going forward to take back some of the share if there's a disruption in the market by a potential strategic transaction in the marketplace today?

[Richard Herren, executive]

Yes. David, I'll start and then Chuck, you can chime in on share. The way to think about the 5% to 7%, if you go back to when we gave that metric, you remember, it was in 2021, actually pre all of the supply chain volatility that we've seen. And since then, of course, we've seen the supply chain set in, which caused a spike in product orders and then a subsequent big building up of our backlog. As we cleared the backlog, we saw a spike in revenue. And so it's been difficult to look at year-on-year compares as all those dynamics were going on.

What we're seeing now is as we've cleared the backlog, and we cleared it very quickly, given the strength of our supply chain team, that bottleneck has just moved downstream. So I don't think you can look at this year's revenue and try to somehow compare it to historical because of all the moving parts underneath the covers. What underpinned that 5% to 7% when we gave it to you was that's the aggregated growth of the TAM of the markets that we play in, right? And so at this point, we still see that as the longer term where we're headed.

I think looking at year-on-year growth rates, I don't think you're going to see those growth rates begin to normalize until we work through the inventory that's in the field right now, which is one of the biggest headwinds we've got, right? And then we can get back to regular ordering and then you need to lap that, right? You need to go 4 quarters out to be able to compare it to a more normalized point. So I think that's the way you need to think about that longer term. But there's no change at this point. We'll update the longer-term model after we finish the acquisition of Splunk and can give you better insight into what we look like as a combined company.

[Charles Robbins, executive]

Yes. David, on the share loss, I think if you look at the -- just look at the last published reports that came out after Q...

[Richard Herren, executive]

3, calendar.

[Charles Robbins, executive]

Calendar Q3, in our 4 largest markets -- so if you take campus switching, you take wireless and you take SP routing, we actually gained share. So I don't know where the share loss thesis is coming from. When you look at data center switching, you will see it show up as a share loss. But to be -- we have to understand that one of our major competitors there reports their webscale sales into data center switching, and we report our webscale sales into SP routing. So those turn into sort of apples and oranges categories. But the others, based on the last reports that were put out, we actually have gained share if you look at a rolling 4 quarter even over the last 3 years.

[Operator]

Simon Leopold with Raymond James.

[Simon Leopold, analyst]

I've got an easy one and a little bit harder one. I'll start with the easy one and then ask the other. It just looks like your order trajectory is getting somewhat better. So the orders this quarter, down 12%, not too bad. And I know you don't forecast orders, but maybe if you can talk about when you expect orders could turn positive again, given the comparison and the trend.

The other question I wanted to see if you could discuss how you envision the AI clusters in terms of will the webscale operators choose multiple vendors in a single cluster or will they designate maybe different data centers to different suppliers? Or will they mix and match? How do you see the split playing out, particularly in the hyperscale opportunity? And I really mean this more longer term, '25, '26, not currently when we're dominated by InfiniBand, but when Ethernet starts taking more share.

[Charles Robbins, executive]

Yes. Thanks, Simon. So on the order trajectory, I think what -- we clearly don't guide bookings. But what I would tell you is that even as our teams modified their second half outlook, the second half will still be more favorable than the first half. So your assessment of sort of the trajectory, I think, is valid, and I'll leave it at that.

On the AI clusters, I think it's a good question because what you'll hear is us and competitors talking about a number of webscale players that are using our technology underneath GPUs, our Ethernet technology underneath GPUs. And so I think it's important to remember they always tend to have a dual vendor strategy. They always want 2 sources. And so we're both actually -- the 2 of us are actually playing in this space today. And I'd say today, they're completely homogenous clusters. And I think it's too early to tell whether there will be some benefit over time for them to mix those. My sense is, unless there's something that changes significantly or there's some sort of technology reason for GPUs to be mixed, which I can't speak to at this point, I don't think the underlying network will be mixed. I just don't think there's any benefit for them to do that.

[Operator]

Tal Liani with Bank of America.

[Tal Liani, analyst]

I have 2 questions. The first one is Security. The market is great. And we met 2 years ago and 3 years ago when you spoke about new strategy and going to market, but it's still only growing 3%. What is happening there? And what can you do to fix Security and benefit from this market growth? And then maybe I'll ask my follow-up.

[Charles Robbins, executive]

Okay. Thanks, Tal. So I think over the last few quarters, I've been pretty consistent that we thought the second half of this fiscal year, we would start to see an acceleration of Security, and I can give you some highlights where we are seeing some of that -- some green shoots early. Some of the new innovation like XDR and Secure Access, Multicloud Defense suites are -- we're seeing good pipeline build with those technologies.

