Wednesday, November 13, 2013

Cisco: The Fourth Horseman Reports First Quarter 2014

In Cisco's current 10-K, we note that for the period 7/2008-7/2013, an indexed investment returned an average annual return of 7.4%, trailing both the Standard and Poors Technology Index (up 18% p.a.) and the Standard and Poors Index (up 16.5%) by a wide margin.

Despite the under performance, Cisco's balance sheet is impressive.  For the fiscal year ended 7-2013, free cash flow was $11.7 billion, for the fiscal year ended 7-2012 FCF was $10.4 billion, and for the fiscal year ended 7-2011 FCF was $8.9 billion.

Despite its long history of acquisitions, which have become fewer in number and larger, Cisco has a tangible book value of about $6.24 even after stripping out goodwill and intangible assets.  The company recently closed on the $2.7 billion acquisition of Sourcefire, a leading innovator in the cyber security field.  In one of their slide presentations about the acquisition, Cisco talks about the importance of compatible corporate cultures when considering a target.  This acquisition is very consistent with CEO John Chambers' remarks on the FY14 1Qtr conference call where he said the number one concern of Cisco's top 95 global IT CIOs was IT security.

While acknowledging the maturity and scale of the current Cisco, the company returned $3.3 billion in dividends to shareholders in the fiscal year ended 7-2013, more than double the $1.5 billion returned to shareholders through dividends in the fiscal year ended 7-2012.

So, a company with a fortress balance sheet and high returns has dramatically under performed its peers and the broad market. Let's look at the recently announced FY 14: 1Q.

Revenue of $12.1 billion increased 2% yr/yr.  $9.4 billion revenue came from selling products, and $2.7 billion came from services.  Subsequent line items are non-GAAP numbers. Cisco's consolidated gross margin is an extraordinary 63%, and that rate increased by 30 basis points over the prior-year period.  Product gross margin was 62% and increased 50 basis points, while services generated a 67% gross margin, which also increased 30 basis points over the prior-year period.

Operating expenses were 33.7% of revenue, down 110 basis points yr/yr reflecting the significant worldwide reduction-in-force throughout the enterprise.  Operating income was an extraordinary 29.3% of revenue, up 140 basis points over the prior-year period.  Net income of $2.9 billion reflected a margin of 23.7% and income grew 12% yr/yr on a non-GAAP basis.  Diluted EPS of $0.53 increased 10% yr/yr.

During the quarter, the company repurchased 84 million common shares at an average price of $23.65 and returned $2 billion to shareholders.  The company also paid dividends of $914 million.

As of the fiscal year ending 7-2013, the company had 75,049 employees.  26,416 worked in research and development. 25,938 employees worked in sales and marketing, a number which clearly reflects the importance of consultative selling in the corporate culture. 7,546 employees worldwide were in administrative positions.  Research and development expenditures were about $6 billion in the last full fiscal year.

Analyst questions and concerns after the management presentations centered on the forward guidance for the next quarter.  One analyst said that he was "floored by the guidance."  Management suggested that revenues for the current quarter might be down as much as 11% sequentially.  While this seemed like a discontinuous change, the explanations were fairly clear.

The first quarter ended with a shortfall in bookings versus sales forecasts in the last two or three weeks of the quarter, and the backlog going into the second quarter was correspondingly low. Combined, these two factors comprise somewhat more than a $1 billion shortfall in the current quarter.

Their core set top box market will decline by about 4-5% in the next two quarters, as a technology transition continues to take place.  Emerging markets, including China, are and will continue to be very challenging. Each of Cisco's top ten emerging market countries missed their sales forecasts for the first quarter. The top five markets had yr/yr sales declines of 18-30%.

The CEO noted that Cisco had relied too much on core switching and routing product sales for many years, without being ahead of technical and engineering developments that would require new platforms for the high end customers.  He said that it took 4-5 years to fix this oversight, and it is done or their two core product segments.  Routing and switching are in the midst of major product line transitions.

The worry is that consolidated gross margins will decline, and they most likely will.  On a GAAP basis, consolidated gross margins have declined about 800 basis points from 2008-2013,  the period of the stock price under performance.

In the meantime, the company's work force has been right sized to work with significant margin pressure, if it comes. The substantial dividend increase and the commitment to share buybacks would suggest a company that should generate substantial free cash flows.  In fact, the company just announced an additional share repurchase authority of $15 billion.

Cisco's goal is to become the number one provider to its top global corporate customers.  It has the sales organization and culture and the balance sheet to make this happen.  Their acquisitions and new product platform launches seem to be in the right direction for their customers.  Their guidance for long-term revenue growth is 5-7%, which is above the "GDP rates" suggested by HP.  If this happens alongside some operating leverage, then the stock would appear to be undervalued, given its capability of producing prodigious cash flows.  

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