Cisco Systems’ (CSCO) third quarter 2010 earnings (excluding one-time items and including stock-based compensation) beat the Zacks Consensus estimate by 6 cents, or 18.8%. Revenue was more or less in line, missing by 0.3%.

While a couple of analysts lowered estimates over the last 30 days, this did not have an impact on the Zacks Consensus Estimate for the quarter, which stayed at $0.32, flat sequentially and easily exceeded by Cisco. The earnings surprise was much better than the preceding four-quarter average.

However, Cisco lowered its expectations for the fiscal fourth quarter, which effectively lowered the 2011 guidance again and accounted for the 3.32% decline in share prices.


Revenue of $10.87 billion was up 4.4% sequentially and 4.8% year over year, within management’s expectations of a 4-6% year-over-year increase.

Products, which generated 80% of revenue, grew 5.3% sequentially and 2.8% year over year. Services accounted for the remaining 20%, up 1.2% sequentially and 13.7% year over year. Cisco stated that services were growing in importance, with technical support services and advanced services growing 12% and 19%, respectively from the comparable prior year quarter.

The U.S. & Canada was the largest revenue contributor, with a 53% revenue share in the last quarter. It was followed by Europe with a 21% share, Asia/Pacific 15% and emerging markets 12%.

Revenues were up sequentially across all regions, although the greatest increase was in emerging markets (up 7.0%). Europe, the U.S. & Canada and Asia/Pacific markets grew 5.4%, 4.3% and 1.4%, respectively. They were up 11.5%, 4.4%, 4.1% and 1.4%, respectively from the year-ago quarter.

Product Revenue by Category

Routers were 17% of total revenue, representing sequential and year-over-year increases of 10.5% and 7.8%, respectively. The ASR edge routers (1,000, 5,000 and 9,000) were again a major driver, growing 46%, 353% and 140%, respectively from the year-ago quarter and at an annualized runrate of $1.5 billion.

Overall, high-end routers (around 70% of total routing revenue) grew 12% year over year, mid-range routers were down 2%, while low-end routers dropped 4%.

Switching revenue accounted for a 31% revenue share, growing 6.9% sequentially, but declining 7.9% year over year. Cisco did not provide the revenue split between modular (relatively smaller percentage of total switching revenue) and fixed switching and attributed the significant declines to ongoing product transitions.

However, they did state that orders for fixed switches grew 8%, while orders for modular switches declined 10%. The Nexus 2,000 and 5,000 lines increased 105% and 29%, respectively from the year-ago quarter. Overall, the mix change toward lower-end switching and lower spending by government customers continued to impact results in the last quarter.

New Products generated 30% of revenue, up 1.8% sequentially and 33.9% year over year. Collaboration, wireless and data center products grew very strongly from last year (39%, 32% and 31%, respectively). Security remained sluggish, growing just 2% while video connected home increased 5% .

The Other segment brought in 2% of revenue, up 3.0% sequentially and down 65.5% year over year.


Cisco’s order growth rates slowed again in the last quarter, which resulted in a book-to-bill ratio of around 1. Cisco stated that total orders were up 4% from last year (compared to 8% in the previous quarter), with the U.S. & Canada, Europe, emerging markets and Asia/Pacific growing 2%, 2%, 4% and 14%, respectively. Brazil, Russia, India and China were particularly strong, growing 18%, 14%, 44% and 16%, respectively.

Cisco also highlights orders generated by the targeted segments of enterprise (including public sector), service provider, commercial and consumer. Of these, the consumer segment appears to have fared the worst in the last quarter, declining 49% from last year. Cisco stated that it had taken initiatives to turn the situation around, especially with respect to the set top boxes.

Public sector was the other segment that performed poorly, recording a year-over-year decline of 8%. Cisco stated that the company’s was strongly positioned at all government customers that were however curtailing expenses or diverting to other areas, such as cloud computing.

Cisco believes that the company has not lost ground at any customer yet, although its switching revenue is suffering. Management has decided to revamp the portfolio to better target these customers.

