10 November 2010

CSCO: Income Statement Analysis for the October 2010 Quarter

Cisco Systems (NASDAQ: CSCO) earned $0.34 per diluted share on a GAAP basis in the October-ending first quarter of fiscal 2011, up 12 percent from $0.30 in the same three months of last year. 

Non-GAAP earnings rose 17 percent, from $0.36 to $0.42 per share.  The non-GAAP results exclude items such as share-based compensation, amortization of acquisition-related intangible assets, and other acquisition-related expenses.  In the latest quarter, these non-GAAP items totaled $666 million pretax, $481 million ($0.08 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 $0.02 less than the $0.36 per share we had forecast. 

The principal sources for the income statement analysis were the earnings announcement and the ensuing conference call presentation [pdf] (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., 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.

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

The market value of the company is currently around $140 billion, on a fully diluted basis. 

Cisco categorizes its products as Routers, Switches, New Products, and other.  Switches generated the most Revenue in fiscal 2010, $13.6 billion, which was 42 percent of net product sales. 

The company's business segments for financial data reporting are defined by geographic region or "theaters."  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.

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 October quarter increased 19.2 percent, from $9.0 billion last year to $10.75 billion in the most recent three months.  Cisco's had told investors to expect Revenue guidance between 18 and 20 percent.

Revenue surpassed our $10.7 billion estimate by 0.5 percent.

Cisco separately identifies Revenue it generates by selling products and by providing services.  Product sales were responsible for 81 percent of total revenue in the latest quarter, up from 80 percent in October 2009.  Product revenue increased 20.8 percent, and service revenue rose 12.6 percent.

Sales of switches (the company's largest product category) increased 25 percent to $3.55 billion in the quarter.  Sales of New Products -- home video, collaboration, security, etc. -- were $3.1 billion, up 22 percent. 

Cisco Systems has four business segments characterized by the "geography" or "theater" they serve: United States and Canada, European Markets, Emerging Markets, and Asia Pacific.  The U.S. & Canada segment provided 54.7 percent of the quarter's total revenue.  Note that the results for Japan have been integrated into the Asia Pacific segment for the new fiscal year.

Revenue grew at a thrilling 41 percent pace in Emerging Markets.  The laggard was Europe, where Revenue increased a modest 11 percent.

The Cost of Goods Sold increased to $4.0 billion (37.2 percent of Revenue) from $3.1 billion in the year-earlier quarter.  The latest results translate into a GAAP Gross Margin of 62.8 percent, 250 basis points less profitable than last year's 65.3 percent.  Cisco blamed the decrease on pricing decisions, higher manufacturing costs in some cases, and a tilt in the product mix towards greater sales of lower margin products.

The non-GAAP Gross Margin was 64.3 percent, which slightly beat Cisco's 64-percent guidance. 

We had assumed the GAAP Gross Margin would be 63.5 percent, which turned out to be 80 basis points too low.

Research and Development spending increased 16.9 percent, from $1.22 billion to $1.43 billion.  R&D spending included $121 million in share-based compensation expenses, up from $97 million last year.  R&D spending fell from 13.6 percent of Revenue to 13.3 percent.

The R&D expense was 6.7 percent more than the $1.34 billion we expected.

Sales, General, and Administrative expenses of $2.86 billion were up a seemingly substantial 17.5 percent from last year's $2.4 billion. However, as a percentage of Revenue, SG&A declined from 27.0 percent to 26.6 percent.

Reported SG&A costs were 5 percent more than our $2.73 billion estimate.  

The combination of R&D and SG&A costs, less share-based compensation expenses, was $3.94 billion or 36.7 percent of Revenue.  Cisco's guidance indicated the company expected these two operating expenses to equal between 37 percent and 38 percent of Revenue.

Other operating expenses (amortization of purchased intangible assets) were $113 million, or $12 million less than the $125 million we had estimated.

Subtracting the various operating expenses mentioned above from Revenue yields Operating Income of $2.35 billion, up 11 percent from $2.12 billion in the year-earlier quarter.  The increase can be credited to higher Revenue, partially offset by the lower Gross Margin and greater R&D and SG&A expenses.

Operating Income was 9.7 percent less than our $2.6 billion target.  The difference was mainly the result of the lower-than-expected Gross Margin and greater-than-expected operating expenses.

Non-operating items, such as interest, summed to a net gain of $74 million, compared to $115 million last year.  We had expected Interest and Other Income of $50 million. The non-operating item that surprised us was "other" income of $80 million.

The effective Income Tax Rate was 20.4 percent.  We had assumed the rate would be equal to the 22 percent mentioned in the company's guidance. 

Bottom-line GAAP Net Income of $1.93 billion ($0.34/share) exceeded last year's $1.79 billion ($0.30 per share) by 12 percent.  The latest results fell 6.8 percent short of our estimate of $2.07 billion ($0.36 per share).

In summary, Revenue increased 19 percent, as expected, in the most recent quarter. Sales of switches and "new products" rose at better than a 20-percent pace.  Emerging market sales were especially robust.  The Gross Margin on a non-GAAP basis was slightly better than expected, but special items pushed the GAAP Gross Margin below expectations.

Operating Income rose 11 percent from the year-earlier quarter, but the increase in Net Income was a more moderate 8 percent because non-operating fell slightly.  Fewer shares outstanding gave a slight boost to the EPS growth rate, but not enough to reach our EPS target.

Full disclosure: Long CSCO at time of writing.

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