08 May 2009

CSCO: Financial Analysis through April 2009

Cisco Systems (NASDAQ: CSCO) earned $0.23 per share, compared to our $0.22 estimate, in the three months that ended on 25 April, which was the third quarter of the company's fiscal 2009.   This post provides the GCFR analysis of the financial statements.

First, we present some background information.

Cisco Systems, Inc. (NASDAQ: CSCO), the proud plumber of the Internet, has a dominant position in the market for enterprise networking products and services, such as routers.  In this market, Juniper Systems (NASDAQ: JNPR) is the most direct threat to Cisco Systems.

The company also sells devices intended for home use.

In a major shift, Cisco is preparing to sell computer servers, equipped with virtualization software, for large data centers.  This move will put the company into competition with Hewlett-Packard (NYSE: HPQ) and IBM (NYSE: IBM), with whom Cisco has partnered in other segments of the market.

Cisco has long been a serial acquirer, insatiably gobbling up companies of all sizes.  Recent acquisitions include Tidal Software, which writes programs for data centers, for $105 million, and Pure Digital Technologies for $590 million.  The latter firm has sold more than two million Flip Video camcorders in the last two years.

Current economic conditions have not deterred Cisco from continuing the acquisition strategy.  Bloomberg reported that Cisco would be taking advantage of lower equity prices to accelerate the expansion of its product line. 

Cisco's executives often express confidence, with appropriate caveats, that the company can expand its Revenue over the long term at a rate between 12 and 17 percent.  However, the "historic collapse," as ChangeWave described it, in information technology spending has derailed this objective.  Revenue in the January 2009 quarter was 7.5 percent less than in the January 2008 quarter.  The company even had to close its North American units for 5 days around New Years Day.

Nevertheless, the GCFR Overall Gauge edged up from 70 to 71 points of the 100 possible points when January's results were assessed.  Value and Cash Management were especially strong, at 23 and 19 points, respectively, of 25 possible points each.  Profitability was a solid 15 points.  However, the most telling number for this former high flier was the three-point Growth score. 

Now, with data available from the April 2009 quarter, our gauges display the following scores: 

Before examining the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously announced expectations.

We reviewed Income Statement prepared in accordance with U.S. GAAP, rather than the non-GAAP ("pro forma" or "ex-items") version that often gets attention.  In the latest quarter, the difference between GAAP and non-GAAP results is more than $400 million.

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.


Revenue was 16.6 percent less than in the April 2008 quarter.  The drop, though substantial, was not quite as steep as the 17.5-percent decline we had expected.

The Cost of Goods Sold was 35.9 percent of Revenue, which translates into a Gross Margin of 64.1 percent.   The margin was down just slightly from 64.4 percent in the year-earlier quarter.  We had expected a lower margin, 62.5 percent, based on Cisco's 63 percent guidance and our concern that declining Revenue would reveal inefficiencies.
Research and Development spending was just 3.6 percent more/less than our $1.2 billion target. The actual R&D figure was 15.2 percent of Revenue.
Similarly, Sales, General, and Administrative expenses were merely 2.6 percent more than our target.  SG&A costs were 27.7 percent of Revenue in the latest quarter.
Amazingly, Other operating expenses (primarily amortization of purchased intangible assets) were just $1 million more than our prediction, which we computed by taking the average value for these charges in the last 10 quarters, and discarding the highest and lowest values.

Operating Income was 24.9 percent less than last year's value, but it was 5 percent more than our prediction.  Better-than-expected Revenue and Gross Margin were the main reasons Operating Income surpassed our weak estimate.
Interest and Other Income matched Cisco's guidance exactly, although the value was down about 50 percent.
The Income Tax Rate was only 20.1 percent, instead of the predicted 22 percent, which boost the bottom line.  The tax rate was 23.2 percent in the April 2008 quarter.

