Cisco Systems Inc

NASDAQ:CSCO

Earnings Call Analysis

Cisco Surpasses Q3 Expectations with Splunk Acquisition

Cisco reported Q3 revenue of $12.7 billion, down 13% year-over-year, but exceeded guidance with non-GAAP EPS of $0.88. The $4 billion Splunk acquisition contributed $413 million in partial-quarter revenue. Despite a 27% decline in networking due to inventory adjustments, security and observability sectors saw significant gains, with Splunk's security boost aiding a 36% increase. Cisco expects Q4 revenue between $13.4 billion and $13.6 billion and non-GAAP EPS between $0.84 and $0.86. Guidance for fiscal 2024 predicts revenue of $53.6 billion to $53.8 billion. The Splunk integration is anticipated to drive revenue synergies from fiscal 2025 onwards.

Introduction and Company Performance

Cisco delivered solid performance in Q3, despite a 13% year-over-year drop in total revenue to $12.7 billion. This was because of ongoing inventory management by customers. Service revenue grew 6%, but product revenue fell by 19%. Non-GAAP net income was down 14% to $3.6 billion, affected slightly by the Splunk acquisition.

Impact of Splunk Acquisition

Splunk, acquired on March 18, contributed $413 million to Q3 revenue. This acquisition significantly boosts Cisco's portfolio, particularly in observability and security sectors. Although the interest cost of financing the acquisition slightly offset Splunk’s positive impact, Cisco expects Splunk to be accretive to earnings per share by fiscal year 2026.

Revenue Breakdown

Networking, Cisco's largest product category, saw a 27% decline due to previous quarters' shipment backlogs. Security revenue increased by 36% thanks to Splunk; without it, the growth was 3%. Observability increased by 27% overall but grew 14% without Splunk’s influence. Collaboration remained flat due to gains in cloud offerings being offset by declines in meetings and devices revenue.

Transformation to Subscription-Based Model

Cisco's annual recurring revenue (ARR) rose 22% to $29.2 billion, with Splunk contributing significantly. Even without Splunk, ARR increased by 5% to $25 billion. Subscription revenue increased 12%, reaching $6.9 billion and accounting for 54% of total revenue. Software revenue grew by 5%, driven by a 17% rise in software subscription revenue.

Future Guidance

For Q4, Cisco expects revenue between $13.4 billion and $13.6 billion, with non-GAAP gross margin in the range of 66.5% to 67.5%. Non-GAAP EPS is projected to be $0.84 to $0.86. The Splunk acquisition is expected to contribute $950 million to $1 billion in revenue but will have a negative $0.03 impact on non-GAAP EPS due to interest costs. Revenue growth for fiscal 2025 is anticipated to be low to mid-single digits.

Geographic and Customer Segment Performance

Geographic segment performance showed mixed results: Americas grew 6%, EMEA 4%, while APJC saw a slight decline of 1%. Customer markets showed a strong performance from service providers and cloud, increasing by 10%, with the public sector and enterprise segments rising by 6% and 2%, respectively.

Earnings Call Transcript 2024-Q3

[Operator]

Welcome to Cisco's Third 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 Third 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.

And given our recently closed acquisition of Splunk, we are also joined by Gary Steele, the former CEO of Splunk, which is now a Cisco company.

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 will 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 made throughout this call will be on a year-over-year basis. The matters we will be discussing today include forward-looking statements, including the guidance we will be providing for the fourth 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 also 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 performance in Q3, with organic revenue coming in at the high end of our guidance range. Strong operating leverage across our business drove gross margins to exceed the high end of our expectations, resulting in better-than-anticipated earnings per share performance. .

We once again delivered good growth in annualized recurring revenue, remaining performance obligations and subscription revenue. We have transformed our business model with revenue from subscriptions now accounting for more than half of our total revenue even before the addition of Splunk.

With the success of our transformation, we are well positioned to drive long-term growth, powered by innovation across the organization. I want to thank the entire Cisco team as it is through their dedicated efforts that our research and development engine has never been stronger across networking and silicon, observability, security, collaboration and AI.

The strength of our core business continues to produce strong cash flows, reinforcing our ongoing commitment to delivering consistent capital returns. In Q3, we returned $2.9 billion in value to our shareholders through share repurchases and cash dividends in the quarter with a total of $8.5 billion in value returned year-to-date.

Q3 was significant for us in 2 important ways. First, I couldn't be more excited about the successful close of our Splunk acquisition, Cisco's largest ever. Our acquisition of Splunk was completed midway through our Q3 on March 18, earlier than initially anticipated. Splunk significantly expands our portfolio of software-based solutions, contributing over $4 billion in annualized recurring revenue and adds to our position as 1 of the largest software companies in the world.

We are thrilled to welcome the Splunk team to Cisco and are very excited about what we can deliver for our customers as we integrate our complementary security and observability capabilities. Our unified platform will revolutionize how customers connect and protect their organizations, using data in new ways to enhance their entire digital footprint.

Second, we introduced Cisco Hypershield, our most significant new security innovation with a groundbreaking AI-powered approach to highly distributed security, a first of its kind.

Combining security and networking in a way only Cisco can, Hypershield is built in the very fabric of the network, bringing the power of hyperscaler security and connectivity to the enterprise. I will talk more about these developments and our innovation momentum in a few moments.

But now I'd like to turn to our performance in Q3 and what we're seeing in terms of customer demand. The breadth of our portfolio, together with our many touch points with partners and customers around the world provides us with differentiated insight into what's happening in our customer base.

Based on activations to the cloud, which we track as well as conversations with our customers and partners, we believe that the products customers have on hand are being steadily deployed in line with the expectations we laid out last quarter. Meaning, we currently expect customers to complete the installation of the majority of their inventory by the end of our fiscal year in July.

