Cisco Systems Q2 2022 Earnings Call Transcript

Presentation

[Operator]

Welcome to Cisco's Second Quarter Fiscal Year 2022 Financial Results Conference Call. [Operator Instructions]

Now, I would like to introduce Marilyn Mora, Head of Investor Relations. Ma'am, you may begin.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Welcome everyone to Cisco's second quarter fiscal 2022 quarterly earnings conference call. This is Marilyn Mora, 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 made 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 made 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 third quarter and full year of fiscal 2022. They are subject to the risks and uncertainties including COVID-19 that we discuss in detail in our documents filed with the SEC, specifically the most recent reports on Forms 10-K and 10-Q which identify important risk factors that could cause actual results to differ materially from those contained in the 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 to an explicit public disclosure.

I will now turn it over to Chuck.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Thanks, Marilyn. I hope you all are remaining safe and healthy. After the solid results we delivered last year, 2022 is proving to be an even stronger year fueled by exceptional demand for our solutions and the continued success of our transformation. In Q2, I'm thrilled to say that we delivered another great quarter with double-digit ARR growth and robust product orders which fueled an all-time high backlog and a strong pipeline. These results underscore the increasing relevance and criticality of Cisco's innovation in the era of digital transformation and cloud and reinforces my confidence in our ability to deliver growth. We are focused on staying ahead of our customer's most pressing needs as they navigate a dynamic world. Our customers are moving faster than ever, driven by the move to hybrid work and hybrid cloud. This requires modernized infrastructure, new security architectures and accelerated digital transformation. The breadth of our innovative solutions and services at a global scale combined with our increasing ability to deliver more flexible consumption offerings is driving even deeper partnerships with our customers across our entire portfolio. Now I'd like to spend a few minutes covering our results in more detail and what we are seeing in the market.

We delivered solid topline growth combined with margins and earnings that exceeded the high end of our guidance despite operating in a supply constrained and inflationary environment. The robust demand we saw in Q1 continued into Q2 with product order growth of 33%, our third consecutive quarter of order growth of 30% or higher with momentum once again across all geographic regions and customer markets. For example, in our enterprise business, we delivered 37% order growth, the highest in over 12 years as large customers prioritize investments to modernize their networks and enable new digital capabilities and resiliency. As more and more becomes digitized, we expect our momentum to continue. We believe the need for highly secure seamless connectivity, hybrid cloud and hybrid work solutions along with edge computing will drive growth for Cisco. The opportunity ahead of us is clear, as demonstrated by our growing pipeline and record backlog, which more than doubled from a year ago and will convert into revenue in the coming quarters.

In our web scale business, we delivered another incredible quarter. Our order growth was up more than 70% year-over-year, which is over 100% growth on a trailing four-quarter basis. We continue to see exceptional performance driven by the rapid pace of adoption of our 400 gig solutions and our routed optical networking portfolio, which grew over 50% fueled by the Cisco 8000 product line, Acacia and Silicon One. We are also seeing tremendous traction with ZR optics as part of the routed optical network strategy. Our optical systems in Acacia businesses, both saw significant double-digit growth driven by our web scale customers. The innovations we've invested in over the last several years have positioned us well as the largest players in this space adopt next-generation technologies. Our customers are making strategic decisions on their future roadmap and recognize Cisco's unparalleled portfolio is critical to their strategies. We believe there is still in the early phases of their next-generation platform buying decisions and expect our momentum to continue.

From a product revenue perspective, we delivered another strong and balanced quarter with 9% growth with broad-based demand across the majority of our product portfolio. This was led by increased customer spending to modernize their networks, securely connect their hybrid workforce and build out their 5G networks, all with a strong uptake of our subscription offerings. We continue to prioritize investments that will drive our long-term performance and capitalize on the megatrends and large growing markets, including cloud, full stack observability 5G, 400 gig, WiFi 6 and security. Our expertise in these areas along with a deep integration of hardware, software and silicon across our portfolio differentiates us and sets us up to win.

Our team continues to innovate at a speed and scale like never before. To help our customers build and deliver the best hybrid work experience, we recently introduced new breakthrough networking innovations, including Catalyst 9000 X switches built on Silicon One, the industry's first high-end WiFi 6E access points and an as-a-service private 5G offering for the enterprise enabling communication service providers to deliver cloud-based services to their customers. We are committed to also lead in a more sustainable way. An example of this is our Silicon One Catalyst 9000 X switches I just mentioned which are approximately 40% more power-efficient compared to prior versions. Building technologies in this way is key towards our goal to reduce our Scope 3 emissions to net zero by 2040.

I'm also proud of the progress of our business transformation to more software and subscription-based recurring revenue as we transition more of our business to the cloud. Annualized recurring revenue or ARR of $21.9 billion was up 11% with product ARR increasing by 20%. Product remaining performance obligations or RPO, which is largely software revenue that is committed, but not yet recognized was up 16%. We remain one of the largest software companies in the world. In Q2, our software revenue grew by 6% to $3.8 billion. Total subscription revenue accelerated to $5.5 billion, up 7% year-over-year. It's important to note that both of these metrics continue to be negatively impacted by subscription software and service that is attached to hardware were the shipments are delayed due to the component situation. The strength in our software, RPO and ARR clearly demonstrate the value we are creating through our transformation and provides us a greater degree of visibility and predictability into our future growth.

