09 February 2011

CSCO: Income Statement Analysis for the January 2011 Quarter

Cisco Systems (NASDAQ: CSCO) earned $0.27 per diluted share on a GAAP basis in the January-ending second quarter of fiscal 2011, down 14 percent from $0.32 in the same three months of the previous year. 

Non-GAAP earnings fell 7.5 percent, from $0.40 to $0.37 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 $861 million pretax, $557 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 $0.32 per share we had forecast. 

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

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.

The market value of the company is currently around $125 billion, on a fully diluted basis. 

In fiscal 2011, Cisco will issue its first cash dividend.  The amount and timing of the dividend are subject to tax considerations.

Cisco categorizes its products as Routers, Switches, Advanced technologies, and other.  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 in October 2010 listed nearly $39 billion in Cash and Short-term Investments.

Gartner has predicted $3.5 trillion will be spent on Information Technology in 2011, up 5.1 percent from last year.  However, in a separate announcement, the well-known researcher was less sanguine about spending on Enterprise Information Technology, forecasting a modest 3.1 percent rise in 2011.  Gartner commented that EIT spending growth would be "timid and at times lackluster" during the next five years.

Tepid industry spending would test Cisco's frequent assertion that its revenue can expand over the long term at a rate between 12 and 17 percent per year.

In a major diversification effort, Cisco introduced in 2009 the Unified Computing System 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 responded by challenging Cisco on its home turf when it acquired 3Com.

Cisco has also branched out into home entertainment, tablet computers (the Cius), video camcorders, and smart grid technology.  Cisco might be satisfied if these products merely increases the demand for enterprise network infrastructure. 

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 January quarter increased 6 percent, from $9.8 billion last year to $10.4 billion in the most recent three months.  This growth rate exceeded Cisco's earlier guidance that Revenue would grow between 4 and 5 percent.

The latest Revenue amount surpassed our $10.2 billion estimate by 2.0 percent.

Cisco distinguishes between the Revenue it generates by selling products and by providing services.  Product sales were responsible for 79 percent of total revenue in the latest quarter, down from 81 percent in the January 2010 quarter.  Product revenue increased 3.3 percent, and service revenue rose 18 percent.

Sales of switches (the company's largest traditional product category) dropped 7 percent to $3.15 billion in the quarter.  Sales of New Products -- home video, collaboration, security, etc. -- were $3.2 billion, up 15 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 53 percent of the quarter's total revenue. Note that results for Japan, previously reported separately, have been integrated into the Asia Pacific segment.

Revenue growth was most robust in Europe, 8.9 percent.  This seems surprising.

The Cost of Goods Sold increased to $4.15 billion (39.8 percent of Revenue) from $3.48 billion in the year-earlier quarter.  The latest results translate into a GAAP Gross Margin of 60.2 percent, which is a far less profitable margin than last year's 64.5 percent.

Pricing, product mix, and new product transitions all had negative effects on the Gross Margin.

The non-GAAP Gross Margin was 62.4 percent.

We had assumed the GAAP Gross Margin would be 63.0 percent, which turned out to be 280 basis points too optimistic.

Research and Development spending increased 18.5 percent, from $1.25 billion to $1.48 billion.  R&D spending included $132 million in share-based compensation expenses, up from $110 million last year.   R&D fell from 12.7 percent of Revenue to 14.2 percent.

The R&D expense was 11.5 percent more than the $1.33 billion we expected.

Sales, General, and Administrative expenses of $2.90 billion were up a substantial 12.4 percent from last year's $2.58 billion.  As a percentage of Revenue, SG&A increased from 26.3 percent to 27.8 percent.

Reported SG&A costs were 5.2 percent more than our $2.75 billion estimate.

Other operating expenses (amortization of purchased intangible assets) were $203 million, significantly more than the $125 million we had estimated.

Subtracting the various operating expenses mentioned above from Revenue yields GAAP Operating Income of $1.68 billion, down 29 percent from $2.37 billion in the year-earlier quarter.  The decrease was due to the lower Gross Margin and greater R&D and SG&A expenses.

Operating Income was 24 percent less than our $2.22 billion target, a substantial miss. Although Revenue was a little higher than we expected, operating costs were all greater than we had anticipated.

Non-operating items, such as interest, summed to a net gain of $46 million, compared to a $15 million loss last year.  We had expected Interest and Other Income of $60 million.

The effective Income Tax Rate was only 12 percent.  One reason for the unusually low rate was a $65 million tax benefit related to the reinstatement of the U.S. federal R&D tax credit. 

We had assumed the tax rate would equal 20 percent. 

Bottom-line GAAP Net Income of $1.52 billion ($0.27/share) was significantly less than last year's $1.85 billion ($0.32 per share). The latest results were 17 percent below of our estimate of $1.825 billion ($0.32 per share).

In summary, Revenue increased 6 percent, better than expected, in the most recent quarter.  However, the Gross Margin was light, and other expenses were generally higher than we anticipated.  A lower tax rate cushioned the fall, but earnings in the quarter were still less than in the same period of the previous year.  The results didn't satisfy our expectations.

Full disclosure: Long CSCO at time of writing.

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