At a time where customers are ruthlessly prioritizing their IT investments, we saw product order growth in 2 of our largest product portfolios, data center switching and campus switching as well as product order growth in our security and collaboration product categories.

Overall, product orders were up 4%, and excluding Splunk, product orders were flat year-on-year. In our customer markets, public sector was strong in EMEA and APJC, but continuing resolution discussions in the U.S. temporarily impacted public sector performance in the Americas.

We believe this has since cleared with the subsequent signing of the most recent U.S. federal government funding legislation. While our telco and cable customer demand remained muted worldwide, we are encouraged to see early signs of stabilization and improved performance in web scale in terms of pipeline and orders.

Overall, our win rates are stable, and we saw increased strength as we moved through the quarter. This reflects our competitive strength and successful execution and gives us confidence in the long term.

We also know that the value of our portfolio is greater than ever as evidenced by recent sell-side research IT spending surveys, which show that Cisco is expected to be the only net share gainer within large network budgets over the next 12 months.

Now let's look at our performance in Q3 in more detail. We saw revenue growth in security and double-digit growth in observability year-over-year, excluding Splunk, as customers look to enhance their digital resilience with Cisco's technologies.

In the past year, we've accelerated our pace of innovation and security, and I'm proud of what our teams have achieved. As I mentioned earlier, last month, we introduced Cisco Hypershield, the first truly distributed AI-native cybersecurity solution which will be built into our networking fabric.

This new innovation leverages the recently closed Isovalent acquisition to facilitate deployment and software and the first shipment is scheduled for August this year. This launch furthers our vision for the Cisco Security Cloud, which is expected to deliver the industry's most comprehensive, unified platform with end-to-end solutions, making it easier for our customers to protect against the threats of today and tomorrow.

Our newest available security solutions, XDR and Secure Access continue to ramp quickly with strong customer feedback. Just last week at RSA, we also announced the integration of Cisco XDR with Splunk Enterprise Security, which will give our customers even more value and insights.

The closing of the Splunk acquisition in Q3 will also enable us to begin driving revenue synergies in our security and observability markets. Upon closing the deal, we identified 5,000 existing Cisco customers who have the potential to become meaningful Splunk customers, and our sales teams are already making those connections.

We also see significant opportunities for revenue synergies by leveraging Cisco's robust partner and customer ecosystem in markets where Splunk had limited or no presence.

Earlier this week, Splunk was ranked as the leader in Gartner's Magic Quadrant for security incident and event management, which is a testament to the strength of the offering and the continued business momentum that Splunk has delivered.

We are working on a rapid integration, investing in both product integration and go-to-market resources, starting with aligning our Cisco and Splunk sales forces and accelerating channel enablement processes for cross-selling and upselling our combined solutions.

We also continue to capitalize on the multibillion-dollar AI infrastructure opportunity. In web scale, we continue to see momentum with 3 of the top 4 hyperscalers deploying our Ethernet AI fabric, leveraging Cisco-validated designs for AI infrastructure. In the past 2 quarters, Cisco has been granted additional design awards based on our 51.2 terabit G200 Silicon One ASIC.

We expect these awards to yield orders in fiscal year '25, and -- reinforcing our confidence in our line of sight to $1 billion of AI product orders in fiscal '25.

Additionally, for those leading-edge enterprise customers who seek to be the early adopters of AI, our partnership with NVIDIA will offer easy to deploy cloud-based and on-prem networking solutions for AI inferencing.

We believe we are well positioned to be the key beneficiary of AI enterprise application proliferation with the breadth of our portfolio and the vast amounts of data we see.

Before I turn it over to Scott, I'd like to share 1 more update. Earlier today, we announced that Jeff Sharritts our Chief Customer and Partner Officer, is departing Cisco, and that Gary Steele, Splunk's former CEO has been named Cisco's new President of go-to-market.

Gary is well known for his operational excellence. And in this new role, he will work closely with me to set and execute against our strategic plans and goals for the company. He will continue to lead the Splunk team through the integration process to ensure a seamless integration into Cisco.

Gary's operational mindset, combined with his intense focus on simplicity and proven ability to drive growth position him well in his role, and I look forward to working closely with him in this new capacity.

I'd also like to take a moment to thank Jeff for all that he's helped Cisco achieve, which is quite a long list of accomplishments in his 24 years here.

Moving back to Q3, let me briefly summarize. While our core product portfolio is trending towards normalization as we continue to see customer deployments of shipped equipment progress, we are pleased that our security and observability portfolios have continued to grow and are significantly enhanced by the acquisitions of Splunk and Isovalent.

As our customers adopt and deploy AI, they need the infrastructure to power it, the data to develop it and the security to protect it. and we believe only Cisco can deliver and integrate all 3.

With our unified platform approach, vast global partner ecosystem and ability to support hybrid and multi-cloud environments we will deliver innovation at an unprecedented pace and scale to organizations around the globe.

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

[Richard Herren, executive]

Thanks, Chuck. Our Q3 results reflect solid execution with strong margins and a stabilization of orders. Both including and excluding Splunk, our revenue, gross margin and non-GAAP earnings per share were at or above the high end of our Q3 guidance range.

Total revenue was $12.7 billion, down 13% year-over-year. Splunk contributed $413 million in revenue in the partial quarter post close. Non-GAAP net income was $3.6 billion, down 14%. Non-GAAP earnings per share was $0.88, down 12%.

The interest cost of financing with Splunk acquisition slightly more than offset the positive operating impact of Splunk. The net effect was a negative impact of $0.01 on non-GAAP earnings per share.