From a macro perspective, the component shortage continues to remain challenging. Our incredibly strong demand continues to outpace supply expanding our backlog of products, software and services. Our supply chain team continues to take aggressive action through strong inventory positions, deepening supplier relationships, qualifying alternative components and increased use of expedited freight. There are still significant constraints with semiconductors, preventing us from completing manufacturing of some of our products and that remains a headwind to revenue growth despite very strong demand. In addition, the constrained environment continues to drive up supply chain costs which we have successfully passed through to help offset these increases.

In summary, we continue to work through the impact of the pandemic and component shortages and we've never felt better about the Company, our position and our outlook for growth. Our Q2 results reflect healthy momentum, a clear vision and outstanding execution by our teams. Our innovation engine and pipeline have never been stronger, and we are rapidly transforming our business by accelerating our transition to more software and subscription offerings. I'm so proud of our teams and what they've accomplished during these very dynamic times. We are bringing industry leading innovation to market and further enhancing our differentiated position across the portfolio by delivering flexible consumption models for our customers. I remain confident and optimistic about our future. Cisco was at the epicenter of massive shifts toward hybrid cloud, hybrid work and digital transformation, which we believe creates momentum for our business and positions us well to capture the significant opportunities ahead.

I'll now turn it over to Scott.

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Thanks, Chuck. Q2 was a strong quarter across the business. We executed well, delivering our third consecutive quarter of more than 30% product order growth driven by strength across our portfolio, including continued robust demand for our products and services, along with disciplined spend and supply chain management. Total revenue increased by $760 million to $12.7 billion, up 6% year-over-year in line with our guidance range for the quarter. We saw strength in a number of product areas and across all of our geographies. Our business performed well and is highly dynamic and supply constrained environment which as Chuck said continues to hinder our ability to convert the significant demand we have in the revenue.

Overall profitability in Q2 was strong with non-GAAP operating margin of 34.3%, non-GAAP net income of $3.5 billion and non-GAAP earnings per share of $0.84, with non-GAAP earnings per share coming in above the high end of our guidance range. Looking at our Q2 revenue in more detail, total product revenue was $9.4 billion, up 9%; service revenue was $3.4 billion, down 1%, driven by delays in hardware support contracts related to the supply constraints. Within product revenue, Secure, Agile Networks performed well with revenues up 7%. Switching had solid growth driven by a double-digit increase in data center switching, driven by our Nexus 9000 products. Campus switching had solid growth led by our Catalyst 9000 and Meraki Switching offerings. Wireless had very strong double-digit increase driven by our WiFi 6 products and our Meraki wireless offerings. We also saw double-digit growth in compute revenue driven by servers.

Enterprise routing declined primarily driven by Access slightly offset by strength in SD WAN. Hybrid Work, which is where we report just our collaboration portfolio was down 9% driven by declines in our collaboration devices and meetings offerings, partially offset by the continued ramp of our communication platform as-a-service. Beginning next quarter, the name of this category will change from hybrid work to collaboration, there will not be any changes to the components within this category.

End-to-end security grew 7%, with broad strength across most of the portfolio. Our zero trust portfolio performed well with double-digit growth, driven by strong performance in our Duo offerings. Our subscription portfolio continued to perform well, driven by cloud security and zero trust. Internet for the Future was up 42%, driven in large part by the strength of our web scale customers. We saw broad strength in the portfolio with growth in edge, driven by double-digit growth from our ASR 9000 offerings and core with strength in Cisco 8000 and optical. We also saw continued strong contribution from Acacia, our optical networking offerings. Optimized application experiences was up 12% driven by double-digit growth in both ThousandEyes and Intersight. SaaS revenue for AppDynamics grew mid-single digits with the continued shift to its cloud delivered platform.

We continue to make progress on our transformation metrics as we shift our business to more software and subscriptions. Software revenue was $3.8 billion, an increase of 6% with the product portion up 9%. 80% of software revenue was subscription-based, which is up 4 percentage points year-over-year. Total subscription revenue was $5.5 billion, an increase of 7%. Total subscription revenue represented 44% of Cisco's total revenue. Annualized recurring revenue or ARR was $21.9 billion, an increase of 11% with strong product ARR growth of 20%. And remaining performance obligations or RPO was $30.5 billion, up 8%. Product RPO increased 16%, service RPO increased 3% and the total short-term RPO grew 8% to $16.3 billion.

As a reminder, the short-term portion will convert to revenue over the next 12 months. Relative to acquisitions, there was an approximate 200 basis point year-over-year positive impact on Q2 revenue growth and no material impact on our non-GAAP EPS, which is in line with our expectations. We continue to have exceptionally strong order momentum in Q2. Total product orders grew 33% with strength across the business. Looking at our geographic segments, the Americas was up 36% and EMEA and APJC were both up 30%. Total emerging markets were up 39% with the BRICS plus Mexico up 48%. In our customer markets, service provider was up 42%, enterprise was up 37%, commercial was up 30% and public sector was up 20%. As you can see, it was broad strength across our geographies and customer markets.

From a non-GAAP perspective. Total gross margin came in at 65.5% down 140 basis points year-over-year. Product gross margin was 64.3%, down 230 basis points and service gross margin was 68.8%, up 90 basis points. The decrease in product gross margin was primarily driven by ongoing higher component costs related to supply constraints as well as higher freight and logistics costs. As we've been discussing for several quarters, we continue to manage through the supply constraints seen industrywide by us and our peers due to component shortages, which have resulted in extended lead times and higher supply costs.

