04 November 2007

CSCO: Look Ahead to the 1Q FY08 Earnings

On Wednesday, after the stock market closes, Cisco Systems (CSCO) will report how much it earned during the quarter that ended 27 October 2007. The quarter was the first of Cisco's 2008 fiscal year.

Our analysis after the July quarter noted that Revenue, Cash Flow, and Net Income all increased sharply. However, our Value gauge warned that Cisco, as is the case for many companies in the late stages of a bull market, had become relatively expensive. Valuation measures, which are double-weighted, kept our Overall gauge capped at a quite modest 27 points.

Since Cisco's shares are even more richly priced now, it will be interesting to see if the company can grow at a pace fast enough to justify the expanding multiples it is now commanding in the stock market. During the August-through-October quarter, the price of CSCO shares increased by 14 percent, from $28.91 to $33.06. This was an impressive performance considering the struggles of so many other companies during this period.

During the quarter, Cisco gave financial analysts more optimistic guidance about revenue expectations. The company forecast that revenue in the quarter would be between $9.45 and $9.55 billion. The mid-point of this rather narrow range, which we have used below, equates to an increase of about 16 percent over the revenue brought in during the October 2006 quarter. The company has also said it "expects annual revenue growth of between 12 percent and 17 percent over the next three to five years."

Cisco's Gross Margin slipped a few percentage points over the last few years from an enviable 70 percent to a still-impressive 64 to 65 percent. The company's guidance for the latest quarter was to expect the Gross Margin to hold at 65 percent. Therefore, the forecast for Cost of Goods Sold (CGS) is 35 percent of $9.5 billion, or $3.3 billion.

Research and Development (R&D) expenses have recently been about 13 percent of revenue. This would equate to $1.2 billion in the last quarter, if the revenue estimate is achieved. Similarly, Sales, General, and Administrative (SG&A) expenses tend to be around 25 percent of revenue, which would be about $2.4 billion.

We need to mention at this point that Cisco stated that they expect quarterly operating expenses, by which they mean R&D, SG&A, and other various other operating charges, "will be in the range of 36% of revenue." Note that this is two percentage points less than the 13 and 25 percent figures we used in the previous paragraph. Cisco executives are certainly better equipped to make the predictions than we are, but a reduction in R&D expenses to, say, 12 percent of revenue and a reduction in SG&A expenses to 24 percent of revenue would be quite a coup for the company.

The various other operating changes mentioned above include payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and the mysterious in-process research and development. We don't know how to forecast these costs, but they have been averaging about $100 million per quarter.

These figures would result in Operating Income of $2.5 billion, compared to $2.0 billion in the year-earlier quarter.

Non-operating interest and other income has been around $200 million per quarter, but the company indicated that $180 million is a reasonable estimate for the October quarter.

The effective income tax rate is expected to drop from 25 percent to 24 percent.

Therefore, we're looking to see Net Income in the quarter of $2.0 billion. This would equate to about $0.32 per share. If we were to shave 2 percentage points off Operating Expenses, as the company has suggested, Net Income would increase to $2.16 billion ($0.35/share)

October 2007
October 2006
9500 8184
Op expenses

CGS (3325) (2951)

R&D (1235) (1083)

SG&A (2375) (2050)

Other (100)
Operating Income
2465 1991
Other income

Investments 0 0

Interest, etc. 180 185
Pretax income
2645 2176
Income tax
Net Income
2010 1608

$0.32/sh $0.26/sh

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