Thursday, August 14, 2014

Cisco's 4Q FY'14: Low Quality Earnings Concerns

Cisco reported a heavily financially engineered 4Q FY'14.  Revenue of $12,357 million was down 0.5% from $12,417 million a year ago. The gross margin rate of 61.8% declined 30 bp from 62.1% in 4Q FY'13. Operating expenses as a percent of revenue decline 10 bp to 33.8% on $4,181 million. Net income of $2,835 million compared to $2,847 million, translating into GAAP diluted EPS of $0.43 versus $0.42 in the prior year period, an increase of 2.4%. Full year GAAP diluted EPS for FY'14 of 1.49 compared to $1.86,  a decline of 20%.

To get to the non-GAAP EPS for the full year, there were $3,998 million in adjustments to GAAP pre-tax income, compared to $2,486 million in adjustments to GAAP pre-tax income in FY'13, an increase of 61%. For the fourth quarter of FY14, non-GAAP diluted EPS of $0.55 compared to $0.52 in the prior year period, an increase of 6%. For the full year FY'14, non-GAAP diluted EPS was a 'record' $2.06 per share compared to an adjusted $2.02 in the prior year, an increase of 2%, and above internal expectations.

The shareholders were returned $2.5 billion in 4Q FY'14, through $1.5 billion in repurchases (average price of $25.11), and $1.0 billion in dividends, comprising 69% of the quarterly CFO of $3.6 billion, above the economically meaningless target of 50%.  For the full year FY'14, CFO amounted to $12.3 billion and $13.3 billion was returned to shareholders, comprised of $9.5 billion in repurchases ($22.71 per share) and $3.8 billion in dividends.  Since inception, the average price per share repurchased was $20.63.

Somehow expectations were met, cash was returned, and the analysts on the call seemed chloroformed.

CEO John Chambers noted orders were up 1%, book-to-bill ratio was up 1%, and the backlog was $5.4 billion.  The company, which knew in 2011 about the coming tsunami of change in the way IT services were bought and deployed, during this call talked about "significant risks" to the business.  It also announced that it was reducing its work force by 6,000, or 8% of the force. Pre-tax charges of FY'15 income will be up to $700 million, or an astonishing average of $117k per headcount reduced. Non-GAAP diluted EPS will benefit over GAAP diluted EPS to the tune of $0.14-$0.18 per share.

If the company is so far ahead of the curve, why is it seemingly reacting reflexively after the fact to the increased pace of change in IT?  Someone asked the question, "Why now?"  I can't remember what was said. because it was meaningless.

Domestic U.S. business was up 5%, with Government business up 6%.  In the U.S. orders larger than $1 million increased by 22%. This was about the only real, meaningful ray of light in what was called a "solid" quarter that decidedly "mixed," at best.

EMEA in the quarter grew by 2%, with the U.K. being the strongest at 8%.  Russian business declined by 35%, and excluding Russia, the EMEA region's sales would have increased by 4%.  Looking at a half-empty glass through 3D glasses makes it seem like two half empty glasses, which is a full one!  The BRICs were assigned a dire outlook for the indefinite future: we'll let you know when we think things are getting better. As off handed as this sounded, all of the Tech Troika (IBM, HP, Cisco) are in the same boat, but it does make Cisco's ability to grow beyond non-GAAP adjustments questionable.

Collaboration declined by 4%, and TelePresence sales also declined, which seems odd since it was one of the subjects of a WSJ article ahead of the earnings report.

The big question investors have about Cisco is the effect of software defined networking (SDN) on gross margins, as hardware components (switches are 30% of revenue) become commodity products.  How will Cisco manage the declines without growing the total revenue base at mid to high single digits?  No answer was forthcoming, but the CEO blew lots of sunshine up the analysts' kilts.

Cisco will be the leader in SDN, said the CEO, without saying by when, by what measure, or how.  There was the announcement of a mind-numbing collaboration with Microsoft, but I couldn't understand what it meant.  The CEO assured investors that SDN will not drive gross margins down for Cisco, again without any elaboration or explanation, simply an assertion. No analyst had the energy to challenge the salesman/cheerleader CEO.

The network will be at the heart of the corporate future, and Cisco will be at the core.  I don't know what this means.  The example of a taxi company was cited, but it wasn't clear if it was Uber, Lyft, or a new competitor.

The CEO referenced three recent acquisitions: Tail-f Systems ( cloud virtualization), ThreatGRID (Internet security), and Assemblage (collaboration on mobile platforms). In reality, nobody knows how well Cisco has done with its huge number of acquisitions over CEO John Chambers' tenure. Amortization of purchased intangibles from acquisitions is a perennial feature of adjustments to GAAP income in Cisco's results.

Cisco's sales force and channel partners make for a complex distribution system, requiring inventory management which is hampered by the terms required to compete for strong channel partners who are also competitors of the company, in some product areas.  I suspect Cisco's sales force needs some rationalization, particularly as the company shifts to more software-oriented sales. Leadership changes were referred to several times on the earnings call by the CEO.

All in all, the numbers were made, but like other tech companies driven largely by financial engineering, including share buybacks.  It's hard to see how this company can be valued outside of a range of $20-$25, given the magnitude and quality of the Q4 FY'14 numbers and the lackluster guidance from the perennially optimistic management. Perhaps there is little downside risk, but there is also no compelling case for owning the stock now either.

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