The situation remains challenging, we continue to partner closely with our key suppliers, leveraging our volume purchasing and extended supply commitments as we address the supply challenges and cost impacts, which we expect will continue into the second half of our fiscal 2022. As I mentioned, the component supply constraints also slow the conversion of our strong demand into revenue. This has resulted in a substantial increase and continued build in our backlog levels, well beyond our normal historical levels. Additionally, the ongoing supply constraints have not only impacted our ability to ship hardware, but also impacts our delivery of software such as subscriptions to customers order with the hardware. That undelivered software is also included in backlog until the hardware ships [Phonetic] which is when we begin to recognize the revenue. Of course, this impacts our software revenue growth and other related metrics.

To give you a sense of scale of our backlog, our Q2 ending product backlog was more than $14 billion, an increase of more than 150% year-on-year. Within that amount, software backlog almost doubled to more than $2 billion. Keeping in mind that backlog is not included as part of our $38.5 billion in remaining performance obligations. We ended Q2 with total cash, cash equivalents and investments of $21.1 billion; operating cash flow for the quarter was $2.5 billion, down 17% year-over-year, primarily driven by advanced payments to secure future supply. These advanced payments had a negative 17% year-over-year impact on operating cash flow. Additionally, we made a tax payment of approximately $100 million this quarter, which had been deferred as a result of the CARES Act. This payment had an additional negative 4% year-over-year impact on our operating cash flow.

In terms of capital allocation, we returned $6.4 billion to shareholders during the quarter. It was comprised of $4.8 billion of share repurchases and $1.5 billion for our quarterly cash dividend. Given the confidence we have in our business today and into the future, our Board has authorized an additional $15 billion for share repurchases, bringing the total to approximately $18 billion. We are also raising our dividend by $0.01 to $0.38 per quarter, which represents our 12th increase. Combination of our dividend increase, additional share repurchase authorization and higher share repurchases during the quarter demonstrates our commitment to returning excess capital to our shareholders and our confidence in the stability of our ongoing cash flows.

We continue to invest organically and inorganically in our innovation pipeline. We closed the acquisition of Reflex in Q2 and Opsani in early Q3 to enhance our full stack observability offerings. These investments are consistent with our strategy of complementing our internal innovation in R&D with targeted M&A to allow us to further strengthen and differentiate our market position and our key growth areas.

To summarize, we had another good quarter with robust product demand and solid execution and a complex supply constrained environment. We continue to make progress on our business model shift and are making the investments in innovation to capitalize on our significant growth opportunities and expanding addressable markets. We're seeing progress as we drive the continued shift to more software and subscription revenue delivering growth and driving shareholder value. Now let me provide our financial guidance for Q3. As a reminder, the third quarter of last year included an extra week, which was a benefit to total revenue of approximately 3 points of growth. The total impact on our cost of sales and operating expenses was approximately $150 million and this translated into a $0.04 benefit to earnings per share in our Q3 of last year.

For next quarter, we expect revenue growth to be in the range of 3% to 5%. We anticipate non-GAAP gross margins to be in the range of 63.5% to 64.5% reflecting the continuing increase in supply chain costs we're incurring as we protect shipments to our customers. Our non-GAAP operating margin is expected to be in the range of 32.5% to 33.5%. Non-GAAP earnings per share is expected to range from $0.85 to $0.87.

For the full year fiscal '22, we are tightening the range as follows. We expect revenue growth to be in the range of 5.5% to 6.5% year-on-year. Non-GAAP earnings per share is increasing to $3.41 to $3.46, up 5.9% to 7.5% year-on-year. In both our Q3 and full year guidance, we're assuming a non-GAAP effective tax rate of 19%.

I'll now turn it back to Marilyn, so we can move into the Q&A.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Scott. Michelle, let's go ahead and queue up the Q&A.

Questions and Answers

[Operator]

Thank you. Ittai Kidron from Oppenheimer. You may go ahead.

[Ittai Kidron, Analyst at Oppenheimer]

Thanks. Hey, guys, nice to see the good results. I want to dig into the supply chain a little bit Chuck and Scott. Maybe you can talk about, just kind of quarter-over-quarter, have things gotten a little bit worse, a little bit better? And is there any timetable in mind where you think we could see a material improvement? And maybe on the back of that, Scott, when we see this improvement, should we just expect like a period of, I don't know, two, three quarters where you really have outsized growth as you fulfill this unusual backlog? I'm just trying to understand the scenario here of how all of this gets unwounded?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah, Ittai, thanks for the question. I'll start and then Scott can jump in. I would say, during the quarter, supply chain didn't get materially worse and didn't really get materially better. It was pretty consistent. There were gives and takes throughout the quarter, but I think at a macro level, that's where I'd characterize it. They were a little bit towards the end of some Omicron effect with people being sick and not being able to show up in factories and some of the logistics issues that are well documented. But in general, that's what we saw. We don't have -- I wouldn't say we have a great timeline for you as to when things begin to improve. All we know now is we expect this to be with us through the second half of our year. Scott, would you add?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah. No, I think that's right. That's in sync with our expectations. And Ittai to your question on how does this unwind, it's -- I don't believe it unwinds in a lumpy fashion. I think it will unwind as supply and demand get more imbalanced. And I think that will just happen gradually over the course of the next few quarters. So I'm not expecting a significant bump in any given quarter. I think the supply frees up with $14 billion of backlog, we've got plenty of demand to go off and fulfill. It's really a question of when does that supply free up. And as it does free up, I think it will happen gradually over time.

