08 November 2007

CSCO: Financial Analysis through October 2007

We have analyzed Cisco Systems' (CSCO) preliminary results for the quarter that ended on 27 October 2007. The financial statements included all the data needed to compute our gauge scores, but we will scour the formal 10-Q after it is filed with the SEC and update our evaluation if necessary.

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. CSCO shares have rallied for the last year. During the August-through-October quarter, the share price increased by 14 percent, from $28.91 to $33.06.

When we analyzed Cisco after the July quarter, the Overall score had dropped to an unimpressive 27 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 15 points. Value was weakest at 0 points.

Now, with the available data from the October 2007 quarter, our gauges display the following scores:

· Cash Management: 10 of 25

· Growth: 14 of 25

· Profitability: 12 of 25

· Value: 0 of 25

· Overall: 28 of 100

Before we examine the factors that affected each
gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.


October 2007

October 2007

October 2006






Op expenses

















Operating Income




Other income





Interest, etc.




Pretax income




Income tax




Net Income







Revenue in the quarter was 0.6 percent above the midpoint of company's earlier estimate, which we used. Revenue was 16.7 percent greater than in the year-earlier quarter, beating the forecast of 16.1 percent. We expected Cost of Goods Sold (CGS) to be 35.0 percent of Revenue, and the actual value was 35.4 percent for a Gross Margin of 64.6 percent. Research and Development (R&D) expenses were 12.5 percent of Revenue, a little less than our 13 percent estimate. Sales, General, and Administrative (SG&A) expenses were 26.1 percent of Revenue, compared to our forecast of 25 percent.

These higher SG&A costs, plus $20 million additional miscellaneous operating costs (primarily amortization of purchased intangible assets), were the primary reasons actual Operating Income came in at 3.9 percent below the forecast value.

Non-operating interest income was a substantial $74 million more than expected. In addition, the Income Tax Rate was 15.9 percent, instead of the predicted 24 percent. The rate was artificially low because of a $162 million settlement on U.S. income tax matters. The non-operating results enabled Net Income to overcome the shortfall in Operating Income and exceed the prediction by 9.7 percent.

We suggest that more attention be given to the Operating data than the Non-operating data. While higher than expected interest income and a one-time tax settlement are appreciated, they will not drive Cisco’s long-term future.

Cash Management. This gauge increased from 9 points in July to 10 points now.

The measures that helped the gauge were:

· Current Ratio =2.7; a sign of strength, up from last year's value of 2.4.

· LTD/Equity = 19.4 percent; manageable and down from 25.3 percent in October 2006

· Inventory/CGS = 39.1 days, compared to 39.0 and 48.4 days 3 and 12 months ago, respectively

· Cash Conversion Cycle Time (CCCT) = 47.9 days, down from 54.2 days, for this measure of efficiency

· Debt/CFO = 0.6 years, compared to 0.7 years 12 months ago

The measures that hurt the gauge were:

· Finished Goods/Inventory = 68 percent, above its 48 percent median value

· Days of Sales Outstanding (DSO) = 32.7 days, about the same as the 32.9-day level one year earlier

· Working Capital/Market Capitalization = 9.8 percent, down from 10.2 percent

We view the high level of Finished Goods/Inventory as a potential warning flag. Did production levels increase faster than sales?

Growth. This gauge decreased from 15 points in July to 14 points now.

The measures that helped the gauge were:

· Net Income growth = 33.8 percent year-over-year, up from 5.7 percent

· Revenue growth = 20.5 percent year-over-year, up from 18.7 percent in October 2006

· CFO growth = 24.6 percent year-over-year, up from 16.7 percent.

As mentioned above, Net income benefited significantly from a tax settlement. On a year-over-year basis, the income tax rate dropped from 26.4 to 20.0 percent.

The measures that hurt the gauge were:

· Revenue/Assets = 65.2 percent, down from 67.1 percent in a year

Profitability. This gauge stayed at the 12 points achieved in July.

The measures that helped the gauge were:

· ROIC = 21.1 percent, a smidgeon above the 21.0 percent achieved last year

· FCF/Equity = 28.3 percent, impressive but down from 31.3 percent in a year

The measures that hurt the gauge were:

· Operating Expenses/Revenue = 73.8 percent, unchanged from a year ago.

· Accrual Ratio = -3.0 percent, up from -4.6 percent in a year.

The increasing Accrual Ratio tells us that less of the company's Net Income is due to CFO, and, therefore, more is due to changes in non-operational Balance Sheet accruals.

Value. Cisco's stock price rose over the course of the quarter from $28.91 to $33.06. The Value gauge, based on the latter price, remained stuck on zero points.

No measure was able to help this gauge.

· Enterprise Value/Cash Flow = 17.5, up from a five-year median of 15.6

· P/E = 26.4, up from its median value of 25.0, which is about where it was a year ago

· P/E to S&P 500 average P/E = 62 percent premium, up from a median value for the premium of 56 percent

· Price/Revenue ratio = 5.8, compared to its median of 5.1

The average P/E for the Computer Peripherals industry is about 25.4. The average Price/Revenue for the industry is currently 4.1.

Cisco had an excellent quarter: Revenue, Cash Flow, and Net Income all increased sharply. But, the company doesn’t seem to have achieved all of the predicted operating cost efficiencies. Net Income expectations were met as a result of non-operating factors; while a dollar is a dollar, these interest income and tax settlements are not how Cisco’s financial health will ultimately be assessed. The Overall gauge is now a mere 28 points. We are reminded that it is important not to focus solely on Growth; of our gauges, the Growth score is the one that generally correlates least well with future stock price gains. This might be because optimistic investors bid up the share price at a rate even faster than the income increases. The cold Value gauge is signaling that the stock has become quite expensive. Alas, this is true for many companies in the late stages of a bull market.

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