XDR, we now -- we announced that in April of last year, we shipped it in August, and we have 230 customers, 230-plus customers on the platform today. And the important thing to remember is that it's a big platform play. And we actually typically see that as a 6- to 9-month sales cycle. So to have 230 customers already, I think, is a statement on the value that our customers are seeing. That's going to be a real important integration point with Splunk, by the way. So that we see. We see -- we feel good about the pipeline.

From a demand perspective, just to give you some insight, the Americas, the demand was almost double digits this past quarter, which is the highest we've seen in a while. So I think we're seeing a lot of good indicators. And if you just watch over the next 6 to 9 months, you're going to see more and more innovation that comes out. And I think you'll begin to believe and see the results around that same time frame.

[Operator]

Samik Chatterjee with JPMorgan.

[Samik Chatterjee, analyst]

Chuck, I'm going to, for my first question, ask you to go back to sort of the drivers of demand that you're seeing here. We walked away from the call last time sensing a sense of optimism about a sharp rebound when you see the inventory digestion complete. But I guess what I'm hearing from you today is even as that inventory digestion ends in fiscal '24, you're seeing a bit more of a macro impact on your customer demand. And are your expectations still sort of intact in terms of thinking about a more sharp rebound as you go into fiscal '25, if you can share what you're seeing from customers there?

And for my follow-up, the NVIDIA partnership, how should we think about the impact of that on your AI order target of $1 billion? Or is it really most of that partnership that realizes beyond that sort of target window, target time frame?

[Charles Robbins, executive]

Thanks. I would say on the -- the thing that's changed from last quarter is that we do just see a little more caution with our customers. I don't want to over-rotate and say that it's a massive shift, but we definitely saw more caution. We talked with our sales leaders ahead of the call, and they indicate -- we asked them point-blank, was there more caution or the same caution from the prior quarter? And we heard more, a little bit more. And then we saw the pushout of the forecast. So that just tells us that there is a little bit more in the system. So therefore, I think we need a couple of quarters to see it play out before we can declare what's going to happen in fiscal '25.

On the NVIDIA discussion, a couple of comments. We talked about the $1 billion of orders, which I know someone is going to ask me about at some point. And what I would say is that in the last 90 days, our pipeline of AI opportunities continue to grow. The pipeline is now almost 3x that particular number that we gave last time, which were more orders that we see in '25. The total pipeline is now about 3x that, roughly 3x that. And I would say that virtually none of that is anything associated with the NVIDIA partnership yet. It's all independent of that.

[Operator]

Ben Reitzes with Melius Research.

[Benjamin Reitzes, analyst]

Chuck, Scott, I wanted to ask about the HPE-Juniper deal. Are you seeing any uncertainty in the market near term? And how do you think that helps you long term? And if you -- Chuck, if you don't mind, just with regard to that last AI comment, your -- one of your competitors, obviously, is expecting quite a big pick up next year, next calendar year. Do you feel like that AI $3 billion in pipeline or so kicks in next year, next calendar year? Or what's your timing on that?

[Charles Robbins, executive]

Thanks, Ben. So I would say on the HPE-Juniper deal, the one area where they have meaningful overlap is in wireless, and I don't know if there's any connection to the fact that we had a 50% increase in $1 million-plus wireless deals sequentially. So it's hard to say. But I mean there is a lot of noise in the system or in the industry about what they do there, but I can't say specifically that any customers have talked to me about it, to be honest. So I think we're -- I think it's a little early for them to -- for the customers to be expressing that concern. They may be asking them directly, but they're not talking to us.

On the timing, yes, I think we said fiscal '25, which starts in August of this year. And I think you probably should assume most of that is probably in the second half, I would guess, but we'll see how things play out. I think customers are going to move as fast as they possibly can, but we're still in the early strategy and planning stages right now on most of it. The pipeline stuff are well-defined use cases that are already in place with certain customers, and we're actually just working through the opportunities.

[Richard Herren, executive]

Yes. But Ben, our expectation is the majority of that $1 billion in orders will turn into revenue in our fiscal '25, just to be clear.

[Operator]

Matt Niknam with Deutsche Bank.

[Matthew Niknam, analyst]

I'll keep it to one and one follow-up. So main question, just around inventory digestion. Is that dynamic primarily affecting enterprise and commercial customers? And can you talk a little bit about the visibility you've got towards this actually resolving itself by fiscal year-end? And then a follow-up just on gross margins. You were fairly stable sequentially, and I think the guide implies more of the same. So I'm just wondering, are we now largely past a lot of the supply chain dynamics or headwinds? Or has anything changed on the supply chain front?

[Charles Robbins, executive]

Yes. So I'll take the first, and then Scott, you can take the second. On the inventory digestion issue, I think it's -- I would say it's largely an enterprise and a service provider issue. And particularly the cloud providers, we think they've got probably in excess of 20-plus weeks of inventory that they're working through right now as they built up when the lead times were so long.