[Ittai Kidron, Analyst at Oppenheimer]

Got it. Maybe, Scott, just to clarify this last point, is there any way for you to know how much of this backlog is double ordering? I don't know what it means from a customer standpoint that you have all this backlog. Are customers really waiting for a long time to product? And what is the risk you have some kind of double order elements in these figures?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Ittai, that's something that we've been alert to and watching for since we began building the backlog after three consecutive quarters of demand growth in the 30% range and revenue growth only in the 6% to 8% range. We've been building substantial backlog, and so we've been looking to that. I think it's clear that customers are responding to our lead times, and our lead times have extended as the lead times for the components have extended. So there's I'd say, some extension in there. But I think what we're seeing is real demand. I think it's a combination of pent-up demand from products that didn't get done during the pandemic. I think it's the leading edge of several of these trends that we've talked about that we're investing into.

And when we look at things like if there was double ordering, you probably wouldn't see that as much in the commercial and small customers, and we're still seeing strong growth in that segment. You probably also would see the pipeline build begin to slow down and we're not seeing that either. Our pipeline is quite robust at this point. So we're looking for proxies to try to understand that better. We're not seeing anything at this point that would indicate there's double ordering in there.

[Ittai Kidron, Analyst at Oppenheimer]

Excellent. Thank you so much.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Ittai. Next question, please.

[Operator]

Paul Silverstein from Cowen. You may go ahead, sir.

[Paul Silverstein, Analyst at Cowen]

Thanks, guys. I guess, is there anything wrong with the following logic with respect to your elevated costs? At some point, logistics freight costs are going to return to normal, if not, entirely back to where they were a year, year and a half ago, largely. And as far as the stickier component of semiconductor costs, to the extent they don't revert, your price increases eventually over the next three to four quarters as you burn off backlog that they will offset, if not in full and large measure those elevated costs. Before I ask the follow-up, is that -- is there anything wrong with that logic?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

I think, Paul, there's nothing wrong with the logic. I think the expectations that I would give you are the same that I gave you last quarter. As I think about gross margin through the end of this fiscal year, I think it stays in the range we're in, in the 64% to 65% range through the end of the year. Beyond that, as you said, and I hope you're right that logistics costs begin to return to something that's more normal. Obviously, the price increases that we put in place, we've talked about this previously. We're not seeing much benefit from that today. Because the price increase goes in, there's offsets between the time we started and it gets out to the field.

The field in has to take those prices, sell it to customers. Those orders have to come in into the backlog and then get fulfilled out of the backlog before we finally get the revenue credit for those price increases. And I think that, we'll beginning this -- we will begin to see benefit from those price increases toward the end of this quarter and more into Q4. But my expectation on gross margins at this point is that they stay in the range that we're in right now in the 64% to 65% range through the end of the year.

[Paul Silverstein, Analyst at Cowen]

Got it. Chuck, on the revenue side, this is the best demand environment across enterprise, carrier and web scale. I've seen in 26 years covering the segment. And you'd have to go back to the late '90s. And of course, that proved to be a bubble. We see the growth of your peers, Arista, Juniper, Extreme, F5, etc. How much of what's going on is pure market growth? How much of this has improved execution on the part of Cisco?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

That's a really good question. And I would say that it is definitely a combination of both. The markets are certainly robust as you called out with seeing some of our peers who are having solid results as well. But then when you look at -- when I look at the order growth rates in certain segments of our business, certain technology areas, I can tell you we're gaining share. I mean web scale, obviously, we're executing incredibly well because we didn't exist there just a couple of years ago.

And it's some of our technology areas like WiFi, I mean, the growth rates on the order side, even campus switching to gross on the order side. I think that -- I think there's a lot of really good execution. I think our portfolio is in great shape. And you have to remember, we're on the front end of these multiyear trends that are really in our favor, whether it's 5G, whether it's 400 gig, WiFi 6, hybrid cloud, hybrid work, edge, compute. I mean these are all technology areas and transitions that are positive for us. So those are somewhat market-related, but I think our portfolio is well-positioned for them, those transitions.

[Paul Silverstein, Analyst at Cowen]

Appreciate it.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Chuck. Next question.

[Operator]

Sami Badri from Credit Suisse. You may go ahead, sir.

[Sami Badri, Analyst at Credit Suisse Group]

Hi. Thank you very much. So I got two hard questions for you guys. I'll keep the second one short, here's the first one. So I want to congratulate you guys on the 30%-plus product order growth. And I think what a lot of us really want to know is, what is the right normalized growth rate? Or when do you see the normalized growth rate finally starting to flow through your numbers? And we look at the 30% and think this is a thematic trend. But at some point, needs to come back down a little bit. When do you see the normalization of that product corridor growth to actually happen? So that's the first question. The second question is a $20 billion question. Are you guys buying Splunk? And if not, what have been the internal considerations for not doing the deal?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

So let me answer, I guess, both of them. So the -- on the first one, I think that next quarter, Q3, the compares definitely get tougher from a year ago, particularly because we had an extra week of order as well. And then in Q4, obviously, that was the first quarter that we experienced a 30% plus quarter from last fiscal year. So certainly, those will be good quarters for us to sort of see a litmus test on your question. Until then, I'm not sure I have a direct answer for you, but certainly, the math will get tougher here in the next couple of quarters.

