Cisco Highlights AI Demand, Margin Pressures

Cisco Systems (CSCO) executives told investors at a Morgan Stanley (MS) conference that fiscal second-quarter product orders rose 18%, with demand described as “really strong” and “very balanced.” Excluding hyperscale customers, orders still grew 10% globally.

All three of Cisco’s managed geographies delivered double-digit order growth, each accelerating versus the prior quarter. By vertical, the company cited double-digit gains in public sector across all regions, improved enterprise demand from the first to the second quarter, and “significant acceleration” in service provider and cloud.

Management highlighted two multi‑billion‑dollar opportunities underpinning the stronger order trends: hyperscale AI infrastructure and a multi‑year campus networking refresh. Cisco booked $2.1 billion of new hyperscaler orders in 90 days, which Patterson said matches the company’s total hyperscaler orders for the prior year.

In campus networking, Cisco reported strong overall growth, with wireless, routing and campus switching migrating to new platforms faster than in previous product cycles. Executives linked these trends to the broader refresh underway across customer campuses.

Patterson said gross margin pressure stems mainly from sharply rising memory prices and a shift in revenue mix toward faster‑growing hardware relative to software. He described memory price increases as occurring at an “unprecedented” pace.

Cisco’s hardware business grew more than 20% in the quarter, while software was “a little bit softer,” particularly in security. Patterson noted that while hardware maintains “very good margins,” they remain below software margins; he estimated gross margin would have been one point higher if security revenue had grown mid‑single digits instead of declining 4%.

To offset cost inflation, Cisco is implementing a new price increase “on Monday,” focused on compute and higher‑memory products across its portfolio. The company is also shortening the time between announcing and implementing price changes.

Patterson said Cisco is tightening policies for honoring prior quotes, limiting extensions to an additional 30 days. The company raised advanced purchase commitments by $1.8 billion over the last 90 days, driven by stronger demand, particularly from hyperscalers, and by the need to secure memory supply.

Despite gross margin headwinds, Cisco is emphasizing operating margin and earnings. Patterson said the firm has guided operating margin between 33.5% and 34.5%, including for the third quarter, and reported the highest operating margin in four quarters in Q2.

Software and subscriptions remained “a little over 50%” of total business in Q2, with continued growth in annual recurring revenue and remaining performance obligations, which total $43 billion. Patterson said this backlog supports predictability and durable growth.

In security, he identified the main revenue headwind as Splunk customers shifting from on‑premises to cloud deployments, which moves revenue recognition from upfront to ratable over contract terms. He characterized the transition as longer‑term positive but a near‑term drag on reported revenue.

Excluding Splunk, Patterson cited “really good momentum” in newer security offerings such as Hypershield, Secure Access, XDR and AI Defense. These products added 1,000 new customers in Q2, double the number in Q1, and he said organic security growth is expected to be “approaching double digits” by fiscal year‑end, excluding the Splunk impact.

Discussing hyperscaler relationships, Patterson pointed to prior acquisitions such as Leaba and Acacia and the recruitment of industry talent, including Martin Lund and his team. Lund said Cisco changed its approach by serving hyperscalers in the ways they prefer to buy, from branded systems to white‑box designs using Cisco silicon or components only.

Lund highlighted Cisco’s Silicon One chips, including the G200 and P200, and said only a few companies globally can design comparable solutions. He emphasized a unified architecture for switching and routing with a programmable engine using P4 microcode to adjust forwarding behavior after deployment.

Cisco said it has Silicon One adoption with hyperscalers in “five out of six,” with opportunities across scale‑out and scale‑across roles. Lund also referenced Luxtera’s silicon photonics as relevant to future co‑packaged optics, noting Cisco demonstrated a co‑packaged optics solution in 2023 but has not yet announced a product.

On capital allocation, Patterson reported “no real change” in policy. Cisco plans to build more capabilities internally while remaining opportunistic in mergers and acquisitions where deals can create differentiation, add a “moat” or speed time to market.