Guidance Overshadows Cisco's Q3 - Analyst Blog

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Cisco Systems' ( CSCO ) third quarter 2012 earnings (excluding one-time items and including stock based compensation) beat the Zacks Consensus estimate by 5 cents, or 12.7%. Revenue was more or less in line with the consensus.

Revenue

Revenue of $11.59 billion was flat sequentially, up 6.6% year over year and better than management's expectations of a 5-7% year-over-year increase.

Products, which generated 79% of revenue, came in flat sequentially and up 5.0% year over year. Services accounted for the remaining 21%, up 3.0% sequentially and 13.0% year over year.

Cisco is seeing relatively stronger demand in the Asia/Pacific/Japan/China region, revenue from which grew 15.0% sequentially. Revenue from the regaion has grown very strongly over the past year from $1.82 billion to $2.25 billion.

The Americas also increased 6% sequentially and 3.0% from the year-ago quarter. The EMEA region tumbled 7.2% sequentially, after growing 17.5% in the fiscal second quarter, as enterprise customers turned cautious, according to management. However, revenues continued to increase on a year-over-year basis.

Product Revenue by Category

Switching revenue accounted for a 31% revenue share, flat sequentially and increasing 4.7% year over year. Management provided encouraging commentary about the business, stating that the modular business was quite strong in the last quarter and that the Nexus 2000 and 5000 lines saw over 75% growth over the copmparable prior-year quarter. The Nexus product line is largely dependent on the UCS platform (UCS servers jumped 57% from a year ago).

Routers accounted for 19% of total revenue, increasing 3.2% sequentially, while staying flat on a year-over-year basis. The ASR edge routers had another very strong quarter, as a result of UCS deployments and greater adoption of cloud computing. The ASR 9000 routers in particular were up over 90%. The high-end routers had a strong quarter, with the next generation category flattish and optical down on a sequential basis.

New Products generated 27% of revenue, down 2.4% sequentially and up 11.7% year over year. All except the collaboration product line within this category were up from the year-ago quarter, with data center up the strongest (68.2%), followed by wireless (20.4%), service provider video (up 11.6%) and security (9.2%). Security and wireless also grew on a sequential basis.

Orders

Cisco saw a 4% year-over-year increase in orders compared to a 7% increase in the fiscal second quarter, indicating slower end markets. The APJC region saw the strongest growth at 7%, with the Americas growing orders 5% and EMEA coming in flat with the year-ago quarter.

The emerging markets were a mixed bag in the last quarter, with Japan and Russia growing 39% and 22%, respectively. China was down 8%. India too remained weak, with continued issues in the public sector.

Russia was the lone bright spot in Cisco's EMEA business, with problems in Southern Europe exanding and Central and Northern Europe also remaining weak.

The weakness was most pronounced in the enterprise segment, which saw orders declining 1% from last year. Other segment, such as public sector, service provider and commercial were up 3%, 5% and 8%, respectively.

Gross Margin

Cisco generated a gross margin of 62.8% in the last quarter, up 83 sequentially but down 56 bps on a year-over-year basis. The gross margin benefited from mix and higher-ASP new products. 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 60.9% was up 90 bps sequentially and 52 bps year over year. Competition remains stiff, increasing pricing pressure and forcing management to offer heavy discounts. However, cost savings helped to offset the impact.

The services gross margin of 65.5% was down 78 bps sequentially , while increasing 56 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 $4.29 billion were 1.5% higher than the previous quarter's $4.22 billion. The operating margin was 25.8%, up 46 bps sequentially and 197 bps year over year. The sequential increases of 10 bps and 48 bps in R&D and G&A expenses, respectively were offset by the 83 bp and 21 bp declines in cost of sales and S&M, respectively.

Compared to the year-ago quarter, R&D and S&M expenses declined 144 bps and 195 bps, respectively, while cost of sales and G&A increased 56 bps 85 bps, respectively.

On a pro forma basis, Cisco generated a net income of $2.52 billion, or a 21.8% net income margin compared to $2.31 billion, or 20.0% in the previous quarter and $2.10 billion or 19.3% 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 $2.34 billion ($0.43 per share) compared to $2.18 billion ($0.40 per share) in the previous quarter and $1.84 billion ($0.33 per share) in the prior-year quarter.

Balance Sheet

Cisco ended with a cash and investments balance of $48.4 billion, up $1.67 billion during the quarter. The company generated $2.97 billion in operating cash flow, spent $281 million on capex, $224 million on acquisitions net of cash and equivalents acquired, $513 million on share repurchases and $432 million on dividends.

The net cash position at quarter-end was $32.04 billion, down from $29.84 billion at the end of the fiscal second quarter. Including short term debt and long term liabilities, the debt-cap ratio was a mere 30.7%.

Inventories dropped 5.8% to $1.50 billion, with inventory turns increasing from 11.0X to 11.5X. Days sales outstanding (DSOs) were flat at around 31.

Guidance

In the fourth quarter, Cisco expects revenue to be down 1.5% to up 1.4% on a sequential basis, or increase 2-5% 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 44 to 46 cents.

The GAAP EPS is expected to be 7-11 cents lower than the non-GAAP EPS. The Zacks Consensus estimate (including stock-based compensation) was 43 cents when the company reported, below the guided range.

Our Take

Cisco beat expectations on both the top and bottom lines, but both the guidance and management commentary was indicative of a slowing down in its business, at least in the current quarter. Most disappointing was the order performance, which given Cisco's relatively short lead times is indicative of a weak fourth quarter.

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 margin expansion in the last quarter.

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 keen on sacrificing margins for market share gains.

While this is unlikely to dislodge Cisco, which has already introduced more competitive switching products and has been increasing headcount in emerging countries, there is likely to be a continued negative impact on margins stemming from discounts and price cuts.  

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. Any weakness in the next quarter is more or less priced into the shares, given their 12.6% decline in after-market trade yesterday.

Cisco shares therefore carry a Zacks Rank of #3, which translates to a Hold rating in the near term (1-3 months). We are also Neutral on a long term basis.


 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Stocks

Referenced Stocks: CSCO , HPQ

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