On your second question, first of all, we don't comment on rumors and speculations or stories. What I will tell you is that we are constantly evaluating potential opportunities. Scott and I were talking. We think for every deal we do, we probably look at 10 to 15 companies. We base our decisions on, first and foremost, strategic fit; secondly, cultural fit and equally as important, the financial and the valuation fit. And we are always disciplined and we continue to focus on both inorganic and organic opportunities. But I will tell you that you should expect us to continue to be very, very disciplined as we go forward as well.

[Sami Badri, Analyst at Credit Suisse Group]

Got it. Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Next question, please.

[Operator]

Rod Hall from Goldman Sachs. You may go ahead.

[Rod Hall, Analyst at The Goldman Sachs Group]

Great. Thanks, guys. I wanted to come back to gross margins for the quarter. You guys substantially beat the top end of your guidance range. And I wanted to see if you could just comment on what were the positive surprises within that gross margin line? And then my second question, maybe kind of a non-sequitur, but I was really surprised, Chuck, on the public sector orders. Those were really strong. And I wonder if you could maybe dig into that a little bit and comment on some of the dynamics there in the public sector? Thanks.

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

I'll take the first one. On the gross margin, Rod, it really came down to product mix that we had the components for that we could build and ship out during Q2. As I said earlier, our expectations on gross margin for the year are unchanged. And we had favorable product mix in Q2 that drove us above as I'm sure you're aware, above the high end of our guidance range. I think it's a bit of a headwind for us as we look at gross margins in Q3, but it equals out for the year. And so our expectations for the full year on gross margin are unchanged.

[Rod Hall, Analyst at The Goldman Sachs Group]

Scott, can you comment on specifically what types of products mixed in positively there? Just give us a little more color?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

It's always a mix. When you go across product lines and across customer size, both of those things have an effect rather than kind of go through and parse product by product, it's -- we had a quarter where the supply we had just allowed us to ship higher margin product. And again, given the visibility we have with sitting on $14 billion of backlog, we have pretty good visibility into what we need to build and a pretty good feel for what that's going to look like in the quarters ahead. So I feel confident that we're going to stay in this range through the end of the year.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

And on the public sector question, I think it's a good catch on your part, because a lot of people look at the 20% and see it as being below the other customer markets in and would look at that negatively. But the reality is, it's been the most consistent for the last couple of years. And we saw broad-based strength. And whether it was in our government business, which has been, I think, we've had -- so I'm looking at some data here, six consecutive quarters of positive growth, and three out of the last four strong double-digit growth. If you look at education, we've had straight quarters or six straight quarters there as well. And it's been particularly strong in the last five quarters. And so it was very broad-based across the public sector.

[Rod Hall, Analyst at The Goldman Sachs Group]

Great. Okay. Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Rod. Next question.

[Operator]

Tim Long from Barclays. You may go ahead.

[Tim Long, Analyst at Barclays]

Thank you. Yeah, I just wanted to ask on the software side, decent year-over-year growth in the quarter. I understand it's still being hampered a little bit. But maybe just talk a little bit, Chuck, about when you think we'll start to see that accelerate a little bit more than the overall revenues? Is it Cat 9k? Is it some other products moving to more software as a recovery in some of the other businesses? And then the follow-up is on the cloud business. You talked about the strong orders again. Could you just give us a little color kind of what's driving that? And then more than just product basis, are you seeing competitive wins, new use cases, new customers? What's really driving that 70% year-over-year and 100% over the last four quarters? Thank you.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

I'm pulling out some data here. So Tim, on the first one, on the software front, I think you have a really good question. I think Scott called out in his section that our product software revenue growth was 9%. The thing -- you got to get behind that to understand what's going on. And our old perpetual software, which we've been in transition from two subscriptions, perpetual was down 12% and subscription was up 17%. So the transition is actually happening the way we expect it. That's the reason you're seeing some of the -- because the subscription stuff, obviously, is recognized over time, and you're taking a 12% hit on a one-time piece of software from the way we used to sell it.

So you've got that dynamic that just has to continue to play out. You have the renewals that you mentioned starting to come through on some of the D&A stuff. In earnest in '23 and then '24, '25 beginning to ramp. But -- and then you've got over $2 billion of software sitting in backlog that is not an RPO yet, because it's connected to a piece of hardware that hasn't shipped. And we recognize a bit of that upfront and then the rest over time. So we've got all of those variables in play right now.

All that being said, I think you should expect -- when we get to a normalized world, I would expect that once we get this supply chain in the backlog, clearly in a normal world, I would expect you would see software growth, revenue growth growing faster. But right now, with our backlog so big, that may not happen for several quarters.

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah. That $2 billion of software, it's a little bit more than $2 billion sitting in our backlog right now. That's almost double where it was just a year ago, right? So there's always some that will sit in backlog, but it's almost double. And of course, most of that software is recognized ratably. So the ramp, once we can get it cleared out of the backlog and shipped, we're still going to have a ratable ramp on that. So longer term, if you remember what we said in September, we said the recurring revenue parts of our product business, we expected to grow at a compound annual growth rate of 15% to 17%. That's what we just put up, all right? The product subscription piece in our software business grew 17% in the quarter. So I think we're right on track in that space.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

I'm trying to find the breakdown of the different franchises in web scale, where was that? Do you remember?

