Cisco Systems’ (CSCO) second quarter 2010 earnings (excluding one-time items and including stock based compensation) beat the Zacks Consensus estimate by 2 cents, or 6.7%. Revenue was more or less in line, missing by 0.1%.
As in the past, estimate revisions were limited prior to the announcement of earnings, leaving the Zacks Consensus estimate for the quarter at $0.30, flat with the year-ago quarter and easily exceeded by Cisco. While positive, the earnings surprise was not exceptional and below the preceding four-quarter average of 9.2%.
Investors reacted to the weak revenues that seemed to validate news flow regarding share losses in some segments, for example to F5 Networks (FFIV), significant margin declines and the repeated lowering of the fiscal 2011 guidance, which pulled down share prices 8.7% in after-hours trading.
Revenue
Revenue of $10.40 billion was down 3.2% sequentially, up 6.0% year over year and slightly better than management’s expectations of a 4-6% sequential decline.
Products, which generated 79% of revenue, were the main reason for the softness, declining 5.3% sequentially although increasing 5.9% year over year. Services accounted for the remaining 21%, up 5.9% sequentially and 18.1% year over year. Cisco stated that services were growing in importance, with technical support services and advanced services growing 14% and 30%, respectively from the comparable prior year quarter.
Revenues were down sequentially across all regions except Europe, which was up 4.7%. It was also up 8.9% from last year. The U.S. & Canada declined 5.6% sequentially and grew 4.2% from last year. Emerging markets, while declining .2% sequentially saw year-over-year growth of 7.6%. The Asia/Pacific region was down 4.8% sequentially and up 7.8% from last year. The four regions contributed 20%, 53%,11% and 15% of quarterly revenues, respectively.
Product Revenue by Category
Routers were 16% of total revenue, representing a sequential decline of 7.3% and a year-over-year increase of 7.2%. The ASR edge routers (5,000, 7,000 and 9,000) were gain a major driver, growing 68% from the year-ago quarter and at an annualized runrate of $1.5 billion. Overall, high-end routers grew 5% year over year, mid-range routers were down slightly, while low-end routers grew 6%.
Switching revenue accounted for a 30% revenue share, declining 11.3% sequentially and increasing 8.2% year over year. Cisco did not provide the revenue split between modular (relatively smaller percentage of total switching reveneu) and fixed switching and attributed the significant declines to ongoing product transitions.
However, they did state that the Nexus 7,000 line did particularly well at the data center, growing 100% from last year at an annualized runrate of $1 billion. Overall, there was a mix change in favor of lower-end switching.
New Products generated 31% of revenue, up 2.8% sequentially and 34.5% year over year. Collaboration, wireless and data center products grew very strongly from last year (37%, 34% and 59%, respectively). Security remained soft, dropping 9% while audio connected home dropped 4% .
The Other segment brought in 2% of revenue, down 8.7% sequentially and 65.1% year over year.
Orders
Order growth slowed slightly again in the second quarter growth in the last quarter, with Cisco seeing an 8% year-over-year increase in global orders compared to a 10% increase last quarter. Emerging markets were again the strongest with 27% growth, followed by the Asia/Pacific, which was up 8%, the U.S. and Canada, which grew around 6% and Europe, with low single-digit growth.
Growth rates in China slowed down considerably, although the region was still up 10%. Cisco stated that other than the U.S., U.K. and Switzerland, which grew mid-single-digits and Italy, which declined, all markets were up 10-30% on a year-over-year basis.
Despite pockets of weakness in some areas, orders were up across all market segments. Commercial strength was the most notable in the last quarter, with order growth of 11%, followed by enterprise (10% increase), service provider (9% increase), global public sector (7% increase), U.S. public sector (9% increase) and consumer (15% decline).
Gross Margin
Cisco generated a gross margin of 61.7% in the last quarter, down 204 bps sequentially and 333 bps on a year-over-year basis. The consumer business was the most important driver of the decline from last year, with mix, pricing and inventory adjustments all contributing. New switching and UCS product ramp up costs accounted for another 100 bps and 50 bps, respectively. Volume and mix across the entire business also impacted the margin in the last quarter.
The product gross margin of 58.9% was down 372 bps sequentially and 577 bps year over year. Competition has stiffened over the past few months, increasing pricing pressure and forcing management to offer heavy discounts. However, component cost savings remain a positive.
The services gross margin of 64.8% was up 120 bps sequentially and 113 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 $4.31 billion were 1.5% higher than the previous quarter’s $4.25 billion. The operating margin was 20.3%, down 396 bps sequentially and 661 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 89 bps, S&M up 114 bps and G&A down 11 bps. All except G&A also increased significantly from the year-ago quarter. Pursuant to the company’s growth plans, Cisco increased the workforce by 300 in the last quarter, which followed increases of 1,900, 2,000 and 1,000 in the three preceding quarters.
On a pro forma basis, Cisco generated a net income of $1.77 billion, or a 17.0% net income margin compared to $2.12 billion, or 19.7% in the previous quarter and $2.06 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 $1.52 billion ($0.27 per share) compared to $1.93 billion ($0.34 per share) in the previous quarter and $1.85 billion ($0.32 per share) in the prior-year quarter.
Balance Sheet
Cisco ended with a cash and investments balance of $40.2 billion, up $1.3 billion during the quarter. The company generated $2.61 billion in operating cash flow, spent $326 million on capex, $25 million on acquisitions net of cash and equivalents acquired and $1.85 billion on share repurchases. The net cash position at quarter-end was $28.07 billion, down from $26.71 billion at the end of the fiscal first quarter. Including short term debt and long term liabilities, the debt-cap ratio was a mere 31.4%.
Inventories increased 5.2% to $1.60 billion, with inventory turns dropping from 10.2X to 9.9X. Days sales outstanding (DSOs) were up from 38 to around 41.
Guidance Lowered
In the third quarter, Cisco expects revenue to increase 3.6-5.6% on a sequential basis, or 4-6% on a year-over-year basis. The operating margin is expected to be 23-24% of revenue, the tax rate 21%, yielding a GAAP EPS, including stock based compensation and acquisition-related charges is expected to be 8 to 10 cents a share and a non-GAAP EPS of 35-38 cents a share.
In the fourth quarter, Cisco expects revenue to increase 8-10% on a year-over-year basis. This would result in annual revenues at the mid to lower end of the previous guidance of 9-12% growth. Cisco expects gross margins in the 62-63% range in the third and fourth quarters.
Our Take
Despite pockets of strength, Cisco’s results and guidance indicate a slowdown in the core routing and switching businesses, which it attributed to important product transitions. While there may be some truth to this and Cisco is no doubt the networking giant, competitors, such as Juniper Networks (JNPR), Hewlett Packard Company (HPQ) through its 3Com acquisition and F5 are very slowly picking up market share.
Also, Cisco’s stellar margins have come as the result of its innovations, something that we may expect to continue going forward. But the company will see increasing pricing pressure as the number of players increase.
Moreover, management has added 5,500 people over the last four 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 about Cisco’s solid product portfolio, comprehensive growth strategy and a leading market position. We continue to believe that hiring during a soft period is not a bad thing, since this usually means better talent at lower cost.
Cisco shares currently have a Zacks #3 Rank (short-term Hold recommendation).
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