We have a lot of our enterprise products that are tethered to the cloud for management perspectives. And so we see the lag between when we ship it to the customer and when they connected. I gave the Meraki example in my prepared remarks. And so we do have visibility, and we can actually see on some aspects of the portfolio how the time frame between shipments and connectivity is shrinking, and it's not shrinking as fast as we thought it would, which leads us to believe this is going to extend through the end of '24. So that's where we are. Scott, gross margins?

[Richard Herren, executive]

Yes. What you saw in the quarter is, of course, gross margins continue to show a year-on-year improving trend, roughly flat, as you said, sequentially. There's a couple of dynamics. But to your question on where does this settle in, I think it settles in, in the range we're in right now, in the 66% to 67% range through the end of the year. There's both the things that are happening from a freight and delivery standpoint, freight costs with what's happening in the Red Sea have gone up slightly, and we continue to see a little bit of component pressure, although in the commodity sections, we're seeing some benefit there.

The scale of the services ramp-up, as you -- obviously, services revenue trails the product revenue. We had those 3 really strong quarters of product revenue growth. We're seeing the tail of that now in our services revenue growth. And since a lot of the cost underneath our services are fixed, you get better leverage when that happens. So I think when you add all those together, we should settle in, in the 66% to 67% range. And the majority of, if not all of the supply chain constraints that we felt are behind us at this point.

[Operator]

Michael Ng with Goldman Sachs.

[Michael Ng, analyst]

I just have 2. First, just on the revenue guidance. I think based on the midpoint of it, the implied fiscal 4Q revenue guidance only implies about plus 1% quarter-on-quarter. Given that we're back to a normal backlog, what's preventing that from going back to a more normal level of seasonality? And then as a follow-up to Amit's question earlier on the NVIDIA AI deal, I just wanted to clarify. I understand that it's Ethernet, but will it be both NVIDIA's Spectrum-X as well as Cisco's Ethernet? And how will that be sold together, if that's the correct assumption?

[Richard Herren, executive]

Michael, on the midpoint of the revenue guide, the math would lead you to what you just said. I think no one ever wants to have to reset guidance, much less have to do it twice. We -- as Chuck just said, as we look at all the various factors coming in from the field, we see caution. And I think you should expect that there's caution in our guide at this point.

[Charles Robbins, executive]

On the NVIDIA front, I think, look, one of the key benefits that they see is leveraging our enterprise go-to market and our global ecosystem and partner community. And therefore, when we are -- when these solutions are flowing through our channels and our sales teams and our partners, it will be Cisco Ethernet.

[Operator]

George Notter with Jefferies.

[George Notter, analyst]

I guess I'm just curious about -- are there any mechanisms or activities you guys are using to help accelerate the clearance of inventory from the channel? Any price discounting, any rebating, stock rotation? How are you taking an active approach here?

[Charles Robbins, executive]

I'll comment -- I'll make one quick comment. I think I said this in my prepared remarks as well. We've deployed a lot of transaction services for some of our larger customers just to help them do that. And I know that our sales teams were talking this week, Scott, maybe you remember or you have some more detail on looking at some partner incentives to help?

[Richard Herren, executive]

Yes. We absolutely are working with the field on that. In a lot of cases, it boils down to a lack of the skilled resources required at both -- sometimes at our partner level, sometimes at the customer level to get that done. There's only so much you can do to accelerate it. We have put in place incentives to make that accelerate. To your other point on cancellations or stock rotation, we're seeing those continuing to be well below where they were prepandemic. So we're not seeing any of that -- any pressure on that front.

[Operator]

Woo Jin Ho with Bloomberg Intelligence.

[Woo Jin Ho, analyst]

Given that most of the weakness is going to be on the networking side, could you just talk a little bit more about the future software subscription renewal rates? You did a good job this quarter with software subscriptions going up 5%, but given that networking is poised to be down, I'm curious where that's heading going forward.

[Richard Herren, executive]

Yes. I think -- thanks for the question, Woo Jin. I think the way to think about it is we put a -- as you can imagine, when you built up the level of annualized recurring revenue that we have, we've put a huge amount of focus on both customer success and driving adoption and then turning that adoption into renewals. We've invested fairly heavily in that space over the last couple of years, and we're seeing renewal rates respond accordingly.

When you look at where we're more software-heavy outside of networking, but in both security and collab, as you saw, we reported growth -- revenue growth in both of those categories. Observability is almost exclusively software, and we posted 16% revenue growth in observability. So we are seeing that actually trend in the right direction.

[Operator]

Tim Long with Barclays.