Looking at our Q3 revenue in more detail. Total product revenue was $9 billion, down 19% and service revenue was $3.7 billion, up 6%. Networking, our largest product category was down 27%. We saw declines across all geographic segments due to the continued implementation of inventory by our customers.

Bear in mind that our Q3 2023 networking revenues benefited from significant shipments of excess backlog. Security was up 36%, including the benefit received from the Splunk acquisition. Excluding Splunk, Security grew 3%, driven by growth in SASE and double-digit growth in our Zero Trust offering.

Collaboration was flat, driven by growth in our cloud calling and contact center offerings, offset by declines in meetings and devices. And observability was up 27%, driven by growth in ThousandEyes Network Services and the benefit from the Splunk acquisition. Excluding Splunk, observability grew 14% for the quarter.

As Chuck said, we have successfully transformed our business model. ARR ended the quarter at $29.2 billion, which increased 22% due to continued strong performance and contribution from Splunk. These factors also drove our product ARR growth of 44%.

The -- without Splunk, ARR was $25 billion, up 5% and product ARR was up 9%. Total subscription revenue increased 12% to $6.9 billion which now represents 54% of Cisco's total revenue. Without Splunk, total subscription revenue was up 5%, representing 53% of Cisco's total revenue.

Total software revenue was up 5% at $4.5 billion with software subscription revenue up 17%. Without Splunk, total software revenue was down 4% and software subscription revenue was up 6%, 91% of our total software revenue was subscription-based.

Total RPO was $38.8 billion, up 21% due to both strong performance and the Splunk acquisition. Product RPO grew 29%. Total short-term RPO was $20.1 billion, up 19%. Without Splunk, RPO was $35.3 billion, up 10%, with product RPO also growing at 10%.

We -- Q3 product orders were up 4%. Excluding Splunk, product orders were flat year-over-year. We see customer product implementations progressing in line with our expectations and we expect these deployments to be largely complete by the end of our current fiscal year.

Looking at our geographic segments year-over-year. The Americas was up 6%, EMEA was up 4% and APJC was down 1%. In our customer markets, service provider and cloud was up 10%. public sector was up 6% and enterprise was up 2%.

The -- Total non-GAAP gross margin came in at 68.3%, up 310 basis points year-over-year and above the high end of our guidance range. Product gross margin was 66.9%, up 240 basis points, of which Splunk contributed 70 basis points.

The remaining improvement was driven primarily by favorable product mix and lower freight and other costs. Service gross margin was 71.6%, up 430 basis points. Non-GAAP operating margin came in at 34.2%, up 30 basis points, driven by our continued commitment to disciplined spend management. Operating cash flow was $4 billion, down 24%.

The -- Shifting to the balance sheet. We ended Q3 with total cash, cash equivalents and investments of $18.8 billion. Uses of cash during the quarter included a net outflow of $27.4 billion related to our acquisition of Splunk. And in line with our capital allocation strategy, we returned $2.9 billion in value to our shareholders, including $1.6 billion for our quarterly cash dividend and $1.3 billion of share repurchases. Year-to-date, we've returned $8.5 billion in capital to our shareholders.

To summarize, we successfully completed the acquisition of Splunk, drove strong non-GAAP margins and increased our operating leverage in the quarter.

Turning to our financial guidance that includes our integration of Splunk. For Q4, our guidance is as follows: we expect revenue to be in the range of $13.4 billion to $13.6 billion. We anticipate the non-GAAP gross margin to be in the range of 66.5% to 67.5%. Non-GAAP operating margin is expected to range from 31.5% to 32.5%. The -- non-GAAP earnings per share is expected to range from $0.84 to $0.86.

Our Q4 guidance includes $950 million to $1 billion in revenue from Splunk and non-GAAP EPS of negative $0.03 as the interest impact more than offsets the operating benefit. In Q4, we're assuming a non-GAAP effective tax rate of approximately 18%.

For fiscal year '24, our guidance is as follows: we expect revenue to be in the range of $53.6 million to $53.8 billion. Non-GAAP earnings per share guidance is expected to range from $3.69 to $3.71. And -- we're assuming a non-GAAP effective tax rate of approximately 19%.

Looking beyond Q4 and into our fiscal 2025, in addition to the top line benefits from the Splunk acquisition, there are a few points to bear in mind as you build your models. First, we expect revenue growth to be in the low to mid-single-digit range next year.

Second is the interest impact from the acquisition, which we expect to be a headwind of approximately $350 million per quarter, including both the foregone interest from cash off the balance sheet and the additional interest payments on debt.

Third, we're working to quickly integrate Splunk into our product offerings, go-to-market engine and expect to invest in OpEx in fiscal '25 to drive those revenue synergies. I -- given these points, we expect fiscal '25 operating margins to be in line with our Q4 guidance.

We'll give more formal guidance as we get to the next earnings call, but I want to make sure you have those 3 thoughts in mind. And as we've stated, we expect the deal to be non-GAAP earnings per share accretive in fiscal 2016 and beyond.

Sami, let's now move into the Q&A.

[Ahmed Sami Badri, executive]

Thank you, Scott.

[Operator]

Thank you. Amit Daryanani with Evercore.

[Amit Daryanani, analyst]

Have 2. I'll ask them both at the same time. Chuck, it's really nice to hear about inventory digestion or of being done in order growth, getting back to flat growing in some of the verticals.

Some of the tech companies, I guess, have talked about a softer macro environment that's resulting in some positive spending. I'd love to understand kind of away from the inventory digestion that it seems like it's happening. What are you seeing from a macro environment? And if that's actually starting to improve as well for you folks?

And then if I could just follow up on a different side. The $1 billion of AI orders that you have that you believe you can get in fiscal '25. Can you just talk about -- is there other wins more coming from the Silicon One side or optical or on the switching solution? Just anything on kind of where do you expect to get these wins would be helpful.

