11 August 2010

CSCO: Income Statement Analysis for the July 2010 Quarter

Cisco Systems (NASDAQ: CSCO) earned $0.33 per diluted share on a GAAP basis in fiscal 2010's fourth quarter, which ended on 31 July 2010.  Earnings per share increased almost 80 percent when compared to the $0.19 Cisco made in the same quarter of 2009.

Non-GAAP earnings rose 39 percent, from $0.31 to $0.43 per share.  The non-GAAP results exclude items such as share-based compensation, amortization of acquisition-related intangible assets, other acquisition-related expenses, and impairments.  In the latest quarter, the non-GAAP results excluded items that totaled $776 million pretax, $572 million ($0.10 per share) after-tax.

This post examines Cisco's Income Statement for the quarter and compares the entries on each line to our "look-ahead" estimates.  Reported GAAP earnings were $0.05 less than the $0.38 per share we had forecast. 

The principal sources for the income statement analysis were the earnings announcement, the CFO's video discussion of the results, and the conference call (both presentation [pdf] and transcript (made available by Seeking Alpha)).

In a second article, we will report Cisco Systems' scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

Cisco Systems, Inc. (NASDAQ: CSCO), the proud plumber of the Internet, has a dominant role in markets for enterprise networking products and services.  Its products are broadly categorized as routers, switches, or advanced technologies. 

The company's reportable business segments are defined not by product types but by geographic region.  The U.S./Canada segment provided 53.6 percent of fiscal 2009's Total Revenue.

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 also intends to expand its product line with a tablet computer, called the Cius, for business customers.  The device, which won't be widely available until next year, runs the Android operating system promoted by Google (NASDAQ: GOOG) for mobile devices.  Cisco might be satisfied if the tablet's videoconferencing capabilities merely increases the demand for enterprise network infrastructure.   It's worth remembering that Cisco recently acquired, for $3.3 billion, video-specialist Tandberg.

Additional background information about Cisco and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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.

Revenue in the July quarter increased 27 percent, from $8.54 billion last year to $10.84 billion in the most recent three months.  Our $10.80 billion estimate was on the money, but it was based on Cisco's accurate guidance to expect Revenue growth between 25 and 28 percent.  

Cisco separately identifies Revenue it generates by selling products and by providing services.  Product sales were responsible for 81.3 percent of total revenue in the latest quarter, up from 78.8 percent in July 2009.  Product revenue increased 30.9 percent, and service revenue rose 12.3 percent.

Sales of switches (the company's largest product category) increased 27 percent to $3.6 billion in the quarter.  Advanced Technology -- security, Unified Communications, wireless, storage, etc. -- sales, now $2.6 billion, matched the 27 percent growth rate.  Router sales were $1.7 billion, up 15 percent. 

Cisco Systems has five business segments characterized by the "geography" or "theater" they serve: United States and Canada, European Markets, Emerging Markets, Asia Pacific, and Japan.  The U.S. & Canada segment provided 54.3 percent of the quarter's total revenue.  Four of the five geographies had Revenue growth over 20 percent in the July 2010 quarter, with a thrilling 57 percent Revenue growth in Emerging Markets.  Revenue growth of 29 percent in Europe might be surprising, given recent headlines about that continent.  The laggard was Japan, where Revenue grew only 7 percent.

The Cost of Goods Sold increased to $4.0 billion (37.3 percent of Revenue) from $3.1 billion in the year-earlier quarter.  The latest results translate into a GAAP Gross Margin of 62.7 percent, 130 basis points less profitable than last year's 64 percent.

The non-GAAP Gross Margin was 64.1 percent, within, but towards the bottom of, the 64-to-65 percent range in Cisco's guidance. 

We had assumed the GAAP Gross Margin would be 64.5 percent, which turned out to be 180 basis points too high.

The GAAP Gross Margins for Products and Services were 62.4 percent and 63.8 percent, respectively.

Research and Development spending increased 8.7 percent, from $1.28 billion to $1.39 billion.  R&D spending included a share-based compensation expense of $114 million, up from $99 million last year.  With Revenue up sharply, R&D expenses fell from 15.0 percent of Revenue to 12.8 percent.

The R&D expense was 4.0 percent more than the $1.34 billion we expected.

Sales, General, and Administrative expenses of $2.95 billion were up a substantial 18.0 percent from last year's $2.50 billion.  As a percentage of Revenue, SG&A declined from 29.3 percent to 27.2 percent.

Reported SG&A costs were 10.7 percent more than our $2.66 billion estimate. 

Other operating expenses (amortization of purchased intangible assets) were $131 million, or $44 million less than the $175 million we had estimated.

Subtracting the various operating expenses mentioned above from Revenue Operating Income of $2.325 billion, up 59 percent from $1.46 billion in the year-earlier quarter.  The increase can be credited to higher Revenue, partially offset by greater R&D and SG&A expenses.

Operating Income was 16.7 percent less than our $2.79 billion target.  The difference was mainly the result of a lower-than-expected Gross Margin and and greater-than-expected SG&A expenses. 

Non-operating items, such as interest, summed to a net gain of $93 million, compared to $73 million last year.  We had accepted Cisco's guidance for a $10 million net gain for this category, so we were off by $83 million.  The non-operating item that surprised us was "other" income of $108 million.

The effective Income Tax Rate was 20.0 percent.  We had assumed the rate would be equal to the 21 percent mentioned in the company's guidance. 

Bottom-line GAAP Net Income of $1.935 billion ($0.33/share) exceeded last year's $1.08 billion ($0.19 per share) by 79 percent.  The latest results fell short of our estimate of $2.21 billion ($0.38 per share).

In summary, Revenue increased 27 percent and was strong across products and geographies. GAAP operating expenses, especially SG&A, were higher than we anticipated.  Net income, as a result, was disappointing.

Full disclosure: Long CSCO at time of writing.

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