Cisco Systems’ (CSCO) first quarter 2010 earnings (excluding one-time items and including stock based compensation) beat the Zacks Consensus estimate by 2 cents, or 5.7%. Revenue was more or less in line, missing by 0.1%.
As in the past, estimate revisions were minimal prior to the announcement of earnings, leaving the Zacks Consensus estimate for the quarter at $0.35, flat with the year-ago quarter and easily exceeded by Cisco. While positive, the earnings surprise was not exceptional and below the four-quarter average of 11.6%.
However, the 12.6% decline in share prices was not based on the quarter’s performance, but rather, on the disappointing guidance.
Revenue
Revenue of $10.75 billion was down 0.8% sequentially, up 19.2% year over year and slightly better than management’s expectations of a 0-2% sequential decline.
Products, which generated 81% of revenue, were the main reason for the softness, declining 1.2% sequentially although up 20.8% year over year. Services accounted for the remaining 19%, up 1.1% sequentially and 12.6% year over year.
All except the Asia/Pacific region declined on a sequential bases. The Asia/Pacific region was up 5.6% sequentially and 21.8% from last year. The U.S. & Canada were flat sequentially and up 17.8% from last year. Emerging markets, while declining 3.6% sequentially saw the highest year-over-year growth at 40.8%. The four regions contributed 15%, 55%,19% and 11% of quarterly revenues, respectively.
Product Revenue by Category
Routers were 17% of total revenue, representing a sequential increase of 4.4% and a year-over-year increase of 14.6%. The ASR edge routers were particularly strong, growing 200% from the year-ago quarter. Overall, high-end routers grew 16% year over year, mid-range routers grew 7% and low-end routers 8%.
Switching revenue accounted for a 33% revenue share, declining 1.5% sequentially and increasing 23.6% year over year. Modular switches, which make up a relatively smaller percentage of total switching revenue grew 25% year over year and fixed switches, which makes up the balance grew 24%. The Nexus line had another good quarter.
Advanced Technologies (now christened New Products) generated 29% of revenue, up 22.1% sequentially and 37.0% year over year. Most product lines within this category grew strongly from the year-ago quarter, with data center increasing 59%, collaboration 45%, wireless 9% and audio connected home 11%. Security was the only product line to soften, declining 2%.
The Other segment brought in 2% of revenue, down 75.1% sequentially and 52.0% year over year. The company lost some ground here, although management stated that the UCS business continued to do well. We will continue to watch the progress of the UCS business keeping in mind the competitive scenario involving Hewlett Packard Company (HPQ), International Business Machines (IBM) and Juniper Networks (JNPR) among others.
Orders
Cisco saw strong order growth in the last quarter, although growth rates were slower than in the previous quarter. Global orders increased 10% from the year-ago quarter. Emerging markets were the strongest with 32% growth, followed by the Asia/Pacific, which was up 18%, the U.S. and Canada, which grew around 7% and Europe, with growth of around 2%.
Management stated that 13 out of the 15 countries in which Cisco has a presence grew orders at mid-teens or better percentage rates, with Russia up over 100%, India and Brazil (up by over 60%), Mexico (up 40%) and China (up around 30%) seeing the most significant increases.
Despite pockets of weakness in some areas, orders were up across all industries. Enterprise strength was the most notable in the last quarter, with order growth of 16%, commercial followed with a 13% increase, which was then followed by service provider (8% increase), public sector (6% increase) and consumer (flat).
Gross Margin
Cisco generated a gross margin of 63.8% in the last quarter, up 23 bps sequentially but down 198 bps on a year-over-year basis. The gross margin was negatively impacted by pricing and discounts, as well as some supply chain constraints that pushed up manufacturing costs.
The product gross margin of 62.7% was up 22 bps sequentially and down 282 bps year over year. Competition has stiffened over the past few months, increasing pricing pressure and forcing management to offer heavy discounts. However, cost savings more than offset these negatives, leading to sequential expansion in the gross margin.
The services gross margin of 63.6% was down 20 bps sequentially and 86 bps year over year. The sequential variation in services gross margins is attributable to the mix of business (higher-cost advanced versus lower-cost technical support), as well as the timing of contract initiations.
Operating Performance
Cisco’s operating expenses of $4.25 billion were 1.7% higher than the previous quarter’s $4.18 billion. The operating margin was 24.3%, down 73 bps sequentially and 96 bps year over year. The sequential decline in operating margin was the combined effect of the lower cost of sales and higher operating expenses (as a percentage of sales)
Specifically, R&D was up 20 bps, S&M up 90 bps and G&A down 21 bps. S&M also increased compared to the year-ago quarter. Pursuant to the company’s growth plans, management increased the workforce by $1,900 in the last quarter, which followed an increase of 2,000 in the June quarter and an increase of 1,000 in the preceding quarter.
On a pro forma basis, Cisco generated a net income of $2.12 billion, or a 19.7% net income margin compared to $2.22 billion, or 20.5% in the previous quarter and $1.89 billion or 21.0% net income margin in the same quarter last year.
Our pro forma estimate for last quarter excludes acquisition-related costs and intangibles amortization charges on a tax-adjusted basis but includes stock based compensation expenses. Our pro forma calculations may differ from management’s presentation due to the inclusion/exclusion of some items that were not considered by management.
On a fully diluted GAAP basis, the company reported a net income of $1.93 billion ($0.34 per share) compared to $1.94 billion ($0.33 per share) in the previous quarter and $1.79 billion ($0.30 per share) in the prior-year quarter.
Balance Sheet
Cisco ended with a cash and investments balance of $38.9 billion, down $936 million during the quarter. The company generated $1.67 billion in operating cash flow, spent $326 million on capex, $69 million on acquisitions net of cash and equivalents acquired and $2.70 billion on share repurchases.
The net cash position at quarter-end was $26.71 billion, down from $27.67 billion at the end of the fiscal fourth quarter. Including short-term debt and long-term liabilities, the debt-cap ratio was a mere 31.2%.
Inventories increased 14.8% to $1.52 billion, with inventory turns dropping from 11.9X to 10.2X. Days sales outstanding (DSOs) were up from 42 to around 38.
Guidance
In the second quarter, Cisco expects revenue to decrease 4-6% on a sequential basis, or increase 3-5% on a year-over-year basis. The operating margin is expected to be 23-25% of revenue, the GAAP EPS, including stock based compensation and acquisition-related charges is expected to be 8 to 10 cents a share and the non-GAAP EPS to be 32 to 35 cents a share.
Cisco expects to report full-year revenues 9-12% over 2009 levels.
Key Takeaways
Despite pockets of strength, Cisco’s results and guidance indicate a slowdown in several important areas, such as its routers and switches, which can only be attributed to the macro weakness, especially in Europe. Despite this softness, the company saw two quarters of supply constraints, although Cisco stated that things had already started improving.
However, competition and pricing pressure/discounts will no doubt continue, so we don’t really see significant gross margin expansion in the next few quarters. Moreover, management has added 4,900 people over the last three quarters, which will increase opex going forward. The hiring is expected to continue over the next few quarters. Therefore, if revenue growth is sluggish, there will be an automatic negative impact on margins.
That said, we remain positive on Cisco shares because the short term softness is related to macro issues that will have the same impact on peers. Cisco on the other hand, has a solid product portfolio, comprehensive growth strategy and a leading market position. Moreover, hiring during a soft period is not a bad thing, since this usually means better talent at lower cost. Consequently, when the macro situation improves, Cisco will be in a better position to outdo the competition.
Cisco shares currently have a Zacks #2 Rank (short-term Buy recommendation). Our long term recommendation is Neutral.
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