Cisco Systems’ (CSCO) third quarter 2010 earnings beat the Zacks Consensus estimate by 6 cents, or 17.6%. Revenue was more or less in line, exceeding by 1.4%.
Estimate revisions were minimal over the last 30 days. Only 2 of the 35 analysts covering the stock made upward revisions, while there were no downward revisions. Consequently, the Zacks Consensus estimate remained at $0.34, a 25.9% increase over the year-ago quarter, easily exceeded by Cisco.
Shares moved up 3.0% during the day, since the company has a history of positive surprises, having beaten the Zacks Consensus by an average of 12.39% over the four preceding quarters. However, the stock opened 74 cents lower, as investors were probably confused with the seemingly softer outlook, and not discounting the extra week in the third quarter.
Revenue
Revenue of $10.37 billion was up 5.6% sequentially, 27.0% year over year and just sightly better than management’s guidance range of a 2-5% sequential increase. Growth was balanced across customers and geographies. Market share gains in routing and switching products were partially responsible for the year-over-year increase.
Products generated 81% of revenue, increasing 5.8% sequentially and 31.4% year over year. Services accounted for the remaining 19%, increasing 5.1% sequentially and 10.9% year over year.
Revenue was up across all geographies. Around 54% was generated in the U.S. & Canada (up 4.3% sequentially), 21% came from Europe (up 10.1%), Emerging Markets 11% (up 3.3%), Asia Pacific 11% (up 6.1%) and Japan 4% (up 6.7%). All geographies increased strong doube-digits on a year-over-year basis.
Product Revenue by Category
Routers were 17% of total revenue, representing a sequential increase of 9.9% and a year-over-year increase of 23.7%. The year-over-year increase was driven by a 37% growth in high-end routers, which typically make up around two-thirds of total sales. Mid-range and low-end routing grew 1% and 7%, respectively. New products are being well accepted by customers and continued to grow strongly in the quarter.
Switching revenue reached record levels in the last quarter, accounting for a 35% revenue share. Revenue was up 6.6% sequentially and 41.3% year over year (the strongest year-over-year growth experienced over the last decade or so). Modular switches, which make up a relatively smaller percentage of total switching revenue grew 45%, while fixed switching, which makes up the balance, grew 30% from the year-ago quarter.
Advanced Technologies generated 24% of revenue, up 2.3% sequentially and 17.2% year over year. All product lines within this category grew strongly from the year-ago quarter, with wireless growing 27%, unified communications 26%, video systems 9% and security 15%.
The Other segment brought in 6% of revenue, increasing 4.3% sequentially and 70.3% year over year. Strength in optical and cable products, the positive impact of the Pure Digital acquisition (which added the flip video product line) as well as some success with emerging technologies such as UCS, telepresence and physical security drove the year-over-year increase. 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
Order growth was also strong, indicative of momentum in the business. Orders increased 30% or more across all geographic theaters except Japan. Japan was up in the low single-digit percentage range. Twelve out of the 15 countries in which Cisco has a presence grew more than 20%.
All major segments within the U.S. rebounded strongly, with revenues from enterprise, public sector, search provider, commercial and consumer segments growing in excess of 25% year over year.
Gross Margin
The company generated a gross margin of 64.6% in the last quarter, which was a sequential decrease of 50 bps and a year-over-year decrease of 3 bps.
The product gross margin of 64.3% was down 39 bps sequentially and up 57 bps year over year. Competition has stiffened over the past few months, forcing management to offer heavy discounts. This was the main reason for the sequential contraction, although the impact was softened by higher volumes and cost savings. Volumes were significantly higher than in the year-ago quarter, which coupled with mix benefits, offset the negative impact of heavy discounting.
The services gross margin of 62.3% contracted 136 bps sequentially and 289 bps year over year. Both the sequential and year-over-year declines were on account of higher personnel expenses associated with an extra week of operation and a higher mix of advanced services, although these were partially offset by higher volumes.
The U.S. and Canada theater saw its gross margin decline from the year-ago quarter, although other geographic theaters expanded margins. However, the U.S. and Canada market was stable sequentially, while other regions declined.
Operating Performance
The operating expenses of $4.13 billion were higher than the previous quarter’s $3.74 billion. The operating margin was 24.8%, down 215 bps sequentially, but up 161 bps year over year. The sequential decline was due to increase in all expenses as a percentage of sales, although R&D increased the most. The improvement from the year-ago quarter was driven by lower S&M expenses as a percentage of sales, helped by lower R&D and partially offset by higher G&A and COGS (as a percentage of sales).
On a pro forma basis, Cisco generated a net income of $2.34 billion, or a 22.6% net income margin compared to a $2.06 billion, or 21.0% in the previous quarter and $1.55 billion or 19.0% net income margin in the same quarter last year. Our pro forma estimate excludes intangibles amortization charges on a tax-adjusted basis but includes stock-based compensation expenses in the last quarter. 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 $2.19 billion ($0.37 per share) compared to $1.85 billion ($0.32 per share) in the previous quarter and $1.35 billion ($0.23 per share) in the prior-year quarter.
Balance Sheet
Cisco ended with a cash and investments balance of $39.11 billion, a slight decrease of $532 million during the quarter. The company generated very strong operating cash flow in the third quarter that nearly equaled the cash generated in the first two quarters combined.
Cisco spent $291 million on capex, $2.64 billion on acquisitions net of cash and equivalents acquired, and $2.20 billion on share repurchases. The net cash position at quarter-end was $26.99 billion. Including short-term debt and long-term liabilities, the debt-cap ratio was a mere 31.5%.
Inventories increased 2.9% to $1.25 billion, with inventory turns increasing from 11.1X to 11.8X. Days sales outstanding (DSOs) were down from 39 to around 36.
Guidance
In the third quarter, management expects revenue growth of 3-5% on a sequential basis and 25-28% on a year-over-year basis. The normal sequential increase from the third to the fourth quarter is 5-6%. The less-than seasonal increase is not related to weakness, but the extra weak operated in the third quarter. Additionally, the TANDBERG acquisition, which generated $200-300 million in the last few quarters, is expected to fetch $200 million next quarter.
The gross margin is expected to be 64-65%, operating expenses 36.5-37% of revenue, interest and other income of approximately $10 million and a tax rate of 21%. The GAAP EPS, including stock based compensation of 9 cents a share is expected to be around $0.06 to $0.07.
Management expects the company to generate operating cash flow of $2-2.5 billion.
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