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Yeah, let me get it for you.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Okay. On the cloud side, I think I'd just -- no, I don't have it in front of me. On the cloud side, here's what I would tell you is that, we are winning -- continuing to win new use cases around with our integrated systems, the Silicon One systems as well as we have on use cases where they're simply buying our hardware, meaning a switch that they're running their operating system on. We have certain customers that are running multiple consumption models where one may be buying silicon and they also buy the hardware switch, one may be buying an integrated system and silicon. And so it's a variation of all of those, and we are winning new competitive use cases, and I don't think that's not what I look for. Okay. So it's a -- sorry, I was just, Marilyn was trying to find it. But I was going to tell you, a number of customers and what, which -- how many franchises we want in -- tied to each [Phonetic], but I don't have that in front of me right now, and we'll try to get that. But in general, we are definitely winning new use cases.

[Tim Long, Analyst at Barclays]

Okay. Great. Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Next question, please.

[Operator]

David Vogt from UBS. You may go ahead.

[David Vogt, Analyst at UBS Group]

I like that. Thanks for taking my questions. I just want to go back to capital allocation for a second. Over the last five years, you've been pretty consistent in deploying free cash flow to dividends, buybacks, although that materially accelerated in the quarter and acquisitions. Can you kind of expand on your philosophy over the next several years with respect to potential uses going forward given the recent increase in the buyback today? And has your position around leverage and the use of leverage changed? And ultimately, what amount of cash flow would you be comfortable with on the balance sheet to run the business given the order strength that you're seeing, the working capital needs and supply chain uncertainty?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

There's a lot in there, David. What I'd start by saying is the buyback that you saw, the additional buyback that you saw in Q2 and the add to our, outstanding authorization to take it up to just short of $18 billion and the $0.01 increase in dividend, those are all signs of the confidence we have in our business and the growth we see ahead. So 2018, we have returned, as you alluded to, we've returned $76 billion in capital to shareholders just since 2018. There's no change in our overall capital allocation policy to answer that question for you.

It starts with, first and foremost, supporting the growth of the business through both organic and inorganic means. Obviously, we'll support the dividend. We'll, at a minimum, offset the dilution of our equity plans and beyond that, return the excess to shareholders as you saw us just do. There's no change in our overall policy. In terms of working capital, we've got -- I would wager to say the strongest balance sheet in the industry. Certainly amongst our peers, we've got the strongest balance sheet out there. So it's not -- I don't feel like we're constrained at all by the amount of cash we have to keep on the balance sheet to support operations.

[David Vogt, Analyst at UBS Group]

Maybe just as a quick follow-up to that, along the same lines. Obviously, you talked about culture, tech-fit and ultimately, making it work financially if there is an M&A opportunity on the horizon, I think historically, you haven't really used your balance sheet as aggressively using leverage to do a transaction. I mean, does that fit with how you're thinking about the business going forward? Is that a consideration? Or should we expect to be in sort of the same ranges from a leverage perspective, whether it's measured on gross or net debt perspective or cash perspective in your case?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah, I don't actually think of it in those terms as it relates to M&A. It's more back to what Chuck said earlier, is it a strategic fit? Is it a cultural fit? Does the valuation makes sense? Those are the kind of considerations that come into play as we're thinking about M&A versus what's the strength of the balance sheet. Again, I would stack our balance sheet up against anyone.

[David Vogt, Analyst at UBS Group]

Great. Thanks, Scott.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

I want to jump back in real quick and answer -- give Tim the double click that I was looking for on the use cases. So we have five players who use -- our customers who use Silicon One and Cisco 8000 systems. We have two that use Silicon One with the 8000 series routers with their own operating systems. We have two that use Silicon One embedded in their own white box hardware. And we have three that use at least two of the flexible consumption modes simultaneously. So that's the data that I was trying to get to Tim.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Chuck. Next question.

[Operator]

Meta Marshall from Morgan Stanley. You may go ahead.

[Meta Marshall, Analyst at Morgan Stanley]

Great, thanks. Maybe just a question on passing through pricing to customers. Just what those conversations are like maybe by category of customer? And just whether you're seeing larger orders in the attempt to kind of offset some of those pricing increases? And then maybe a second question for you, Chuck, just as you're starting to see customers move towards more architecture modernization versus just kind of catch-up spend. Maybe more specifically, by enterprises, are there -- what are some of the strongest themes that you're seeing in terms of that modernization? Thanks.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah. Thanks, Meta. So I think that clearly, we have customers who are definitely trying to buy ahead of price increases. And the conversations are, they've gone from, I'd say, being generally understanding to being a little more frustrated, primarily because of the length of time it's taken to get the product. And so they're running out of patience as we all are, but everybody generally understands. Because candidly, most of our customers are probably doing the same thing to their customers in whatever business they're in, in general, given the inflationary pressure that we see everywhere. So that's the first one.

And the second one on the architectural transformations that we see out there, there's a massive one that is really being driven by hybrid work. So rearchitecting your entire network infrastructure to deal with distributed applications, distributed users, distributed data, a new security architecture to accommodate it. That's one. Obviously, within that is hybrid cloud, where you have applications running in multiple cloud providers as well as in private data centers. I mean, the demand we saw for our data center switching portfolio was extremely strong in addition to UCS, which tells me that customers are still investing in private data centers as well. So that creates traffic patterns that are not aligned with the architectures that our customers built over the last 15 years. So that's the first one.

