02 October 2008

CSCO: Look Ahead to October Quarterly Results

The GCFR Overall Gauge of Cisco Systems' performance and value rose to 61 of 100 possible points, a very good score, when we analyzed their 10-K financial report for the fiscal year that ended on 26 July 2008.  The score had been 43 points after the April quarter.

Three of our four individual gauges increased in July.  Given current economic conditions, it's understandable that the Growth gauge would lag the others.  The Value gauge, which increased from 11 to 16 of the 25 possible points, was the beneficiary of Cisco's 14 percent share price drop during the fourth fiscal quarter.

Revenue in the July 2008 quarter was 9.9 percent greater than in the year-earlier quarter.  Net Income grew by a more modest 4.4 percent.

Cisco Systems, Inc. (NASDAQ: CSCO), the proud plumber of the Internet, has a commanding position in the market for enterprise networking products and services, such as routers.  After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use.

After the U.S. markets close on 5 November 2008, Cisco will report its results for the quarter (the first of fiscal 2009) that will end on 25 October 2008.  In anticipation of this report, we've modeled the company's Income Statement for the quarter.  The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

During the conference call with analysts in early August to discuss the latest earnings, Cisco provided guidance for the first half of fiscal 2009.  The company indicated that challenging economic conditions precluded issuing guidance for the full year.  As is now common, management expressed confidence that Cisco can grow over the long term at a rate between 12 and 17 percent, with some quarters above or below this range.  As recently as 16 September, CEO John Chambers stated that "never been more comfortable" with this long-term forecast.

Confidence aside, Cisco's guidance for Revenue growth in the October quarter is about 8 percent "year-over-year."  [The GCFR definition of "year-over-year" is "the last four quarters compared to the four previous quarters."  We learned the hard way that Cisco's alternative definition is "this quarter compared to the year-earlier quarter."]

Applying a 8.0 percent growth factor to Cisco's $9.55 billion Revenue in the October 2007 quarter, yields a $10.32 billion Revenue target for the October 2008 quarter.  Note that this target is slightly below Revenue in the July 2008 quarter.

Management's guidance for Gross Margin in the October quarter is 65.0 percent.  Our analysis doesn't support a margin quite that optimistic, and we will, therefore, set the target at a more conservative 64.5 percent.  In other words, our forecast for Cost of Goods Sold (CGS) is 35.5 percent of $10.3 billion, which is $3.7 billion.

Cisco stated that they expect the quarter's Operating Expenses to be about 37 percent of Revenue.  Operating Expenses, as Cisco defines the term, include Research and Development (R&D) and Sales, General, and Administrative (SG&A) costs.  [On GCFR Income Statements, CGS is also listed as an Operating Expense.]  Based on past results, we expect R&D expenses will be 12.5 percent of Revenue.  This would equate to 0.125 * 10.3 billion = $1.3 billion.  Similarly, we expect SG&A expenses to be 26 percent of Revenue, which would be about $2.7 billion.
Our R&D and SG&A estimates sum to 38.5 percent of Revenue, a significant 1.5 points above the guidance.  This may be one place we're seeing a difference between the GAAP results we track and the non-GAAP results on which Cisco concentrates.

Cisco always reports various other operating charges, including payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and the mysterious in-process research and development.  The average value per quarter for these charges is about $120 million, which happens to be the expense incurred in the October 2007 quarter.

These figures would result in Operating Income of $2.56 billion, compared to $2.37 billion in the year-earlier quarter, for an increase of 8.2 percent.

Cisco indicated that Interest and Other Income would be $175 million in the October quarter.  The equivalent figure in the year-earlier quarter was a much richer $254 million.  This easy-to-miss, non-operating line item establishes a higher bar for Cisco to overcome if it hopes to achieve positive earnings growth in the current quarter. 

Pretax income would, therefore, be about $2.7 billion.  Management forecasts a 24 percent Income Tax Rate, which would lead to Provisions for Income Taxes of $660 million.  Note that the tax rate was an artificially low 15.9 percent in the October 2007 quarter as a result of a $162 million settlement on U.S. income tax matters. Taxes, therefore, also will make the current quarter look less favorable.

Given all of this, it's should be clear why we're looking to see GAAP Net Income in the quarter equal $2.08 billion (about $0.35 per share), which is 5.6 percent below earnings of the year-earlier quarter.

Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats.  A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.

($M) October 2008
October 2007
Revenue 10,318 9,554
Op expenses
CGS (3,663) (3,381)
R&D (1,290) (1,192)
SG&A (2,683) (2,493)
Other (120)
Operating Income 2,563 2,368
Other income
Investments 0 0
Interest, etc. 175 254
Pretax income 2,738 2,622
Income tax (657)
Net Income 2,081 2,205
$0.35/sh $0.35/sh
Shares outstanding 6,010 6,330

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