Cisco Systems’ (CSCO) second quarter 2010 earnings beat the Zacks Consensus by 10 cents. Revenue beat by 4.6%.
Estimate revisions have been minimal over the last two months. Of the 35 analysts covering the stock, just two have made upward revisions and one a downward revision. Consequently, the Zacks Consensus estimate has remained steady at $30, a $0.01 increase over the year-ago quarter.
However, the surprise history is a positive 11.11%, indicating that the shares have beaten the Zacks Consensus estimate by an average 11.11% in the four preceding quarters. The $0.30 estimate for the December quarter represents a 3.33% upside potential. However, reported earnings were significantly higher. Consequently, we expect buoyant prices when the market opens.
Total Revenue and Orders
Revenue of $9.82 billion was up 8.8% sequentially and 8.0% year over year. Revenue exceeded the high-end of management’s guidance range of a 2-5% sequential increase.
Products generated 81% of revenue, increasing 10.8% sequentially and 8.6% year over year. Services accounted for the remaining 19%, increasing 1.0% sequentially and 5.6% year over year.
Revenue was flat to up double-digits across all geographies. Around 54% of total revenue was generated in the U.S. & Canada (up 6.3% sequentially), 21% came from Europe (up 13.5%), Emerging markets 11% (up 27.4%), Asia Pacific 11% (up 11.6%) and Japan 4% (down 3.6%). All geographies increased on a year-over-year basis.
Orders strengthened across all geographies from a year-over-year perspective, with the U.S. growing 17%, Asia/Pacific and Japan also growing double-digits, Europe low single-digits and emerging markets approximately flat.
The strengthening of revenues indicates resumed spending on networking products, while the strengthening of order rates indicates that growth will be sustained. The increases in the U.S. and Canada region are particularly encouraging, since they are a clear indication of a turnaround in the economy.
Product Revenue by Category
Routers were 16% of total revenue, representing a sequential increase of 1.7% and a year-over-year increase of 5.1%. The company sells high, mid and low-end routng products, although high-end typically makes up around two-thirds of total sales. High-end routing (including the acquisition impact) grew 12% sequentially, while mid- and low-end routing declined by low-teen percentage rates. New products are being well accepted by customers andare expected to drive strong sales growth going forward.
Switches were 35% of revenue, up 18.4% sequentially and 12.6% year over year, with both modular and fixed switches contributing picking up momentum in the last quarter.
Advanced Technologies generated 24% of revenue, up 5.6% sequentially and flat (up 0.5%) year over year. Unified communications and wireless segments of the market strengthened in the last quarter, partially offset by declines in other product categories. However, the rate of decline was lower than in the first quarter.
The Other segment brought in 6% of revenue, increasing 25.6% sequentially and 44.8% year over year. The positive impact of the Pure Digital acquisition was around $80 million in the last quarter, with the rest of the growth attributable to strength in core product categories (particularly Nexus and UCS).
Gross Margin
The company generated a gross margin of 65.6% in the last quarter, which was a sequential decrease of 62 bps and a year-over-year increase of 161 bps.
The product gross margin was 64.7%, down 77 bps sequentially and up 196 bps year over year. The sequential decline was mainly due to an unfavorable mix of products, as well as higher discounts, partially offset by higher volumes and certain related cost savings. The services gross margin of 63.7% declined 79 bps sequentially and 22 bps year over year. The sequential decline was on account of higher costs and a higher mix of advanced services, partially offset by higher volumes.
There were significant gross margin declines in both the U.S. and Canada and Europe, as the company offered higher discounts and also had a negative mix of business. Margins were relatively more stable in Japan and the Asia/Pacific.
Operating Performance
The operating expenses of $3.43 billion were higher than the previous quarter’s $3.38 billion. The operating margin was 30.7%, up 191 bps sequentially and 542 bps year over year. The operating margin improvement was largely on account of lower S&M expenses (as a percentage of sales), although R&D was also down significantly and G&A down slightly. The only offsetting factor was the increase in COGS (as a percentage of sales).
On a pro forma basis, CSCO generated a net income of $2.34 billion, or a 23.8% net income margin compared to a $2.11 billion, or 23.5% in the previous quarter and $1.87 billion or 20.5% net income margin in the same quarter last year. Our pro forma estimate excludes intangibles amortization charges, acquisition-related charges and stock-based compensation charges on a tax-adjusted basis 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 recorded a net income of $1.85 billion ($0.32 per share) compared to $1.79 billion ($0.30 per share) in the previous quarter and $1.50 billion ($0.26 per share) in the prior-year quarter.
Balance Sheet
Cisco ended with cash and investments balance of $39.64 billion, an increase of $4.27 billion from the end of the previous quarter. In the second quarter, the company generated $2.49 billion in cash from operations and spent $248 million on capex, $2.31 billion on acquisitions and $1.38 billion on share repurchases. It also raised $4.94 billion of fresh debt, taking the total debt position to $15.19 billion, or a net cash position of $24.44 billion. Including long term liabilities, the debt-cap ratio was a mere 33.0%.
Inventories increased 11.6% to $1.22 billion, with inventory turns down slightly from 11.2X to 11.1X. Days sales outstanding (DSOs) were up from 32 to around 39.
Guidance
In the third quarter, management expects revenue growth of 2-5% on a sequential basis and 23-26% on a year-over-year basis. The company will include an extra week of operation in the fiscal third quarter and approximately 2-3% of the sequential increase will be on account of the extra week.
The gross margin including the extra week is expected to be 64-65%, operating expenses 36.5-37% of revenue, interest and other income of approximately -$10-20 million and a tax rate of 22%. The ScanSafe acquisition is expected to be slightly dilutive (less than $0.01 a quarter). The GAAP EPS, including stock-based compensation and acquisition-related expenses are expected to be around $0.06 to $0.08.
Management expects the company to generate operating cash flow of $2-2.5 billion.
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