And then there are these transitions that I talked about earlier. You've got customers upgrading to 400 gig. We're almost at 700 customers now who have 400-gig ports. We've now taken orders for 737,000 ports. We had 200,000 plus ports booked in the quarter, which is almost 1,500% growth. So we -- 400 gig is certainly taken off. The WiFi 6 transition has been pretty significant. And those are just some of the things we see. And then in the service provider space, you see 400 gig, you see 5G transition and you see them building out enterprise services based on 5G. So those are some of the major transitions that we see.

[Meta Marshall, Analyst at Morgan Stanley]

Great. Thanks.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Next question, please.

[Operator]

James Suva from Citigroup. You may go ahead.

[James Suva, Analyst at Smith Barney Citigroup]

Thank you. Scott, you had mentioned margins, and I think you'd mentioned at this level through the rest of the year. I did want to -- I just want to qualify, was that for the calendar year or fiscal year? And a little bit of color because my understanding is as you put through product price increases, customers who may have already booked things prior to those increases will still get the product, but you're still paying higher shipping costs and potentially component costs. So I wonder if in the second half of calendar year 2023, if actually margins could expand or maybe they just offset each other? Thank you.

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah. I think you're thinking about it the right way, Jim. It's not a -- most -- a lot of what we have in the backlog of our products that were ordered pre the price increase, certainly the latest round of price increases. Logistics costs are still with us. But as I said earlier, I think that if you remember, we've had a couple of rounds of price increases, and I think we begin to see the benefit of that first one toward the end of Q3 and expect to see it again in Q4. With the level of visibility we have, both $16 billion of short-term RPO, $30 billion of total RPO and add to that $14 billion of backlog, we have better visibility than we've ever had as I look ahead. So feel good that the gross margins will stay in that 64% to 65% range through the second half. And that is of the fiscal year is what I'm talking about, the second half of our fiscal year.

[James Suva, Analyst at Smith Barney Citigroup]

Thank you so much for the details and congratulations.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Jim. Next question?

[Operator]

Tal Liani from Bank of America. Please go ahead.

[Tal Liani, Analyst at Bank of America]

Hi, guys. I have questions on two of your segments. The first one is on security. Your trends are kind of not correlated with the industry trends. First, the previous two quarters, you slowed down materially, but now you're accelerating again, and there was acceleration over the last two quarters. Can you explain why you're seeing these trends? Why we see acceleration as much as why we saw deceleration before? And second is the service revenues. This is the fourth quarter of deceleration. We got to negative territories for growth now. Can you speak -- can you also explain services? And how should we model it going forward?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah, Tal, thanks for the question. I'll take security, and I'll let Scott talk about services because I know he did some work on that. On the security front, I would say that we have strength in several areas of that portfolio, particularly a lot of the SaaS elements that we have in the portfolio. We do have some supply chain issues that are continuing with the firewalls. But again, the SaaS and software components grew at a healthy rate. The teams are working on a next-generation strategy right now. And I feel confident that over the next 12 months to 18 months, you should continue to see improvement in that business, but we also need to get supply chain issues still with on the firewall front. Scott, do you want to talk about services?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah, Tal, on the services piece, what you have to bear in mind is two things. Most of that's ratable. And most of that is the support services we sell attached to hardware. And so there's always a lag, right? When you build up a big ratable revenue base, it takes time to build it up. So it takes it a while to ramp up to speed, but it also takes time for it to come back down. And if you look at our product revenue rates go back 12, 18 months during the midst of the pandemic, of course, our product growth rates were quite low. And the echo effect of that is, we sold fewer services contracts, and we're selling less revenue. It takes time for that to show up in the revenue stream because so much of that is ratable and it builds up in deferred revenue and bleeds out over time.

So what we're dealing with now is just the tail of the services that would have been attached to the hardware at a time when hardware sales, if you go back 12 to 18 months ago, we're fairly low. The flip side is, look at the growth of our RPO at $30.5 billion, growing 8%. Obviously, the ratable services fit inside there and the short term at $16.3 billion, growing 8% gives you a sense of what the path ahead looks like, that's both services and software, but it gives you a sense of what the path ahead looks like.

[Tal Liani, Analyst at Bank of America]

Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Thanks, Tal. Next question?

[Operator]

Amit Daryanani from Evercore. Please go ahead.

[Amit Daryanani, Analyst at Evercore ISI]

Yeah, thanks for taking my question. I guess the first one I have is really on the campus side -- on the campus solutions side. And I'm not under sense of how do you think that segment or product portfolio stacks up as we go through the rest of the year and we get back to some form of hybrid work. And also on campus, I think a lot of your peers is not every one of your peers has talked about picking up market share. You have the dominant position there. I'd love to understand what you see in the marketplace and what your ability to defend share given everyone's talking about it?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah. Amit, I could not understand the first part of your question. Would you like repeat that one?

[Amit Daryanani, Analyst at Evercore ISI]

Yeah. Chuck, I was just trying to understand, on the campus side, how do you think that segment stacks up for the year as we go back into some form of hybrid work? And then competitively, a lot of your peers have talked about picking up share. So how do you see the market share dynamic play out?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Got it. Okay. So what we believe we're seeing is this pure modernization that's occurring. We see densification of WiFi networks, in particular. So we're seeing more and more access points per workspace than what was pre-COVID to just ensure reliability, which then falls through to requiring a more robust switching infrastructure to support it. We believe customers are preparing for putting more and more video units into conference rooms, which will be hardwired, which drives more switch ports.