[Charles Robbins, executive]

Thank you, Amit. I appreciate the questions. So from a macro perspective, what I would say is that ironically, we saw the quarter actually showed slight improvement as we move through the quarter. So the end of the quarter was actually a little stronger than the beginning.

So we -- and look, we obviously believe that our customers now are on track with the inventory digestion that we talked about last quarter. So that's positive. But we saw the Americas, excluding Splunk was up 2%. So that was a positive sign. And Europe was flat. So that was good.

And when you see campus switching and data center switching both positive. And by the way, data center switching was in the mid-teens growth. So customers are investing in these private data centers. and collaboration being positive security being high single digits on the order side, it was -- but we didn't see any different behavior from our customers during this quarter than we've seen. They still are ruthlessly prioritizing what projects they spend money on, where they spend their IT dollars, but we didn't see any fundamental shift in the macro.

On the second question, on the $1 billion of AI, it is largely driven by the web-scale infrastructure. As I said, we had -- we've got 3 out of 4 that are running our AI Ethernet fabric, and we also had 2 or 3 more design wins during the quarter, I believe, in the back-end networks inside these web scale players.

So it's predominantly that. However, we are beginning to see enterprise pipeline materialize, as I said last quarter. So that's really what it's made up of. And it is both systems as well as optics across those customers.

[Operator]

Our next caller is Simon Leopold with Raymond James.

[Simon Leopold, analyst]

Great. I wanted to see if you can give us some metrics or some help trying to extrapolate the 5,000 customer opportunity for Splunk? I -- just give us a better idea of what that could mean from a dollars perspective if you're able to penetrate it?

And my follow-up is really -- I'm trying to speak a little bit more clarification on this $1 billion AI pipeline because there's been a lot of debate in the investment community regarding it.

So I want to -- I want to see if we can get some clarification that when we talk about the context of what's in there, it's explicitly in the back end that there's not some extrapolation to front-end data center applications.

So explicitly back end and I think, Chuck, you were saying that it is mostly switching in the back end with some optics and some Silicon One. I really would like to clarify this because we're getting a lot of questions.

[Charles Robbins, executive]

All right. Let me answer the second 1 first, if you don't mind, since I just went on that one. It's $1 billion orders that we have line of sight to in next fiscal year is what I had said. And on one of the earlier calls, maybe last call, I think I said our pipeline was roughly 3x that we see, but we believe we have good visibility to $1 billion in orders in FY '25. .

That is primarily back end, and it is a combination of systems that are based on Silicon One, potentially some stand-alone Silicon One, but mostly systems and then optics as well. And then there's -- we're beginning to see some enterprise use cases, but it's predominantly back end in the hyperscaler space.

On the 5,000 customers, we basically did an analysis of where we have -- Cisco has super strong relationships and Splunk doesn't have a presence of 5,000 customers, and we've now mapped those to the sales teams. And Gary, do you want to make a comment on that because you've been involved in that deeply?

[Gary Steele, executive]

Yes. So we're excited about the fact that basically, we've identified these 5,000 customers where Splunk traditionally has had no footprint. And the goal there is to have the Cisco sellers open the door for the Splunk team.

There's also a financial incentive or spiff in place to incent the Cisco sellers to support this activity. And that's really -- that's 1 aspect of where we see tremendous opportunity.

And then second to that, obviously, there's a lot of overlap in our customers where the Cisco team may have hired more strategic relationships where they can extend our footprint, assist in helping extend our footprint within the existing Splunk base. and we're already seeing that activity right out of the gate.

So we feel like we're off to a very good start, and I'm super encouraged by the level of collaboration we've seen so far.

[Operator]

Our next caller is Tal Liani with Bank of America.

[Tal Liani, analyst]

I'm going to ask my 2 questions also together as they are linked. You have great motions in Security with lots of new products, and you have Splunk introduction to the channel and you have also the opportunity for Internet.

Can you give us a sense of timing, meaning how long security grew again only 3% ex Splunk? And how long does it take to get all the benefits that you're talking about in these 3 main areas or in general? Is it something we're going to see early in '25 or later in '25 or '26? If you can give us just a sense of timing of all these initiatives.

The second part is related to it, if I remove Splunk from the numbers, can you give us enough data to completely remove Splunk from '24 and I can take consensus for '25, then your core Cisco, meaning your initial growth expectations for '25 is about 5% because we need to remove also the backlog contribution this year.

So Cisco ex backlog contribution should grow 5%. It's higher than before. So the question is, are you comfortable with Cisco growing 5% next year give or take? And what is the main component of this growth?

[Charles Robbins, executive]

Tal, thanks for the question. So on the -- let's go with the first question, and I'll say on the organic Cisco Security front, you're right, revenue was up 3%. But as I said, our demand was the highest it's been in probably a couple of years and it was high single digits.

So we're seeing the traction on these new products. They're just ramping, right? They're new customers are testing, they're implementing and by the way, a lot of it is ratable. So you don't -- you take the orders and then you -- like close to 80% of our security portfolio is ratable. So that actually impacts the time for it to transition into revenue. So that's on the security side.

But I think on the security and Splunk side, I'll talk about it a little bit. We've -- and then I'll let Gary comment on some of the integration, but we announced our first integration last week at RSA. Our intent is just to continue pushing innovation out. We'll have more announcements at Cisco Live.

So I think that you'll continue to see that happen. I've always said on the security front, even before Splunk, that we had brought in a new team. We've been building new innovation. The team has built 5 new products and solutions from the ground up over the last 12 months, as you alluded to, just done a phenomenal job.

And I had always said that second half of '24, I expected you would see an improvement. And then in '25, you'll see it get to where we really need it to be. And I think that still stands you want to comment on the Cisco, the integration stuff, Gary?

