Cisco Systems’ (CSCO) fourth quarter 2012 earnings (excluding one-time items and including stock based compensation) beat the Zacks Consensus estimate by 3 cents, or 7.8%. Revenue was more or less in line with the consensus.
Revenue
Revenue of $11.69 billion grew less than 1% sequentially, but was up 4.4% year over year and better than management’s expectations of roughly flat sequentially (or +/-1.5%).
Products, which generated 78% of revenue, came in flat sequentially and were up 2.6% year over year. Services accounted for the remaining 22%, up 2.3% sequentially and 11.7% year over year.
Revenue declined sequentially and grew year-over-year across all geographies. The Americas region (57% of total revenue) was generally steady with EMEA (27%) seeing some significant changes, followed by Asia (remaining 16%), which saw the greatest sequential decline and year-over-year increase.
The three regions declined 2.9%, 4.8% and 19.4%, respectively from the previous quarter and were up 1.7%, 5.7% and 10.9%, respectively from last year. The weakness in Southern and Central Europe impacted Cisco in the same way that it has impacted other companies with significant exposure to Europe.
Product Revenue by Category
Switching revenue accounted for a 31% revenue share, down 1.1% sequentially and flat year over year. This was a mixed quarter for Cisco, with the 3% year-over-year increase in fixed switching more than offset by the 7% decline in modular switching.
Management commentary indicates that the trend remains positive, with customers largely shifting fixed switching requirements to the new Nexus 2000 and 5000 product lines. These products grew 24% from last year (much weaker than in the last quarter), driven primarily by data center build-outs. The modular side is also moving to Nexus 7000 as planned (the product line grew 13% in the last quarter).
Routers accounted for 18% of total revenue, down 2.1% sequentially and up 3.9% on a year-over-year basis. The growth from last year is encouraging, although sequential declines indicate that the broad-based weakness in the market is also impacting Cisco.
If the market doesn’t turn around quickly, it could be hard to sustain this growth. Cisco’s growth in the last quarter is attributable to market share gains, which management says came from both the core and edge. The ASR routers had another very strong quarter, with ASR 5000 up 67% and ASR 9000 up 97%.
New Products generated 28% of revenue, up 4.7% sequentially and 6.9% year over year. The wireless and data center segments of this business were extremely strong in the last quarter. The 16.2% sequential and 22.0% year-over-year growth in the wireless business was the combined effect of successful new products (AP3600 for instance) and Cisco’s bundling startegy.
The data center business grew 42.6% sequentially and 89.5% from last year. Here too, there were multiple drivers, the first being Cisco’s UCS system, which saw orders growing 58% and the second being the transition to Intel’s (INTC) Romley, which also spurred demand for additional networking equipment.
Security also did well, though not as well as the first two, mainly because the 15% increase in Cisco’s networking security revenues were partially offset by a 10% decline in content security (compared to last year). Collaboration and service provider video were the weak links, declining 1.5% and 4.0%, respectively from the previous quarter and 7.8% and 2.0%, respectively from last year.
Orders
Cisco saw a 2% year-over-year increase in orders compared to a 4% increase in the fiscal third quarter, similar to the trend in the last quarter and indicating slower end markets. The APJC region saw the strongest growth at 12%, with the Americas growing orders 4% and EMEA declining 6% from the year-ago quarter (consistent with broad market trends).
Australia was the strongest market in the APJC region (up 30% from last year). China (up 17%) and Japan (up 12%) also remained good growth markets. India on the other hand, remains sluggish.
Russia and other emerging markets in the EMEA region were both up 12%, but this was offset by declines in other parts of Europe (Italy 24%, U.K. 13%, France 12% and Germany 4%). The enterprise segment in Europe managed to fight the odds (growing 2%), offset by declines of 15% and 13% in service provider and public sector segments. Commercial on the other hand was consistent with the year-ago level.
Within the U.S., the story appears very different. Not only did the state and local government business grow for yet another quarter, but growth rates accelerated from 7% in the third quarter to 17% in the fourth. At the federal level however, the business decline went from 8% to 11%. The 29 largest enterprise accounts grew double-digits in the last quarter, following a double-digit decline in the third, taking the overall growth in enterprise from 1% to 4%. Growth in commercial went from 6% to 7%.
