Cisco Systems (CSCO) first quarter 2011 earnings (excluding one-time items and including stock based compensation) that beat the Zacks Consensus estimate by 7 cents, or 20.6%. Revenue exceeded the consensus by 2.1%.
CSCO shares dropped 3.82% during the day, in line with the NASDAQ, which dropped 3.88%. However, shares jumped 2.61% after the company reported earnings, making up for most of the loss.
Revenue
Revenue of $11.26 billion was up 0.5% sequentially and 4.7% year over year, better than management’s expectations of a 0-4% year-over-year increase.
Products, which generated 80% of revenue, grew 0.3% sequentially and 2.9% year over year. Services accounted for the remaining 20%, up 1.3% sequentially and 12.4% year over year. Services are growing in importance at Cisco, driven by both technical support services and advanced services.
The Americas generated 59% of Cisco’s quarterly revenue, despite a 1.7% sequential decline. The other major geographical segments, EMEA (26% revenue share) and APJC (15% revenue share) were down 5.4% and 9.8%, respectively. Given the change in classification, we are unable to compare performance versus the year-ago quarter.
Product Revenue by Category
Next Generation Networking (NGN) routers (as routing revenue is now being classified) were 19% of total revenue, up 4.5% sequantially and down 3.2% from the year-ago quarter. Cisco stated that good customer support and a full solutions approach toward cusomers helped results in the last quarter.
Overall, Cisco stated that revenue from high-end routers (around 70% of total routing revenue) was up 4% year over year, while the mid-range and low-end categories declined 16%. High-end orders were up 11%, compared to a 4% increase for mid and low-range routers.
The trend looks positive, as it may be expected to boost the company’s margins over time. However, the improved functionality of low-end routers of today is resulting in share losses for Cisco.
Switching revenue accounted for a 32% revenue share, growing 1.5% sequentially, but declining 0.4% (essentially flat) year over year. The Nexus product line continued to do very well, with revenue and orders for Nexus 2000 and Nexus 5000 growing 80% and 120%, respectively. Cisco stated that its switching markets were stabilizing, which was reflected in the revenue (flat year over year) and orders (up 10% year over year) for the quarter.
New Products generated 26% of revenue, down 3.1% sequentially and up 16.3% year over year. All segments (collaboration, service provider video, wireless, security and data center) grew from the year-ago quarter. However, growth in the data center was the strongest at 107%, helped by the Nexus switching family (included in switching revenue).
UCS alone was up 116% in terms of revenue and 122% in terms of orders, helped by the need for convergence of servers, processing capabilities, networking and storage into the cloud. Collaboration, service provider video, wireless and security revenues were up12%, 13%, 8% and 10%, respectively.
The Other Products segment brought in 2% of revenue, down 7.6% sequentially and 22.4% year over year.
Orders
Cisco’s order growth rates were strong in the last quarter, which resulted in a book-to-bill ratio of around 1. Cisco stated that total orders were up 13% from last year (compared to 11% in the previous quarter), with the Americas, EMEA and Asia/Pacific, Japan & China (APJC) growing 12%, 13% and 13%, respectively. Japan, Mexico, Brazil, China and Russia were particularly strong, growing 43%, 29%, 28%, 27% and 11%, respectively. India was the only market that disappointed, declining 24% from the year-ago quarter.
Cisco also highlights orders generated by the targeted segments of the enterprise (including public sector), service provider, commercial and consumer markets. Management mentioned that the first three segments were up 11%, 16% and 12%, respectively, but did not add color on the consumer segment. Of note, consumer was down 41% year-over-year in the July quarter. Cisco has taken initiatives to turn the situation around and management is optimistic about stronger performance in the future.
The Public sector, which was relatively weak in the July quarter, recorded a year-over-year increase of 10%. Cisco stated that the growth was driven by federal defense, state government and higher education segments, while federal civilian and local government declined. Cisco remains strongly positioned at all government customers and management has decided to revamp the portfolio to better target these customers.
Gross Margin
Cisco generated a gross margin of 61.9% in the last quarter, down 24 bps sequentially and 184 bps year over year.