[Gary Steele, executive]

You bet. So 1 of the things I'm super excited about is the progress we've made from an integration standpoint. So last week at RSA, for example, we announced the integration between the Cisco XDR solution and Splunk's Enterprise Security Solutions.

So bringing high telemetry alerts into Splunk Enterprise Security gives a Splunk customer that much more value in terms of threat detection. And this is just the start of the elements of integration that we can deliver that will ultimately drive growth for the security portfolio broadly, but also Splunk.

And as we've described earlier, our integration strategy really is a strong ground game, meaning we want to move the ball 3 years at a time, and we're going to demonstrate to the industry that we can continue to innovate at a rapid pace as a combined business. And we feel like we're on a really good track to do that.

[Charles Robbins, executive]

Thanks, Gary. And then on your AI timing question in 25, my suspicion is that, that's going to start low at the beginning of the year, and it will ramp as we get through the year. So I would be thinking more back half.

But we'll have to see how these pilots go. We'll probably know a little more about -- we'll know more in the next 90 days on that.

On your second question, first of all, I appreciate the fact that you recognize that several billion of backlog that we cleared last year because this is the -- this is a -- '25 will be a year where we're still going to have strange comparisons because we're just still coming out of the tail end of the supply chain situation and this whole digestion issue and the inventory shipments and everything.

So '26 over '25 will be the year where you will really hopefully get back to real apples-to-apples year-over-year comparisons. And while I -- we aren't giving a breakdown today of the FY '25 Cisco or Splunk contribution, we'll obviously have an Analyst Day in June, and we'll go into more detail there. And Scott, do you have anything to add to that? Or is that good?

[Richard Herren, executive]

No. I think you said it right. And Tal, the fact that you recognize the backlog work off. It clearly is a headwind on just the core Cisco when you look at year-on-year growth rate into fiscal '25.

Bear in mind, too, obviously, Q3 was a tough compare. If you remember that we had those 3 consecutive quarters of revenue growth in the mid- to upper teens. Q3 of '23 that we're comparing to now, Q4 and then Q1 of this year.

And so in addition to doing the year-on-year growth rates the way you're doing it, you need to think of the backlog impact on the year-on-year growth rates in both this quarter, next quarter and again, a tough compare in Q1 of '25.

[Operator]

David Vogt with UBS.

[David Vogt, analyst]

So maybe, Scott, I want to follow up on that line of questioning from Tal. I recognize that you have that backlog headwind in '24. But if I just kind of run through what Splunk should be doing versus what they contributed this year, it certainly looks like the backlog headwind is going to cause core Cisco to be down next year. I know you said you're going to hold off on giving numbers. Is that the right math?

And so basically, all of the low single to mid-single-digit growth comes from Splunk. And then from a gross margin perspective, obviously, Splunk can be a much bigger part of the business. Can you maybe walk through -- you gave us an operating margin framework, but sort of what do you expect from a gross margin perspective given the stronger margin profile of Splunk being a bigger part of the business next year versus this year?

[Richard Herren, executive]

Yes. Thanks, David. You remember, Q1 of this current fiscal year, of fiscal '24 was really the last quarter where we shipped a lot of, I'll call it, excess backlog, right? There's always a an ambient level of backlog, where we had a lot of excess backlog that built up during the supply constraints.

So when you think about the growth rate from '24 to '25 clearly, Splunk is a positive on that, obviously, adding that to it. But you also have to think of this year, fiscal '24, having a nonrepeatable bit of excess backlog that was shipped in the first quarter of this year. Remember, first quarter this year, we grew in the mid-teens on revenue.

So if you net that out, and that's the math that Tal was doing to say the core business is actually growing in those mid-single digits in fiscal '25. And when we can walk through, I know there's a lot of moving parts there. David, we can walk through that if you want.

On the gross margins, I think the way to think about that, we had some benefit in the quarter. Splunk itself is a benefit, of course. We had some benefits in the quarter on product mix. and some cost savings that I don't think are repeatable longer term.

So I talked about the guide for Q4 being gross margins in the 66.5% to 67.5% range. for Q4. I think that's the right range as you think about fiscal '25 as well.

[Operator]

Meta Marshall with Morgan Stanley.

[Meta Marshall, analyst]

Maybe first question, Chuck, if you could just kind of update where your kind of conversations with customers are around AI, either in kind of desire to invest on-premise or invest in kind of Cisco security products for preparedness or just impact to budgets?

And then maybe second question for Scott. Just as we think about kind of the OpEx investment that you guys noted for Splunk, how should we think of that versus kind of original targets to have Splunk be kind of accretive 1 year post close?

[Charles Robbins, executive]

Thanks, Meta. I would say the conversations, I think the web scalers is pretty well understood. So I'll talk about the enterprise.

And I think most enterprises, there are some that are certainly running pilots that are doing some work today. And we actually have had some -- we had a handful of wins in the enterprise space for infrastructure that was supporting AI build-outs. I'd say they're still very, very, very early.

We had our global customer advisory board last week in Canada. And I think we had about 60 customers there, and they're all still trying to figure out exactly what their use cases are and how the architecture is going to play out. So I would say it's still super early on the enterprise side.

[Richard Herren, executive]

And then -- sorry, did you want to add something, Gary? And in terms of the way to think about the OpEx comment that I made, we talked, meta, When we announced the acquisition of Splunk, that this is much more driven by revenue synergies and cost synergies. .

There's no question there will be cost synergies as we work our way through this. But we will spend fiscal '25 -- from this point through fiscal '25, ensuring that we get both the product integration right, the organizational integration right, we have to do channel enablement. We have to train their sales team on Cisco, train the Cisco sales team on Splunk.

