03 January 2010

CSCO: Look Ahead to January 2010 Quarterly Results

Cisco Systems (NASDAQ: CSCO) earned $0.30 per share in the first quarter of fiscal 2010, which ended 24 October 2009, down from $0.37 in the same quarter of last year.  Non-GAAP (i.e., "pro forma" or "ex-items") earnings per share slid from $0.42 to $0.36.  Share-based compensation and amortization of acquisition-related intangible assets were the most significant differences between the GAAP and non-GAAP results.

In November, we examined Cisco's Income Statement for the October quarter and compared the entries on each line to our "look-ahead" estimates.  We later performed a financial gauge analysis of Cisco, which determined that the GCFR Overall gauge fell from 36 to 25 of the 100 possible points.

We have now modeled Cisco's Income Statement for fiscal 2010's second quarter, which will end on 23 January 2010.  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 3 February.  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. 

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

According to Gartner, financially strapped consumers and businesses spent about 5 percent less on information technology in 2009, but spending is expected to rebound 3 percent in 2010.  Cisco optimistically asserts its Revenue can expand over the long term at a rate between 12 and 17 percent per year.

In a major diversification initiative, Cisco is promoting the Unified Computing System for large data centers.  The platform consists of computer servers, virtualization software, storage systems [from EMC (NYSE: EMC)], and, of course, networking gear.   Tutor Perini's (NYSE: TPC) new data center was the first UCS installation.

The UCS puts Cisco into direct competition with heavyweights Hewlett-Packard (NYSE: HPQ), IBM (NYSE: IBM), and others. HP responded by challenging Cisco on its home turf by acquiring network equipment maker 3Com (NASDAQ: COMS).

Cisco has long been a serial acquirer, insatiably gobbling up companies of all sizes.  Recent acquisitions include Tandberg, Starent Networks, and ScanSafe.

The company certainly has the financial resources for further acquisitions.  Cisco's Balance Sheet listed $35 billion in Cash and Short-term Investments on 24 October 2009

We're now ready to look specifically at the current quarter.

Our starting point was the presentation material [pdf] and prepared remarks [pdf] used during Cisco's conference call with financial analysts on 4 November 2009.  Relevant excerpts follow:

For Q2 FY10, we anticipate total revenue for the second quarter to be up approximately 1% to 4% year-over-year. From a sequential perspective, we expect to see approximately 2% to 5% growth. ...

... That being said, we believe total gross margin in Q2 will be approximately 64% to 65% reflecting the revenue guidance I just shared with you.

With recent acquisitions and our entry into some lower margin markets, gross margin could be negatively impacted by product mix. We believe Q2 operating expenses will be approximately 37.5% to 38.5% of revenue. We expect interest and other income to be approximately $25 million in the second quarter. Our tax provision rate for Q2 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. As a point of reference, a one dollar movement in our average share stock price would change the calculated shares outstanding for purposes of determining earnings per share by approximately 17 million.

[emphasis added]

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

Since Revenue in the January 2009 quarter was $9.09 billion, the guidance range for the current quarter is $9.18 to $9.45 billion.  We are splitting the difference and selecting $9.32 billion as our Revenue target.

We are accepting the mid-range 64.5 percent estimate for the Gross Margin, which leads to a forecast for Cost of Goods Sold (CGS) of (1 - 0.645) * $9.32 billion = $3.31 billion.

Operating Expenses are expected to be between 37.5 and 38.5 percent of Revenue.  If we apply a mid-range rate to the Revenue target, Research and Development and Sales, General, and Administrative costs will total about $3.54 billion.  We assumed $1.24 billion for R&D and the remaining $2.3 billion 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 $2.34 billion.  This result is more than 30 percent above the comparable year-earlier value.

Cisco indicated that Interest and Other Income would be about $25 million.  This is much lower than our $75 million estimate based on historical data.

Management forecasts a 22 percent Income Tax Rate, which would lead to Provisions for Income Taxes of $531 million.

Given all of the following, it should be clear why we're looking to see GAAP Net Income in the quarter equal to $1.88 billion ($0.32 per share), which is 25 percent greater than 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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