24 May 2007

CSCO: Financial Analysis through April 2007

We have updated our analysis of Cisco Systems' (CSCO) financial results for the quarter ending on 28 April 2007 to address the data reported to the SEC on Form 10-Q. Our evaluation, adjusted to account for new information, is reported in this post.

Cisco, the proud plumber of the Internet, has a commanding position in the market for enterprise-level networking devices. After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use. Cisco shares move up nicely in the second half of 2006, but the stock price has vacillated in a narrow range around $27 this year.

When we analyzed Cisco after the results from January 2007 became available, the Overall score was a modest 27 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 14 points. Value was weakest at 1 point.

Now, with the available data from the April quarter, our gauges display the following scores:

Cash Management. This gauge increased 3 points from 9 points in January. The Current Ratio is now 2.6, which is a sign of strength. It has been inching up during the last two years. Long-Term Debt/Equity is a manageable 23 percent. The debt ratio was 24 percent in January and 26 percent in April 2006. Inventory/Cost of Goods Sold dropped substantially to 39 days from 52 days three months ago. This surprisingly large drop in inventory was almost entirely the result of a massive $323 million reduction in work-in-process. Raw materials, finished goods, and other inventory changed by much smaller amounts over the quarter. Did Cisco cut back on production because they are expecting sales to slow? Even though Finished Goods inventory dropped in absolute terms, it increased as a percentage of total inventory from 48 to 58 percent. Accounts Receivable are 35 days of Revenue, which is in line with its average value.

Growth. This gauge increased a hefty 10 points from 14 points in January. Revenue growth is now 24 percent year over year, up from 12 percent a year ago. Net Income growth is a vibrant 25 percent, up from flat levels a year ago. The increase benefited from a change in the income tax rate from 27 to 23 percent. CFO growth is a solid 21 percent, up from 13 percent a year ago. Revenue/Assets is 69 percent. The acquisition of Scientific Atlanta had lowered this parameter in early 2006, but some ground has since been regained.

Profitability. This gauge increased 1 point from the prior quarter's 12 points. ROIC grew to a healthy 23 percent from 20 percent a year ago. FCF/Equity held steady at 30 percent. Operating Expenses/Revenue stayed at 74 percent. Gross Margin edged down a couple percentage points, but reductions in other expenses softened the blow. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from -4 percent to -3 percent. This tells us that a little less of the company's Net Income is due to cash flow, and, therefore, a little more is due to changes in non-operational balance sheet accruals.

Value. Cisco's stock price rose a fraction over the course of the quarter from $26.62 to $26.74. The Value gauge, based on the latter price, increased to 4 points from 1 point three months ago, but down from 7 points twelve months ago. The P/E at the end of the quarter was 24, which is about the same as the average P/E for the Computer Peripherals industry. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 45 percent greater than the average P/E, using core operating earnings, of stocks in the S&P 500. This premium to the market multiple is not unreasonable for Cisco, with its prodigious growth rate, but the premium averaged closer to 35 percent over the last 10 quarters. The PEG ratio of 1.0 is indicative of an inexpensive stock. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has been stable at 5.0. The average Price/Sales for the Computer Peripherals industry is 3.75.

Now at a modest 41 out of 100 possible points, the Overall gauge has recently bounced back. In summary, the recent quarter showed strong growth and steady (but not really improving) profitability. The Value gauge is troubling, as is the apparent reduction in production suggested by the inventory data.

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