Gross Margin
Cisco generated a gross margin of 61.4% in the last quarter, down 134 bps sequentially and 76 bps on a year-over-year basis. Pricing and mix were the main negatives for the quarter, although higher warranty expense also pushed up the total manufacturing cost. Management has been strengthening its portfolio and improving margins within each product category, which has enabled it to generate the strong margins.
The product gross margin of 59.2% was down 163 bps sequentially and 64 bps year over year. The services gross margin of 65.5% was flat sequentially, while declining 129 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 $4.34 billion were 1.1% higher than the previous quarter’s $4.29 billion. The operating margin was 24.3%, down 141 bps sequentially and up 260 bps year over year. All except G&A expenses increased sequentially as a percentage of sales. The 76 bp year-over-year increase in cost of sales was offset by declines of 114 bps, 183 bps and 39 bps in R&D, S&M and G&A, respectively.
On a pro forma basis, Cisco generated a net income of $2.31 billion, or a 19.7% net income margin compared to $2.52 billion, or 21.8% in the previous quarter and $1.92 billion or 17.2% net income margin in the same quarter last year.
Our pro forma estimate for the 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 $1.92 billion ($0.36 per share) compared to $2.34 billion ($0.43 per share) in the previous quarter and $1.23 billion ($0.22 per share) in the comparable prior-year quarter.
Balance Sheet
Cisco ended with a cash and investments balance of $48.7 billion, up $304 million during the quarter. The company generated $3.08 billion in operating cash flow, spent $296 million on capex, $42 million on acquisitions net of cash and equivalents acquired, $1.89 billion on share repurchases and $425 million on dividends.
The net cash position at quarter-end was $32.39 billion, relatively flat with the $32.04 billion at the end of the fiscal third quarter. Including short term debt and long term liabilities, the debt-cap ratio was a mere 30.7%.
Inventories grew 11.1% to $1.66 billion, with inventory turns dropping from 11.5X to 10.8X. Days sales outstanding (DSOs) went up from 31 to 34.
Guidance
In the first quarter of fiscal 2013, Cisco expects revenue to be flat to be down 1.8% on a sequential basis, or increase 2-4% on a year-over-year basis. The non-GAAP gross margin is expected to be 61-62%, non-GAAP operating margin to be 26.5-27.5% of revenue, a non-GAAP tax rate of 22%, yielding a non-GAAP EPS of 45 to 47 cents. The Zacks Consensus estimate (includes stock-based compensation) was 46 cents when the company reported, within the guided range.
The NDS acquisition is expected to have a 50 bp negative impact on the operating margin but not affect the guidance in any other way.
Acquisitions are expected to make a $1-1.1 billion contribution to total revenue and a 3 cent contribution to the EPS for fiscal year 2013.
Our Take
Cisco missed estimates for the fourth quarter, but the guidance was in line with expectations. The slowing down in its business is not surprising and in line with global trends. Despite its size and maturity, Cisco continues to grow in an environment that is conducive to smaller and more nimble players.
It is apparent that Cisco’s strategy of pursuing opportunities in international markets and focus on new products and markets is paying off. Cisco is already the best entrenched company across the world and despite growing competition from several smaller players, the company appears to be holding its own.
Additionally, the focus on new products resulted in continued market share gains and margin expansion in the last quarter. Order growth in the last quarter was very encouraging and the trend is reflective of Cisco’s superior strategy and innovative prowess.
Of course, competitors like Hewlett Packard Company (HPQ) and Chinese company Huawei have manufacturing operations in low-cost countries, which make them more competitive. They are also interested in sacrificing margins for market share gains. We doubt that this would be enough to dislodge Cisco, which has already introduced more competitive switching products and has been increasing headcount in emerging countries.
All things considered, we think that Cisco is a very strong company with significant market share and customer clout that would generate solid results as the economy continues to improve.
Cisco shares therefore carry a Zacks Rank of #2, which translates to a Buy rating in the near term (1-3 months). We remain Neutral on a long term (3-6 month) basis.
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