The product gross margin of 60.2% was up 32 bps sequentially and down 246 bps year over year. The positives for the gross margin were cost savings and higher volumes that were largely offset by discounts and rebates, as Cisco fought aggressively to keep competition at bay. Management stated that the price competition was likely to continue, especially with Huawei in China. However, Cisco intended to build its position through aggressive discounts and combinations with local Chinese players, both of which are likely to have a negative impact on its earnings.
The services gross margin of 65.1% was down 165 bps sequentially and up 154 bps year over year. The sequential variation in services gross margins is generally 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 $4.17 billion went up from the previous quarter’s $4.53 billion. The operating margin was 24.9%, up 317 bps sequentially and 62 bps year over year.
Both the sequential and year-over-year comparisons were impacted by gross margin weakness. However, while the decline from the year-ago quarter was entirely on account of the gross margin decline, the sequential comparison was also impacted by increases in all other expenses. Specifically, R&D, S&M and G&A were up 42 bps, 81 bps and 68 bps, respectively, on a sequential basis.
Cisco has decided to reduce headcount, although strategic additions are likely to continue. Headcount reduction in the last quarter was 8,400, which is a significant number and primarily on account of the sale of the Juarez, Mexico manufacturing facility. Restructuring actions played a smaller role. Management is targeting a workforce reduction of 6,500 in 2012 that would lower expenses by around $1 billion.
On a pro forma basis, Cisco generated net income of $2.22 billion, or a 21.1% net income margin compared to $ 1.92 billion, or 17.2% in the previous quarter and $2.12 billion or 19.7% 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 $1.78 billion ($0.33 per share) compared to $1.23 billion ($0.22 per share) in the previous quarter and $1.93 billion ($0.34 per share) in the prior-year quarter.
Balance Sheet
Cisco ended with a cash and investments balance of $44.4 billion, down $197 million during the quarter. The company generated $2.33 billion in operating cash flow, spent $265 million on capex, $38 million on acquisitions, $1.88 billion on share repurchases and $322 million on dividends.
The net cash position at quarter-end was $27.54 billion, down slightly from $27.76 billion at the end of the fourth quarter of fiscal 2011. Including short term debt and long-term liabilities, the debt-cap ratio was a mere 32.6%.
Inventories grew 9.2% to $1.62 billion, with inventory turns dropping from 11.4X to 10.6X. Days sales outstanding (DSOs) were down from 38 to around 35.
Second Quarter Guidance
In the first quarter, Cisco expects revenue to increase 7-8%. The gross margin is expected to be 61.5% to 62%, operating margin 26-27% of revenue and the tax rate 22%, yielding a non-GAAP EPS of 42-44 cents a share. The non GAAP net income thus arrived at excludes stock based compensation (5-6 cents) amortization of acquisition-related intangibles and other charges (2-3 cents), and restructuring charges (1-2 cents).
Key Takeaways
Cisco’s first quarter results continue the trend of positive surprises that investors have come to expect of the company. However, the 20.6% positive surprise is well over the average positive surprise of 8.51% in the preceding four quarters.
The catalysts we see now are with respect to its revamped switching portfolio, as well as momentum in new businesses, especially in the data center. We think that management’s decision to pursue a customer-centric, platform approach is the way to go and believe that this will enable Cisco to boost revenue across multiple product lines.
The core business is not without hurdles however. A lot of the growth in the next few years is likely to come from emerging geographies, such as China, Brazil, India and so forth. Cisco is seeing pretty tough competition in the Chinese market from local player Huawei. Management has admitted that competition from Huawei will continue to increase (and not just in China) over the next few years. Cisco’s strategy is to partner with other Chinese players to push its products. While this could help the top line, we see a good bit of Cisco’s historically high margins getting wiped away.
However, Cisco is the networking behemoth, with the customer position and financial muscle that may be expected of a company that has for long dominated the market. Therefore, there is every possibility that despite price cuts and share losses to companies like Juniper Networks (JNPR), Hewlett Packard Company (HPQ) through its 3Com acquisition and F5 Networks (FFIV), Cisco’s continued innovations will ensure growth.
Additionally, management’s initiatives to lower the cost structure by reducing headcount are encouraging. These initiatives are expected to take out a billion dollars of expenses in fiscal 2012, which will help stem margin shrinkage resulting from slower revenues due to product transitions and spending levels in the market.
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 shares currently have a Zacks #3 Rank (short-term Neutral recommendation).
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