There's investment that goes along with that integration. And this fiscal '25 is the year we'll do that. We said in the first year post acquisition that we would be accretive in cash flow and we will, that will be accretive in gross margin from Splunk, and we will, and that will be accretive in earnings per share in the second year.

So that's -- think of that as fiscal '26. I know this closed a little bit early, and I think there's this perception that it closed 6 months early, so those times ought to be accelerated. We thought the acquisition would close around the end of our fourth quarter, it closed around the middle of our third quarter. So round numbers, it was a little more than a quarter early. So I think the way to think about that is EPS accretive in fiscal '26. So still being cash flow and gross margin accretive in fiscal '25 as we invest in the integration.

[Operator]

James Fish with Piper Sandler.

[James Fish, analyst]

Did want to double-click on Meta's question here because there's a serious ramp on the OpEx side to get really earnings going down again in '25. If my math is right, somewhere around $3.50 a share. Can you elaborate a little bit further as to why it's going to go be that much?

Do we -- should be expecting revenue synergies starting in fiscal '25 with that initial kind of low to mid-single-digit growth rate? Or is that just going to take too much time another year or so to really get?

And just not to layer on the question here, but is some of the OpEx ramp due to the conversion of stock-based comp of Splunk to cash comp because historically, Splunk and Cisco have had 2 totally different philosophies on compensation.

[Richard Herren, executive]

Yes. Thanks, Jim. On the OpEx ramp, I mean, it's -- I know we haven't -- the Splunk team didn't put out guidance for this fiscal year, but you can look at where their OpEx was headed and layer that into the OpEx that we had.

There is some growth year-on-year. There's some investment. It's not a substantial ramp up, though, in the investment on integration. It's more a question of just pulling the Splunk team together with ours.

As I said, there will be some cost synergies, they're likely to come more in the second half of the year, but this wasn't a deal that was motivated by cost synergies. It was much more motivated by revenue synergies.

I think you will -- what you said, I think, is spot on. We will see those revenue synergies begin to ramp in the second part of fiscal '25 as these are not short sales cycles as we get our team ramped up on how to sell Splunk as we get the Splunk team ramped up on how to sell Cisco.

And as we get our channel fully enabled to sell that. So yes, you're going to see those revenue synergies, but you'll need to think about them more in the second half of the year.

[Gary Steele, executive]

Yes. And I think the revenue synergies that we're focused on really are driven around the 5,000 accounts that we talked about earlier, the sales cycles on those are 6 to 9 months. And so you're not going to see that immediately, but that work is happening. .

And we're also seeing tremendous collaboration across the organization where our sales teams are working together to more broadly penetrated accounts. I think you start to see that in the first half, but it's going to layer in. You're going to see more momentum as we get to the middle part of the year.

[Operator]

Samik Chatterjee with JPMorgan.

[Samik Chatterjee, analyst]

I have a couple as well, if I may. I know you're talking about the deployments with your customers, enterprise customers being higher than what you're shipping to and that implies you'll take a step up in terms of revenue and that inventory digestion end.

I was just curious on sort of the order trends you had mentioned you'll be back to a normal seasonality of orders, maybe more in fiscal '25. But how close are you seeing sort of order trends return on a sequential or quarterly basis to more normalize sort of seasonal trends?

Is that pointing you in any direction in terms of whether that gap between deployment and your orders are starting to sort of compress.

And for the second one, just on the quick follow-up on the AI order, $1 billion sort of target here. Just trying to understand if you feel like you need 1 or 2 more big wins in terms of customers or the land and expand with the existing ones should be good enough to get you to that $1 million target that you have.

[Charles Robbins, executive]

Scott, do you want to take the sequential one?

[Richard Herren, executive]

Yes. Well, on the enterprise deployments, we are seeing that progress, Samik, and one of the things that's been encouraging, and we've given you some of the data on this is where we see it moving more quickly. We talked about WiFi and how our wireless business is growing, where the enterprise deployments of all the product that was pushed out has progressed more quickly, we're seeing demand return. .

Normal seasonality, if you're talking about year-on-year growth rates is a lot tougher, right? You've got to get to a point where you actually have a normal quarter, which we're headed toward now once we get through this inventory consumption at the end of this quarter, and then you have to lap it by a year.

To get to a year-on-year compare, that's an apples-to-apples compare. So think of the normal seasonality in terms of year-on-year growth rates beginning much more in fiscal '26. From a sequential standpoint, you'll see that start to happen in the second half of fiscal '25. .

[Charles Robbins, executive]

And then on the AI, the -- the $1 billion that we talked about. Those are actually identified opportunities that our teams have a high degree of confidence. This is not like -- we didn't set a $1 billion target and tell people to go find deals. They're deals behind the $1 billion. and there actual wins that we either have already won or we have a high degree of confidence that we will win.

There's certainly execution that has to occur between now and whenever we get -- when we get them done. We have to get through the pilots. There's a lot of testing that has to take place. There's power consumption testing that goes on. So a lot of that is going on.

But based on what we know, this is what our teams believe today. So this is not some aspiration that we have to go find. This is -- these are opportunities that have been identified that our teams feel good about.

[Operator]

Matt Niknam with Deutsche Bank.

[Matthew Niknam, analyst]

One question, 1 small follow-up, and I think this has been the theme of the call. On the main question, actually for Scott. .

You've got leverage now that sits just under 1 turn, but the business now has a greater mix of recurring revenue, more visibility that, that naturally lends itself to. So I'm just wondering how you think about optimal leverage for the business and uses of excess cash from here?

And then just on the follow-up, as we think about low to mid-singles growth next year, well aware of the backlog and the tougher comp that, that creates in fiscal 1Q of next year.