Other areas of the enterprise segment remained strong for Cisco, with total enterprise orders (including public sector) growing 12% year over year. The commercial segment is also turning around, going by the 14% order increase, which was higher than the service provider segment growth rate of 3% and overall Cisco order growth rate of 4%. The U.S. portion of both the enterprise and commercial segments was stronger than in the rest of the world.

Gross Margin

Cisco generated a gross margin of 63.3% in the last quarter, up 159 bps sequentially, but down 124 bps on a year-over-year basis.

The product gross margin of 60.4% was up 142 bps sequentially and down 397 bps year over year. The sequential increase was on account of cost savings. Additionally, higher volumes and a favorable mix related to a weaker consumer business helped the gross margin. The year-over-year decline was driven by market dynamics.

Competition has stiffened over the past few months, increasing pricing pressure and forcing management to offer heavy discounts. Mix was also negative. However, component cost savings and volumes partially offset these negatives.

The services gross margin of 65.0% was up 14 bps sequentially and 263 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 $4.30 billion were flattish compared to the previous quarter’s $4.31 billion. The operating margin was 23.8%, up 346 bps sequentially and down 100 bps year over year.

Nearly half the sequential expansion came from lower cost of sales, although R&D expenses also declined significantly as a percentage of sales. Specifically, R&D was down 104 bps, S&M down 97 bps and G&A up 15 bps. R&D and G&A also declined from the year-ago quarter as a percentage of sales, while cost of sales and S&M increased.

Cisco has decided to reduce headcount, although strategic additions are likely to continue. In the last quarter, the workforce increased by 473, around 40% of which were from acquisitions, while the remaining were strategic additions to its sales force. The workforce increased by 5,200 in the four preceding quarters.

On a pro forma basis, Cisco generated a net income of $2.10 billion, or a 19.3% net income margin compared to $1.77 billion, or 17.0% in the previous quarter and $2.34 billion or 22.6% net income margin in the same quarter last year.

Our pro forma estimate for last quarter excludes restructuring charges, 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 $1.84 billion ($0.33 per share) compared to $1.52 billion ($0.27 per share) in the previous quarter and $2.19 billion ($0.37 per share) in the prior-year quarter.

Balance Sheet

Cisco ended with a cash and investments balance of $43.4 billion, up $3.14 billion during the quarter. The company generated $2.98 billion in operating cash flow, spent $278 million on capex, $172 million on acquisitions net of cash and equivalents acquired and $1.01 billion on share repurchases. Cisco also started to pay a dividend in the last quarter, on which it spent $329 million. The net cash position at quarter-end was $26.6 billion, up from $25.00 billion at the end of the fiscal second quarter. Including short term debt and long term liabilities, the debt-cap ratio was a mere 32.4%.

Inventories dropped 100% to $1.44 billion, with inventory turns increasing from 9.9X to 11.1X. Days sales outstanding (DSOs) were down from 41 to around 37.

Guidance Lowered

In the fourth quarter, Cisco expects revenue to lie within the range of a decline of 0.3% to an increase of 1.7%, representing a year-over-year increase of 0-2%. Previous expectations were for 8-10% year-over-year growth. The operating margin is expected to be 24-25% of revenue, the tax rate 22%, yielding a non-GAAP EPS of 37-39 cents a share, including stock based compensation and excluding restructuring and acquisition-related charges and early retirement-related charges of 14 to 23 cents a share.

Key Takeaways

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 Networks (FFIV) 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 more than 5,500 people over the last few quarters, which will increase opex going forward. We think management’s decision to reduce headcount is commendable (and long overdue), but there will be near-term severance costs that will impact the bottom line. Additionally, we expect strategic hirings to continue.

Cisco has at last admitted to its inefficient decision-making structure and management has stated that it intends to streamline the process. We also welcome this change, but prefer to take a wait-and-see approach to execution.

We think the real challenge facing Cisco right now is the possibility of material share losses, as public sector spending shrinks or shifts away from Cisco technology. Given the company’s existing relationships and technological strength, we expect it to ultimately win the war (at the cost of margins). However, near term revenue will be under pressure.

Cisco shares currently have a Zacks #4 Rank (short-term Sell recommendation).

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