[Timothy Long, analyst]

One question, one follow-up. So first, maybe, Chuck, can you talk a little bit about the kind of margin growth trade-off with the head count reduction? Obviously protecting margin here, but how do you think about that trade-off given the challenging growth we've seen? And then just on a follow-up with all of the AI comments, Chuck, could you just remind us kind of where we are with -- from a product standpoint, are you seeing more traction for Silicon One or software or the full system products? If you could just give us a little color on kind of where you're seeing that pipeline growing?

[Charles Robbins, executive]

Yes. Thanks, Tim. So on the margin growth trade-off, we're always considering that, and we're very disciplined, though. And we think that gross margins are clearly a reflection of the value that your customers see and your technology and what you deliver. And if you look at a lot of our competitors and you look at some of the market share -- I mean, some of the gross margins that they have, that tells you that they're viewed more as a commodity. And I think that our customers see real value in what we deliver to them. So while we always look at margins versus growth, we also are -- we're just disciplined across both.

On the AI front, Silicon One is a big play, clearly. We've delivered next-generation silicon into several of the cloud providers right now. We've got the Ethernet running in 3 of the 4 big ones. And we'll use the same silicon in the enterprise data center over time.

We've got GPUs in our UCS platforms. And so it's evolving, but we have -- I tell our teams, unlike the original cloud transition that we talked on this call several times about how we were not prepared for the infrastructure play in the cloud world, I think we are absolutely ready and well equipped to succeed in this transition to AI. It will be a tailwind for us as we get into it over time.

[Operator]

Our next question comes from Aaron Rakers with Wells Fargo.

[Aaron Rakers, analyst]

I'll stick to one, just building on that last question. I know over periods of time, you've talked a little bit about how large your webscale business is. Can you just remind us again the presence you have in some of the webscale opportunities either from a size -- and maybe ex the AI discussion, what kind of growth rates you're seeing, particularly with those webscale customers right now?

[Charles Robbins, executive]

So our team measures what -- their use cases or franchises or however you want to think about it, there are specific areas within the infrastructure that we identify for each of the webscale players. And Scott, keep me honest, I want to say we're designed into 16 or...

[Richard Herren, executive]

21.

[Charles Robbins, executive]

21 of those. And so that's how I would think about it. I don't think that right now, if you looked at the growth numbers, they wouldn't be reflective of what's going on because they're just digesting inventory right now. So they're not in a position where they need to order a lot because lead times have normalized so much. So I don't think that's -- it's not even relevant. I think understanding those 21 use cases -- and as I said earlier, they want dual source, and they want dual source all the way down to the silicon level. In the traditional days with carriers, they wanted 2 vendors who would provide 2 different integrated systems. In this case, that may be the case with cloud, but they also look at silicon. They look at components. They're very deep on wanting to make sure that they have resiliency and optionality.

[Richard Herren, executive]

Aaron, the only thing I'd add is, and we said it earlier, there's no question that over time, given the way we're positioned, both from a complete box, a white box and a silicon standpoint, there's no question that AI is a tailwind for us longer term.

[Operator]

James Fish with Piper Sandler.

[James Fish, analyst]

Scott, based on a couple of comments you made around gross margins. Just wondering, was supply chain starting to go the other way and supply more readily available? Could we see the price increases enacted in the past now have to be given back? And any sense to how should we think about the annualized cost savings on these reductions, understanding there are people here and it's difficulty and what areas you guys expect to kind of reduce down and if some of those reductions are filled elsewhere in terms of like a net basis on head count?

[Richard Herren, executive]

Yes. On the price declines, you got to remember, go back to why we put the price increases in to begin with. And that was really to offset the higher cost that we were seeing from many of our suppliers as everyone was dealing with constraints, and supply/demand is pretty straightforward.

What we haven't seen in the wake of this, some of the commodities, the prices have come down. Memory is a good example. What we haven't seen broadly is cost decreases coming in from our providers at this point. And so with that -- and you see that reflected in our gross margins, which have returned to a more normal range, but are still sitting in that 66% to 67% range. So I'm not anticipating at this point price declines, pending significant cost declines coming into us.

On the cost savings, you can see where we are year-to-date. We've got a -- if you just look at operating expenses for a minute, year-to-date, operating expenses are modestly up. And after working our way through the restructuring that we discussed today, for the full year, we think they'll be modestly down. So I think that's probably the right way to think about it as you're looking to build your model.

[Ahmed Sami Badri, executive]

Thank you, Jim. Cisco's next quarterly conference call, which will reflect our fiscal year '24 third quarter results, will be on Wednesday, May 15, 2024, at 1:30 p.m. Pacific Time, 4:30 p.m. Eastern Time. This concludes today's call. If you have any further questions, please feel free to contact Cisco Investor Relations, and we thank you very much for joining the call today.

[Operator]

Thank you for participating on today's conference call. If you would like to listen to the call in its entirety, you may call [phone]. For participants dialing from outside the U.S., please dial [phone]. This concludes today's call. You may disconnect at this time.