Just as we unpack the networking assumptions, are you assuming normal demand and purchasing cadence returns next year once inventories have been digested? Or is there any incremental caution that's embedded there from a macro perspective?

[Charles Robbins, executive]

You want to take the first one?

[Richard Herren, executive]

Yes. I'll talk about cash first, Matt. And yes, we moved obviously, with the acquisition of Splunk. And this data is out there. We raised about $13.5 billion of term debt that's out there. And we actually funded a lot of it with some cash off the balance sheet, but also with commercial paper with the expectation that as rates come down, obviously, commercial paper is a more real-time reflection of those lower rates. So it's a way of saving money on that. .

Moved to a net debt position for the first time and certainly in my career, probably in the first time in the -- here at Cisco, probably the first time in the last 2 decades here at Cisco.

The use of cash though, we talked about Splunk being cash flow accretive in its very first year, which is highly unusual for a transaction of this size, it will be. And so our cash allocation process is not going to change.

And just to reiterate what it is, first and foremost, it support growth, right behind that, if that's 1, 1A is, of course, continuing to support the dividend, and you see we've continued to grow the dividend on a year-on-year basis, return cash to shareholders through share buybacks. That's been at a steady $1.25 billion per quarter. for the last now several quarters. We'll continue to do that.

And to the extent that we've met those 3 and there still is excess cash, we'll determine whether it makes sense to take that cash and delever or if it makes more sense to return that to shareholders at that time.

[Charles Robbins, executive]

And Matt, on the demand normalization, based on what we see today, I think we would expect starting in Q1 and beyond, we should see that normalize. .

Obviously, with the caveat that there's a lot of hotspots around the world, there are a lot of potential risks out there that are happening. We've got elections all over the world and the most important 1 perhaps in the United States. So we're certainly going to have to see how all of this plays out. But so far, based on what we see, I think that's a decent assumption for FY '25.

[Operator]

George Notter with Jefferies.

[George Notter, analyst]

I guess I wanted to ask about gross margin impacts from the inventory digestion. As we look around the space, we've seen companies use tools like stock rotation or rebates to try to push inventory through the channel. Sometimes that can certainly have an impact on margins. Are you guys seeing any of that in the gross margin results right now?

[Richard Herren, executive]

No, we're not, George. There's very little inventory that -- in the channel that is something that we continue to own. In other words, when we ship into the channel, it's sold at that point. There's very little stocking that happens inside our channel.

So we're not seeing that benefit. What we are seeing is, of course, we've put in place the price increases to help offset the higher costs that we saw coming through the supply chain constraints, and we've lapped those.

So there's actually a little bit, you'll see when our Q comes out, a little bit of pricing headwind back to the normal what it had been kind of pre-pandemic but big benefits, of course, with the product mix of Splunk coming in and some one-off things that we benefited from during the quarter.

[Operator]

Ittai Kidron with Oppenheimer.

[Ittai Kidron, analyst]

I had a question for Gary. I guess, off the press, Palo Alto just announced its acquisition of the SIM business from IBM. Exabeam this morning announced the merger with LogRhythm. So it seems like the market you're operating in is moving at a very fast pace at consolidation.

Maybe you can talk about the competitive landscape for your business and why should we not assume that pricing pressures are going to significantly rise in this environment as everybody is trying to fight for footprint.

[Gary Steele, executive]

Yes. No, great question. there obviously is a lot of activity in this particular market. One of the things that we feel very good about and Chuck referenced in his prepared remarks earlier is our position in Gartner's Magic Quadrant where we stood out as the leader in the SIEM market.

We -- so we have a very strong established market position and our pace of innovation has fundamentally changed over the last couple of years. We continue to deliver very interesting innovative capability that we think is very high value.

So for example, last week at RSA, we announced what we call Splunk Acid and Risk Intelligence. This is a critical capability to help organizations do self-discovery of assets across their environment and then understand the risks associated with those things.

Coupled with that, we're now getting the broad benefit of the Cisco Security product line where we can bring in interesting capabilities like the integration with the XDR solution that we also announced.

So we feel like while yes, it is competitive, we feel like we're incredibly well positioned to continue to drive very important innovation. And we've also taken a very different approach than our competitors, and we think broadly about how do you bring together on a single platform the security capabilities that customers want broadly all the way through observability. And it's very difficult across the industry to see anybody taking a position that we have and driving value.

With respect to pricing, we don't have any fundamental change in our pricing strategy. We're very much focused on driving very good adoption across our customer base and ensuring that they feel like they're getting value every day. and the capabilities that we're offering are hard to match in the industry. So we're not shifting gears from a pricing point of view.

[Operator]

Ben Reitzes with Melius Research.

[Benjamin Reitzes, analyst]

Thanks for the question. I -- in the spirit of the 2, I wanted to ask if we take, I would say, $1 billion to $2 billion of the hit from inventory in 2025 and from the prior question. I just want to make sure that I heard it right that you do you underwrite that the real industry growth is about -- the real networking growth is in that mid-single-digit range that was mentioned in a prior question. .

And then if that's the case, I guess this is the second one, then does it mean at your Analyst Day, we'll hear more about how 2026 could be a higher single-digit growth business for Cisco overall? I mean you're mixing towards Splunk and software.

And therefore, the math would, therefore, have you guys, on a normalized basis after -- after the organic growth is very muted in 2025, accelerating by several hundred basis points to the higher single digits in 2026, if that's true. Be happy to repeat any of this, but hopefully, you were able to follow that.

[Richard Herren, executive]

Yes, I got it, Ben. And you're asking me now for fiscal '26 guide at the same time. Is that the right take? You're thinking about it right. The .

The underlying business, the core business of Cisco net out the benefits of the Splunk acquisition when you look at fiscal '25, but also when you take '24 net out the impact of the excess backlog that we shipped early in fiscal '24, mostly in Q1, a small amount in Q2 as well.

