07 July 2009

CSCO: Look Ahead to July 2009 Quarterly Results

Earnings at Cisco Systems (NASDAQ: CSCO) fell from $0.29 to $0.23 per share in the April quarter.  This result contributed to a decline in Cisco's GCFR Overall Gauge score from 71 to 54 points.

Our initial and updated analysis reports examined the April quarter, which was the third quarter of the company's fiscal year, in some detail.  In summary, total Revenue was 16.6 percent less in April 2009 than April 2008.  Revenue from products dropped 22 percent, with router sales down 32 percent.  The 10-Q attributed the sales decline to the effect of "the global macroeconomic downturn across our geographic theaters" and the consequent "cautious spending by customers in [all] markets." Double-digit sales declines were experienced in each of the five defined "geographic theaters."

The bright spot was services, where Revenue increased 9 percent.  We also gave Cisco credit for carefully managing its costs and inventory.  The Gross Margin was down just 0.3 percent from April 2008.

Despite the weak economy, or, perhaps because the worst financial fears were not realized, the price of Cisco shares rallied 29 percent from $14.97 on 31 January to $19.32 on 30 April.  The contrarian Value gauge responded by falling 8 points, which is why the Overall gauge lost as many points as it did.  The combination of a surging share price and much lower earnings could not have any other result. 

We have now modeled Cisco's Income Statement for the quarter that will end 25 July 2009.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data the company is scheduled to announce on 5 August 2009.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we set the stage with some background information about Cisco and the business environment in which it is currently operating.  Readers that keep close tabs on the company are invited to skip ahead.

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 routersJuniper Systems (NASDAQ: JNPR) is usually considered Cisco's most direct competitor in this market.

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.  While it would appear that this puts Cisco into competition with heavyweights such as Hewlett-Packard (NYSE: HPQ) and IBM (NYSE: IBM), Cisco claims to be creating a new, specialized market called Unified Computing

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.

The company certainly has the financial resources for further acquisitions.  Cisco added $4.0 billion of long-term debt in the April quarter, most of which went (loosely speaking) into the company's bank account.  Cisco had over $33 billion in cash and short-term investments on 25 April.

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 for the time being.

We're now ready to look ahead.

Our starting point was the guidance in Cisco management's prepared remarks when they presented April's results.  A transcript of this 6 May 2009 event is available at SeekingAlpha.com.  For our purposes, the following are the key points:

[W]e anticipate total revenue for the fourth quarter to be down approximately 17% to 20% year-over-year.  [...]

we believe total gross margin in Q4 to be in the range of 63% to 64%, reflecting the revenue guidance

We believe Q4 operating expenses will be approximately 39 to 40% of revenue.

We expect interest and other income to be approximately $30 million in the fourth quarter.  Our tax provision rate for Q4 is expected to be approximately 22%. 
[...]  We are modeling share count to be flat quarter-over-quarter in weighted average shares outstanding for EPS purposes.  [...]

For our Q4 FY ‘09 GAAP earnings, we anticipate that Q4 GAAP EPS will be $0.05 to $0.07 per share lower than the non-GAAP EPS, primarily due to acquisition charges and stock compensation expense. 

The guidance statements were made with appropriate caveats, which we have not reproduced here, about the difficulty in looking ahead in the current environment.

Since Revenue in the July 2008 quarter was $10.4 billion, the guidance range for the current quarter is $8.3 to $8.6 billion.  We have selected $8.5 billion as our Revenue target.

We are using the lower end, 63 percent, of management's guidance for Gross Margin.  In other words, our forecast for Cost of Goods Sold (CGS) is (1 - 0.63) * $8.5 billion, which is a bit over $3.1 billion.

Operating Expenses between 39 and 40 percent of Revenue are expected.  If we apply the 40 percent figure to the Revenue target, we get $3.4 billion to apportion between Research and Development and Sales, General, and Administrative costs.  [On GCFR Income Statements, CGS is also listed as an Operating Expense.]

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 for these charges in the last 10 quarters, discarding the highest and lowest values, is $122 million.

These figures would result in Operating Income, as we define it, of $1.83 billion.  This result is 27.5 percent below the comparable year-earlier value.

Cisco indicated that Interest and Other Income would be about $30 million in the July quarter.  This is much less than in July 2008.

Management forecasts a 22 percent Income Tax Rate, which would lead to Provisions for Income Taxes of $410 million.

Given all of the following, it should be clear why we're looking to see GAAP Net Income in the quarter equal to $1.45 billion (about $0.25 per share), which is 25 percent below earnings of the year-earlier quarter.

Please click here to see a full-sized, normalized depiction of the projected results next to Cisco's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: Long CSCO at time of writing.  No position in any other security mentioned.

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