04 July 2010

CSCO: Look Ahead to July 2010 Quarterly Results

This post describes our model of Cisco Systems (NASDAQ: CSCO) Income Statement for fiscal 2010's fourth quarter, which will end on 31 July.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing background information about Cisco Systems and the business environment in which it is currently operating.

Cisco Systems, Inc., the proud plumber of the Internet, has a dominant role in markets for enterprise networking products and services. 

Earnings fell 24 percent in fiscal 2009, which ended in July 2009, from $8.05 billion to $6.13 billion.  Revenue declined 8.7 percent, from $39.5 billion to $36.1 billion.  Services provided 19 percent of total Revenue in 2009.

The company's market capitalization is around $125 billion. 

Cisco categorizes its products as routers, switches, and advanced technologies.  However, the company's reportable business segments are not defined by product types but by geographic region: United States and Canada, European Markets, Emerging Markets, Asia Pacific, and Japan.  The U.S./Canada segment provided 53.6 percent of fiscal 2009's Total Revenue.

Juniper Systems (NASDAQ: JNPR) is usually considered Cisco's most direct competitor in the enterprise market.

Cisco has long been a serial acquirer, insatiably gobbling up companies of all sizes.  It recently completed a $3.3-billion purchase of Norway's Tandberg, an expert in videoconferencing.

The company certainly has the financial resources for further acquisitions.  Cisco's Balance Sheet for 1 May 2010 listed nearly $40 billion in Cash and Short-term Investments.

Research firm Gartner has just lowered its forecast for worldwide spending in 2010 on information technology to 3.9 percent growth, compared to last year.  The research firm had expected IT spending to grow 5.3 percent.  Cisco frequently asserts its Revenue can expand over the long term at a rate between 12 and 17 percent per year.

In a major diversification effort, Cisco began promoting in 2009 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.  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 also branching out with a planned tablet computer, the Cius, and its Flip video camcorders.

Fiscal 2010's third quarter ended on 1 May 2010 and included a rare fourteenth week.  In this period, Cisco earned $0.37 per diluted share on a GAAP basis, a hefty 61 percent more than the $0.23 per share earned in the third quarter of 2009.  The latest quarter included a one-time $158 million ($0.03 per share) tax benefit.

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

Our starting point was Cisco's conference call (slides [pdf] and transcript [pdf]) with financial analysts on 12 May 2010 after the release of the company's third quarter results

During the call, Cisco described its expectations (with appropriate caveats) for the final quarter of fiscal 2010 as follows:

For Q4 FY10, we anticipate total revenue to be up approximately 25 to 28% year-over-year.

we believe total gross margin in Q4 will be approximately 64% to 65%

We believe Q4 operating expenses will be approximately 36.5% to 37% of revenue. We expect interest and other income to be approximately $10 million in the fourth quarter. Our tax provision rate for Q4 is expected to be approximately 21%.

We are modeling share count to be down approximately 10 million shares quarter-over-quarter in weighted average shares outstanding for EPS purposes. ....  As a point of reference, a $1.00 movement in our average stock price would change the calculated shares outstanding for purposes of determining earnings per share, by approximately 17 million.

Other than those items noted above, there are no other significant differences between GAAP and our non-GAAP guidance. This guidance assumes no additional acquisitions, asset impairments, restructuring and tax or other events which may or may not be significant. ...

Since Revenue in the July 2009 quarter was $8.535 billion, the expected 25-to-28 percent rise establishes a range for fourth-quarter Revenue between $10.67 billion and $10.93 billion.  We have selected the mid-range figure of $10.8 billion as our estimate for the quarter.

For the Gross Margin, we have used the 64.5-percent midpoint of the guidance range.  This projects to a Cost of Goods Sold of (1 - 0.645) * $10.8 billion = $3.83 billion.

Cisco expects Operating Expenses, composed of Research and Development and Sales, General, and Administrative costs, between 36.5 and 37 percent of Revenue.  If we apply the higher rate to the Revenue target, we come up with an estimated expense of 0.37 * $10.8 billion = $4.0 billion.  We allocated $1.34 billion of the total for R&D and the remaining $2.66 billion for SG&A.

Cisco always reports various other operating charges, such as payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and in-process research and development.  These expenses are excluded from Cisco's guidance, but we include them since our objective is to model the GAAP figures.  A check of the historical record shows a tendency for higher special charges in July quarters than the others.  With this in mind, we estimated special charges of $175 million for the July 2010 quarter.

Subtracting these operating expenses from the Revenue target yields an estimated Operating Income, as we define it, of $2.79 billion.  This result would exceed the comparable year-earlier value of $1.46 billion by about 90 percent.

Moving to the non-operating side of the Income Statement, we accept Cisco's $10 million guidance for Interest and Other Income.

We are also using management's forecast a 21 percent Income Tax Rate.  Given this rate and the numbers above, the Provision for Income Taxes would be around $590 million.

This produces a bottom-line target for GAAP Net Income in the quarter of $2.21 billion ($0.38 per share), which would double earnings of $1.1 billion ($0.19 per share) in the fourth quarter of 2009.

For modeling the share count, we used an estimated share price of $23.73 for the current quarter, down $1.66 from the third quarter.  Share repurchases during the quarter could increase per-share earnings slightly.

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. 

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