13 October 2010

CSCO: Look Ahead to October 2010 Quarterly Results

This post describes our model of Cisco Systems's (NASDAQ: CSCO) Income Statement for fiscal 2011's first quarter, which will end on 30 October 2010.

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. 

Cisco's earnings rose 27 percent in fiscal 2010, which ended in July, from $6.13 billion to $7.77 billion.  Revenue increased 11 percent, from $36.1 billion to $40.0 billion.  Fiscal 2010 included a 53rd week.

The market value of the company is currently around $130 billion, on a fully diluted basis. 

In fiscal 2011, Cisco will issue its first cash dividend.  The amount and timing of the dividend have not yet been disclosed.

Cisco categorizes its products as Routers, Switches, Advanced technologies, and other.  The company achieved greater Revenue in each of these categories in fiscal 2010, when compared to the previous year.  Switches generated the most Revenue in fiscal 2010, $13.6 billion, which was 42 percent of net product sales. 

Revenue from product sales was supplemented by $7.6 billion in Revenue from services in fiscal 2010.  Service revenue was 19 percent of total Revenue in fiscal 2010.

The company's business segments for financial data reporting are defined by geographic region or "theaters": United States and Canada, European Markets, Emerging Markets, Asia Pacific, and Japan.  The U.S./Canada segment provided 54.3 percent of fiscal 2010'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.  In 2010, Cisco's two largest acquisitions were Tandberg, for $3.3 billion, and Starent Networks, for $2.6 billion.

The company has the financial resources for further acquisitions.  Cisco's Balance Sheet for 31 July 2010 listed nearly $40 billion in Cash and Short-term Investments.

Research firm Gartner predicts worldwide Enterprise Information Technology spending will rise 2.9 percent to $2.4 trillion in 2010.  They had earlier forecast growth of 4.1 percent, but the economy has slowed.  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 "to unite computing, network, storage access, and virtualization resources" for large data centers.  Since the UCS platform includes computer servers, storage systems [from EMC (NYSE: EMC)], and networking gear, the UCS puts Cisco into direct competition with heavyweights Hewlett-Packard (NYSE: HPQ), IBM (NYSE: IBM), and others.  HP's response was to challenge Cisco on its home turf by acquiring network equipment maker 3Com (NASDAQ: COMS).

Cisco is also investing to become a substantial force in the smart grid market.

Interestingly, 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. 

Cisco Systems 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 were almost 80 percent more than 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. 

Readers wanting to take another look at Cisco's July 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

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

Our starting point was the conference call presentation [pdf] and transcript (made available by Seeking Alpha) on 11 August after the release of the company's fourth-quarter results.

Cisco described its expectations (with appropriate caveats) for the first quarter of fiscal 2011 as follows:

In light of the unusual uncertainty in the macro environment including the comments we heard from the Federal Reserve yesterday, we encourage you to continue to model conservatively especially in the short-term.

For Q1 FY ‘11, we anticipate total revenue to be up approximately 18% to 20% year-over-year.

we believe 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 37% to 38% of revenue. We also expect interest and other income to be approximately $10 million in the first quarter. Our tax provision rate for Q1 is expected to be approximately 22%.

We are modeling share count to be down approximately 40 million shares quarter-over-quarter in weighted average shares outstanding for EPS purposes. In this estimate of share count, we are not taking into consideration any further change in stock price that could occur in the first quarter of fiscal year ‘11.

Since Revenue in the October 2009 quarter was $9.0 billion, the expected 18-to-20 percent rise mentioned above establishes a range for current-quarter Revenue between $10.65 billion and $10.83 billion.  From this range, we have selected $10.7 billion as our Revenue estimate for the quarter.  This estimate is 1.3 percent less than July 2010 quarterly Revenue of $10.84 billion.

We are using an estimate of 63.5 percent for the Gross Margin, which is 50 basis points less than the guidance.  The difference is intended to cover the expenses that the company excludes from its non-GAAP guidance.  The estimates for Revenue and Gross Margin would lead to a Cost of Goods Sold of (1 - 0.635) * $10.7 billion = $3.9 billion.

Cisco expects Operating Expenses, composed of Research and Development and Sales, General, and Administrative costs, to be between 37 and 38 percent of Revenue.  If we apply the higher rate to the Revenue target, we come up with an estimated expense of 0.38 * $10.7 billion = $4.07 billion.  We allocated $1.34 billion of the total for R&D and the remaining $2.73 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.  The special expenses are usually around $100 million to $150 million per quarter.

Subtracting the estimated operating expenses from the Revenue estimate yields a $2.6 billion target for Operating Income.  This amount is 23 percent more than the comparable year-earlier value of $2.12 billion.

Moving to the non-operating side of the Income Statement, we expect Interest and Other Income will be about $50 million.

We are using management's forecast of a 22 percent Income Tax Rate, which would lead to a Provision for Income Taxes of around $580 million.

This produces a bottom-line target for GAAP Net Income in the quarter of $2.07 billion ($0.36 per share), which is 16 percent more than earnings of $1.79 billion ($0.30 per share) in the October 2009 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. 

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