And you get to that mid-single-digit growth of the core business that we've had -- so I think you're thinking about that right. We will talk more. I'm not going to do it on this call, but we will talk more about fiscal '26 and beyond at our Investor Day in June in Vegas. So hopefully, I'll see you there.

[Operator]

Atif Malik with Citi.

[Atif Malik, analyst]

The first 1 is for Gary. Gary, Splunk has been using AI ML for the last 1.5 years with natural language assistant SCLA also event detection and response. Can you big picture talk about how Cisco data will improve your AI capabilities?

[Gary Steele, executive]

You bet. And so if you look at the history with Splunk, we were very early driving capabilities with machine learning. We launched the MLTK package in 2017, and we've had 0.25 billion -- excuse me, 0.25 million users on that. So there's been broad adoption.

We then extended that when we brought Gen AI into the picture delivering an SPL assistant, SPL being our proprietary search language, being able to use English to be able to do that.

We're also bringing AI directly into the workflow. So think -- think about SOR as an example on how you can bring AI into the picture to drive better outcomes from a remediation point of view.

So we've been investing across the product line. You're going to hear and see more announcements from us over at Cisco Live as well as at our user conference, which follows Cisco Live. And the benefit that we're getting, bringing it into Cisco is, Cisco has independently been making a whole set of investments we get to leverage those assets in addition to the richness of data that we get.

So where we benefit from Cisco is the broad rich data sets that exist across networking where you think lateral movement, how can we leverage that data to do a better job from a detection point of view.

And frankly, the data and insights that we have as a combined entity, I think, are second to none in terms of the competitive environment.

So we just basically accelerate our AI efforts as part of Cisco and the outcomes we can deliver to be really important.

[Operator]

Michael Ng with Goldman Sachs.

[Michael Ng, analyst]

I just have 2 as well. First, I think that the guidance this year implies 34% EBIT margins. You commented that fiscal '25 can look like the guide for fiscal 4Q.

It's, I think, about $1 billion of OpEx investment. So I was just wondering if you could kind of qualitatively talk about where most of those OpEx investments will lie.

And then Secondly, last quarter, you characterized the fiscal '24 guidance as conservative, I believe. How would you characterize your initial financial outlook for fiscal '25?

[Richard Herren, executive]

Okay. Michael, thanks for the question. The year-on-year, again, the -- I think what you're struggling with on the fiscal '25 look is expectations if you just added -- straight added where the run rate of Cisco spend to what your expectations are on the run rate of the Splunk spend. And I'd say a couple of things to bear in mind.

There's some onetime benefits that we had this year in our OpEx for the Core Cisco pre Splunk acquisition. frankly, in our variable comp plans which has been a tough year, and we've come up short of our plan. And so there's some savings in variable comp for this year in fiscal '24 that obviously, I don't plan on repeating those in fiscal '25.

So there is some -- and obviously, we'll do a merit increase as well. So there's some small increase that is just kind of the reset of the comp plans and an ongoing merit. There is some investment as well. in the integration, but it's not even approaching the number with the quick math that you just did. So that's kind of the way to think about that piece.

Now if you look at the guide for next year, kind of how would I say -- what I'd say about the guide for next year is I feel with a lot of the tailwinds that we're seeing right now, so let's just go back.

Consumption of all of the inventory that we shipped to customers that they were working very hard to get implemented is going in line with our expectation. We think we work our way through that headwind, mostly by the end of this quarter, our fourth fiscal quarter, that's a tailwind for next year.

Obviously, the AI opportunity that we've talked about and being more second half, but for the full year -- second half of fiscal '25. But for the full year, that's a tailwind as we look ahead.

Security business is doing what we said. I was going to right? It's -- we've launched new products there even before the acquisition of Splunk, and those products are getting good traction. So that's a tailwind as we look at next year as well.

So I think all in all, I feel like it's kind of a down-the-middle view of fiscal '25 at this point. It's not a formal guide. I just wanted to give you a sense of what that looks like, and we'll do -- we'll give you a better feel for what the longer term looks like at our Investor Day in June, and then we'll give you a more fulsome guidance when we get to our Q4 call in August.

[Ahmed Sami Badri, executive]

I now want to hand over back to Chuck for some closing remarks.

[Charles Robbins, executive]

Thanks, Sami, and thanks to all of you for spending time with us today. I guess I'd say I'm -- I'm pleased that we're getting to the tail end of the supply chain situation that we've been navigating for the last several years on track to get this consumption issue behind us as we enter FY '25. And -- Feel good about the overall demand environment we saw in Q4, which supports the fact that our customers are getting this digestion done.

As we look to the future, we obviously are optimistic about AI, both from an infrastructure perspective, a data perspective as well as a cybersecurity perspective.

Security in general, we believe will continue to improve and obviously, we're super excited about the Splunk integration, and we're committed to deliver for both our customers and for you.

Also I just want to quickly thank Jeff Sharritts for everything he's done at Cisco and also they were very excited to have Gary taking on the new role here, and thank you all for being with us today.

[Ahmed Sami Badri, executive]

As a reminder, we will be hosting our 2024 Investor Day as part of Cisco Live on June 4, 2024. And -- Cisco is the next quarterly call, which will reflect our fiscal year 2024 4th quarter and full year results will be on Wednesday, August 14, 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 the Cisco Investor Relations department, and we thank you very much for joining the call today.

[Operator]

And thank you for participating on today's conference call. If you would like to listen to the call in its entirety, you may call 1 [phone]. -- and -- for participants dialing from outside the U.S., please dial [phone]. This concludes today's conference call. You may go ahead and disconnect at this time.