Net Income was 24.0 percent less than last year's value, but it beat our prediction by 7.4 percent.  Earnings per share dropped from $0.29 to $0.23.  (Cisco repurchased 77 million of its shares during the quarter.)
Now for the gauges:
Cash ManagementApril 2009
3 months prior
12 months prior
Current Ratio3.2
 0.9 years
0.5 years
0.6 years
30.8 days
30.5 days34.0 days
Finished Goods/Inventory
Days of Sales Outstanding (DSO)31.6 days
32.5 days
35.1 days
Working Capital/Invested Capital 203%
Cash Conversion Cycle Time (CCCT)
42.5 days
45.0 days
56.9 days
Gauge Score (0 to 25)
Cisco would appear to have substantially more liquid assets ($33 billion in Cash and Short-term Investments; $28 billion in Working Capital).  However, the company chose to take on more Long-term Debt, nearly $4 billion in the last quarter alone.  The company seems to be amassing the resources for large-scale acquisitions. 
The Inventory level was commendably lean, no easy feat in a recession.  The lower proportion of Finished Goods indicates that management is taking steps to scale back manufacturing in response to slower sales.
The ratios that indicate cash management efficiency have improved and, in the case of the CCCT, substantially so.
GrowthApril 20093 months prior
12 months prior
Revenue growth-1.7%
Revenue/Assets 62.3%
CFO growth
Net Income growth -11.3%
Gauge Score (0 to 25)0
Growth rates are trailing four quarters compared to four previous quarters.

Greatly reduced information technology spending, by consumers and businesses, in the U.S. and worldwide, has squelched Cisco's growth, a company hallmark.   Revenue and Net Income were both lower in the last four quarters than in the four preceding quarters.  Cash Flow eked out a small gain. 

The drop in Revenue as percentage of Assets is particularly stunning.

ProfitabilityApril 20093 months prior
12 months prior
Operating Expenses/Revenue 76.5%
ROIC 50.8%
Free Cash Flow/Invested Capital
Accrual Ratio
Gauge Score (0 to 25)15

An upward trend in Operating Expenses as a percentage of Revenue, which dampens Profitability, continued when measured on a trailing four-quarters basis.  The improved Gross Margin in the April quarter might be a sign that the trend has, or will soon, reach its peak for this cycle.

The ROIC and FCF remain in all-star territory.  Alas, the big increase in Accrual Ratio signals that earnings quality has weakened. 

ValueApril 20093 months prior
12 months prior
P/E 15.9
P/E vs. S&P 500 P/E 89%
Price/Revenue 3.0
Enterprise Value/Cash Flow (EV/CFO)
Gauge Score (0 to 25)15

Despite the weak economy, or, perhaps because the worst economic fears weren't realized, the price of Cisco shares rose from $14.97 to $19.32 (29 percent) during the months of February-to-April quarter.

The contrarian Value gauge could not possibly approve of that increase, given that it occurred at a time when the business fundamentals were so weak.  Investors are looking more to the future than the present.

Cisco's valuation ratios can be compared with other companies in the Networking & Communication Devices industry.

OverallApril 20093 months prior
12 months prior
Gauge Score (0 to 100)55

Revenue fell substantially in the April quarter, although not quite as much as we had expected.  Nevertheless, it is shocking to see a double-digit Revenue decline at a company so used to growth well in excess of 10 percent that it seemed a birthright.  We do, however, have to give Cisco credit for managing its costs and inventory in a manner commensurate with current economic conditions.  The Gross Margin was down just 0.3 percent from April 2008.

EPS dropped from $0.29 to $0.23.  Lower interest income hurt the comparison with the earlier quarter, but a lower income tax rate helped.

We noted that Cisco hiked Long-term Debt by almost $4 billion, even though the company already held $33 billion in highly liquid assets.  Is this war chest intended to fund another series of acquisitions?

While Cisco's Growth gauge falling to 0 might seem more remarkable, the 8-point drop in the Value gauge score was more responsible for the big decline in Cisco's Overall score.  We should point out, however, that 55 out of 100 points, is actually a pretty decent score in our system.

Full disclosure: Long CSCO at time of writing.

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