We have more security cameras that are IP base that are going in. IoT is beginning to expand connecting building automation systems and all of those things just require an incredibly robust and resilient campus network. So we think that's what's going on. And on the second question, market share is a funny thing, and it's certainly -- it's obviously based on revenue. And I can tell you that based on the growth rates from an orders perspective and how much of that is sitting in our backlog, I'm not concerned. We -- I cannot imagine that the market is growing faster than the order growth that we've seen over the last three quarters. It's -- just revenue.

[Amit Daryanani, Analyst at Evercore ISI]

Fair enough. And Chuck, if I could just ask you a quick one. What scenario would it take for Cisco to start being buyback about just offsetting dilution? And maybe the inverse midcaps [Phonetic] allocation question, how much cash is too much on your book that you may have to do more aggressive buybacks?

[R. Scott Herren, Executive Vice President and Chief Financial Officer at Cisco Systems]

Yeah. Amit, I mean, you saw we went pretty aggressive into the buyback during Q2 at $4.8 billion in the quarter. That's obviously well beyond what's required just to offset dilution. And I think, historically, if you look back, you'll see we've been pretty aggressive on share buybacks over the last several years with the dividend and share buybacks returning $76 billion since 2018. So I don't think there's a change in stance or a change in demeanor as we look at that. We're constantly evaluating where we are from a cash standpoint, what our needs are. I told you the priority of our capital allocation policy has not changed. Both the growth of the business organically and organically first. The dividend, anti-dilution and beyond that, we'll return cash to shareholders. So I think that's the way you need to think about it going forward. There's no real change in policy, but you saw us get pretty aggressive in the first half of Q2.

[Amit Daryanani, Analyst at Evercore ISI]

Perfect. Thank you and congrats in the quarter.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Thank you.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Next question?

[Operator]

Samik Chatterjee from J.P. Morgan. Please go ahead.

[Samik Chatterjee, Analyst at J.P. Morgan]

Thanks for taking my questions. I had two quick ones. Chuck, you talked about the strength that you're seeing with web scale customers within the service provider customer segment. Maybe if you can give us some details about what you're seeing from telcos and cable and the strength as well what visibility they are providing you at this point? And then from my follow-up, I just want to go back to orders again and your enterprise orders did at straight from 30% to I think 37% from first quarter to second. Is there a composition of all the orders that's driving that acceleration? Or are you seeing an underlying acceleration? Can you just kind of help us think through that? Thank you.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah, Samik. So on the service provider space, I'd say just to give you a general sense, I gave you the web scale numbers at over 70%. I'd say -- and the overall service provider segment was 42%. And cable is roughly flattish, give or take a point or two. And the telco space was incredibly strong, incredibly strong for us. So both the web scale and the telco space were the key contributors to that 42% growth. And then on the second question -- what was the second question?

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Enterprise growth.

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Enterprise growth. Thank you. Yeah, when you look at it across -- I mean, whether you look at it across the geographies or you look at across -- generally across our product portfolio, or even across verticals, it was just super consistent. I mean it was -- every customer seems to be moving right now. And so I don't think there's not one specific thing to call out. It was pretty broad-based.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

And I think that was our last question for the call. And Chuck, do you want to close with some closing remarks?

[Chuck Robbins, Chair and Chief Executive Officer at Cisco Systems]

Yeah, I do, Marilyn. Thank you. First of all, I'm proud of what we were able to accomplish in Q2 despite the ongoing component demands or component dynamics, the product order growth, the revenue, the EPS, the ARR growth, the RPO growth, the balanced growth across the world. Really pleased with our continued success in web scale and just happy that our customers are choosing our technology as they continue down this digital transformation path.

I think it speaks to the relevance and criticality of what we're building and what our teams have built. And I want to just take a minute to thank all the Cisco employees, because it's been an incredibly difficult couple of years. I think the team has showed a great deal of resiliency, delivered breakthrough innovation and really doing everything we can to take care of our customers. So, thanks for spending time with us today, and we'll talk to you next time.

[Marilyn Mora, Head of Investor Relations at Cisco Systems]

Great. Thanks, Chuck. Cisco's next quarterly earnings conference call, which will reflect our fiscal 2022 third quarter results will be on Wednesday, May 18, 2022 at 1:30 PM Pacific Time, 4:30 PM Eastern Time. This now concludes today's call. If you have any further questions, feel free to reach out to the Cisco Investor Relations group. And we thank you very much for joining today's call.

[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 888-568-0332. For participants dialing from outside the US, please dial 203-369-3905. This concludes today's call. You may disconnect at this time.

Participants

Corporate Executives

• Marilyn Mora, Head of Investor Relations
• Chuck Robbins, Chair and Chief Executive Officer
• R. Scott Herren, Executive Vice President and Chief Financial Officer

Analysts

• Ittai Kidron, Oppenheimer Holdings Inc.
• Paul Silverstein, Cowen Inc
• Sami Badri, Credit Suisse Group AG
• Rod Hall, The Goldman Sachs Group, Inc.
• Tim Long, Barclays PLC
• David Vogt, UBS Group AG
• Meta Marshall, Morgan Stanley
• James Suva, Smith Barney Citigroup
• Tal Liani, Bank of America Co.
• Amit Daryanani, Evercore ISI
• Samik Chatterjee, J.P. Morgan