CSCO: Financial Analysis through July 2007

We have analyzed Cisco Systems' (CSCO) preliminary financial results for the fiscal year and quarter that ended on 31 July 2007. Our evaluation will be updated after the company formally submits a complete 10-K report to the SEC.

Cisco, the proud plumber of the Internet, has a commanding position in the market for enterprise-level networking devices. After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use. Cisco shares began the fiscal year at $17.88 and ended July 2007 at $28.91. There was a short dalliance over $30.

When we analyzed Cisco after the April quarter, the Overall score was a fair, but improving, 38 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 24 points. Value was weakest at 2 points. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the July 2007 quarter, our gauges display the following scores:

• Cash Management: 9 of 25
• Growth: 15 of 25
• Profitability: 12 of 25
• Value: 0 of 25
  

• Overall: 27 of 100
  

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.

($M)		July 2007 (actual)	July 2007 (predicted)	July 2006 (actual)
Revenue		9433	9250	7984
Op expenses
	CGS	(3365)	(3284)	(2839)
	R&D	(1178)	(1203)	(1064)
	SG&A	(2404)	(2313)	(1911)
	Other	(183)	(150)	(180)
Operating Income		2303	2301	1990
Other income
	Investments	0	0	0
	Interest, etc.	228	200	156
Pretax income		2531	2501	2146
Income tax		(601)	(625)	(602)
Net Income		1930	1876	1544
		$0.31	$0.30/sh	$0.25/sh

Revenue was 2 percent above the company's estimate, which we used. Revenue was 18.1 percent greater than in the year-earlier quarter, compared to the forecast 15.9 percent. In addition, we expected Cost of Goods Sold (CGS) to be 35.5 percent of Revenue, and the actual value was 35.7 percent. Research and Development (R&D) expenses were 12.5 percent of Revenue, a shade less than our 13 percent estimate. Sales, General, and Administrative (SG&A) expenses were 25.5 percent of Revenue, compared to our forecast of 25 percent.

The higher Revenue was offset by greater other operating costs, resulting in Operating Income almost exactly at the forecast value.

Non-operating income was $28 million more than expected. The Income Tax Rate was 23.75 percent, instead of the predicted 25 percent. As a result, Net Income exceeded our prediction by 2.9 percent.


Cash Management. This gauge decreased from 11 points in April to 9 points now.

The measures that helped the gauge were:

• Current Ratio =2.4; a sign of strength, a little higher than last year's value
• LTD/Equity = 20.4%; manageable and decreasing
• Inventory/CGS = 39.0 days, compared to 39.4 and 50 days 3 and 12 months ago, respectively
  
• Debt/CFO = 0.6 years, compared to 0.7 and 0.8 years 3 and 12 months ago, respectively
• Cash Conversion Cycle Time (CCCT) = 52.9 days, down from 55.3 days, for this measure of efficiency
  

The measures that hurt the gauge were:

• Finished Goods/Inventory = 65 percent, above its 48 percent norm
• Days of Sales Outstanding (DSO) = 38 days, greater than the 35.4-day level one year earlier
• Working Capital/Market Capitalization = 9.7 percent, down from 12.3 percent

Note that the DSO change indicates the company is having less success getting its customers to pay their bills; rapid collection is a sign of efficiency because the payments received can be re-invested sooner.

Growth. This gauge decreased from 24 points in April to 15 points now.

The measures that helped the gauge were:

• Revenue growth = 22.6 percent, up from 14.9 percent in a year
• Net Income growth = 31.4 percent, up from -2.8 percent in a year
• CFO growth = 27.9 percent, up from 4.4 percent in a year

Net income benefited significantly from a change in the income tax rate from 26.9 to 22.5 percent

The measures that hurt the gauge were:

• Revenue/Assets = 65.5 percent, down from 65.8 percent in a year
  

Profitability. This gauge decreased from 14 points in April to 12 points now.

The measures that helped the gauge were:

• ROIC = 20.7 percent, up from 20.3 percent in a year
• FCF/Equity = 28.1 percent, down from 29.8 percent in a year
  

The measures that hurt the gauge were:

• Operating Expenses/Revenue = 73.9 percent, up from 73.7 percent in a year
• Accrual Ratio = -2.8 percent, up from -3.6 percent in a year

The increasing Accrual Ratio tells us that less of the company's Net Income is due to CFO, and, therefore, more is due to changes in non-operational Balance Sheet accruals.

Value. Cisco's stock price rose over the course of the quarter from $26.74 to $28.91. The Value gauge, based on the latter price, dropped to 0 points from 2 points three months ago (and 13 points twelve months ago, when the price was much cheaper).

The measures that helped the gauge were:

• Enterprise Value/Cash Flow = 16.4, up from a 15.6 median value and 12.6 in July 2006
• P/E = 24.7, about the same as its 24.3 median, but up from 19.9 a year ago
  
• P/E to S&P 500 average P/E = 47 percent premium, up from a median premium of 43 percent
  
• Price/Revenue ratio = 5.2, compared to its median of 5.0

The average P/E for the Computer Peripherals industry is also about 24. The average Price/Revenue for the industry is currently 3.8.

By the most popular yardsticks, Cisco had an excellent quarter: Revenue, Cash Flow, and Net Income all increased sharply. But, our gauges aren't impressed. The Overall gauge is a mere 27 points. For one thing, the Growth gauge is the one that generally correlates least with stock price gains. One can argue that the Value gauge overreacted to small increases in each price measure, but it is signaling that the stock price is getting expensive.