27 September 2009

CSCO: Look Ahead to October 2009 Quarterly Results

The GCFR Overall Gauge of Cisco Systems (NASDAQ: CSCO) dropped from 53 to 36 of the 100 possible points in the fourth quarter of fiscal 2009, which ended 25 July.  Our income statement, financial gauge, and gauge update analyses explained in some detail how the score was attained.

Revenue fell sharply in the July quarter, down 17.6 percent when compared to the same period of 2008.  Sales of routers were especially weak, plunging 27 percent.  For fiscal 2009 as a whole, Revenue contracted 8.7 percent relative to 2008. 

If weak sales in the quarter were not enough of a drag on profits, the overruling of a court decision dealing with share-based compensation expenses at Xilinx (NASDAQ: XLNX) led to a $174 million tax provision that further diluted Cisco's Net Income.  Earnings per share fell 44 percent.

We have now modeled Cisco's Income Statement for fiscal 2010's first quarter, which will end on 24 October.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data that the company will announce on 4 November.  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 Systems and the business environment in which it is currently operating.  Readers that keep close tabs on the company might want 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 now selling computer servers, equipped with virtualization software, for large data centers.  While this seemingly puts Cisco into competition with heavyweights such as Hewlett-Packard (NYSE: HPQ) and IBM (NYSE: IBM), Cisco claims to be creating a new, specialized platform called the Unified Computing System.  On 1 September 2009, Cisco announced that Tutor Perini's (NYSE: TPC) new data center has become the first UCS installation.

The Wall Street Journal recently reported that Cisco and EMC (NYSE: EMC) are planning to form a joint venture that would install Cisco's new servers and networking gear and EMC's storage systems in large data centers.

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's Balance Sheet for 25 July 2009 listed $35 billion in Cash and Short-term Investments.

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, financially strapped consumers and businesses have spent less on information technology in 2009 than they did last year.  More positively, a ChangeWave survey determined that corporate IT spending "is continuing to improve" in the third quarter after stabilizing in the second quarter. 

We're now ready to look ahead.

Our starting point was the presentation material and prepared remarks used during Cisco's conference call with financial analysts on 5 August.  Relevant excerpts follow:

[O]ur revenue guidance for Q1 FY 2010, including our using caveats as discussed earlier and in our financial reports, is for revenue to decrease in the 15 to 17% range year over year.

[W]e believe that total gross margin in Q1 will be approximately 64%, reflecting the revenue guidance I just shared with you. ...  We believe Q1 operating expenses will be approximately 38 to 39% of revenue. This Q1 guidance reflects the savings from lower headcount and discretionary spending reductions  ... .

We expect interest and other income to be approximately $25 million in the first quarter. Our tax provision rate for Q1 is expected to be approximately 22%. While we expect to continue our share repurchase program, it is difficult to predict the exact weighted average shares outstanding. We are modeling share count to be up approximately 50 million shares quarter over quarter in weighted average shares outstanding for EPS purposes.

Regarding cash flow from operations, we would expect to generate $1.2 billion to $1.5 billion during the first quarter. For our Q1 F '10 GAAP earnings, we anticipate that GAAP EPS will be $0.05 to $0.07 per share lower than our non-GAAP EPS, primarily due to acquisition related charges and stock compensation expenses.

[emphasis added]

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 October 2008 quarter was $10.3 billion, the guidance range for the current quarter is $8.57 to $8.78 billion.  We selected $8.7 billion as our Revenue target.

We are estimating 63.5 percent for the Gross Margin, which is 0.5 percent less than management's guidance.  We use a lower value because the guidance applies to non-GAAP results that exclude certain charges.  Our forecast for Cost of Goods Sold (CGS) is (1 - 0.635) * $8.7 billion, which is a bit less than $3.2 billion.

Operating Expenses between 38 and 39 percent of Revenue are expected.  If we apply a mid-range rate to the Revenue target, Research and Development and Sales, General, and Administrative costs will total about $3.35 billion.  We assumed $1.2 billion for R&D and the rest for SG&A.

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 $132 million.

These figures would result in Operating Income, as we define it, of $2.04 billion.  This result is 18 percent below the comparable year-earlier value.

Cisco indicated that Interest and Other Income would be about $25 million.  This is much less than in October 2008.

Management forecasts a 22 percent Income Tax Rate, which would lead to Provisions for Income Taxes of $455 million.

Given all of the following, it should be clear why we're looking to see GAAP Net Income in the quarter equal to $1.6 billion (about $0.28 per share), which is 27 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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