The hot news is Cisco's weak assessment of future sales growth. We will address the forecast later and review the current financial situation in this post.
Cisco Systems, the proud plumber of the Internet, has a commanding position in the market for enterprise networking devices. After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use. Cisco shares rallied for the first nine months of 2007, reaching $33, before beginning a steep decline that has carried the shares below $24.
When we analyzed Cisco Systems after the October quarter, the Overall score was an unimpressive 28 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 14 points. Value was weakest at 0 points. We were concerned that the abnormally high Finished Goods/Inventory ratio was signaling that production levels increased faster than sales.
Now, with the available data from the January 2008 quarter, our gauges display the following scores:
- Cash Management: 12 of 25
- Growth: 10 of 25
- Profitability: 12 of 25
- Value: 12 of 25
- Overall: 47 of 100
Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations. We came pretty close, and would have done better if we had given less weight to company guidance.
| ($M) | | Jan 2008 (actual) | Jan 2008 (predicted) | Jan 2007 (actual) |
| Revenue | | 9831 | 9789 | 8439 |
| Op expenses | | | | |
| | CGS | (3491) | (3426) | (3051) |
| | R&D | (1216) | (1224) | (1094) |
| | SG&A | (2604) | (2447) | (2066) |
| | Other | (116) | (100) | (98) |
| Operating Income | | 2404 | 2592 | 2130 |
| Other income | | | | |
| | Investments | 0 | 0 | 0 |
| | Interest, etc. | 234 | 225 | 205 |
| Pretax income | | 2638 | 2817 | 2335 |
| Income tax | | (578) | (676) | (414) |
| Net Income | | 2060 | 2141 | 1921 |
| | | $0.33/sh | $0.34/sh | $0.31/sh |
| |
Revenue in the January 2008 quarter was 16.5 percent greater than in the year-earlier quarter, beating the company's guidance of a 16.0-percent increase. We expected Cost of Goods Sold (CGS) to be 35.0 percent of Revenue, and the actual value was 35.5 percent for a Gross Margin of 64.5 percent. Research and Development (R&D) expenses were 12.4 percent of Revenue, an iota less than our 12.5 percent estimate. Sales, General, and Administrative (SG&A) expenses were 26.5 percent of Revenue, compared to our forecast of 25 percent.
These higher SG&A costs, plus $16 million additional miscellaneous operating costs (primarily amortization of purchased intangible assets), were the principal reasons actual Operating Income fell 7.3 percent below the forecast value.
Non-operating interest and other income was $9 million greater than expected. More significantly, the Income Tax Rate was trimmed to 21.9 percent, instead of the predicted 24 percent. The lower rate helped close the gap, and Net Income fell short of the prediction by only 3.8 percent.
Cash Management. This gauge increased from 10 points in October to 12 points now.
The measures that helped the gauge were:
- Current Ratio =2.7; a sign of strength, up from last year's value of 2.5.
- LTD/Equity = 20.9 percent; manageable and down from 24.1 percent in January 2007
- Debt/CFO = 0.6 years, compared to 0.7 years 12 months ago
- Inventory/CGS = 39.5 days, compared to 39.1 and 47.7 days 3 and 12 months ago, respectively
- Working Capital/Market Capitalization = 12.8 percent, up from 9.8 percent
- Cash Conversion Cycle Time (CCCT) = 50.1 days, down from 53.7 days last year, for this measure of efficiency
The measures that hurt the gauge were:
- Finished Goods/Inventory = 64.7 percent, down from a scary 68 percent last quarter, but up from 48 percent last year. (The five-year median value is also about 48 percent.)
- Days of Sales Outstanding (DSO) = 34.3 days, edging up from 32.7 days after the October quarter and 31.1 days in January 2007
Growth. This gauge decreased from 14 points in October to 10 points now.
The measures that helped the gauge were:
- Net Income growth = 24.7 percent year-over-year, up from 16.0 percent
- Revenue growth = 18.0 percent year-over-year, nothing to sneeze at, but down from 23.1 percent in January 2007
Net income benefited from a drop in the income tax rate from 23.6 to 21 percent.
The measures that hurt the gauge were:
- Revenue/Assets = 68.1 percent, down from 69.0 percent in a year
- CFO growth = 12 percent year-over-year, up from 26.0 percent.
Profitability. This gauge stayed at the 12 points achieved in October.
The measures that helped the gauge were:
- ROIC = 22.4 percent, a nice increase over the 20.9 percent achieved last year
- FCF/Equity = 28.7 percent, impressive but down from 32.5 percent in a year
The measures that hurt the gauge were:
- Operating Expenses/Revenue = 74 percent, essentially unchanged from 73.9 percent a year ago.
- Accrual Ratio = -2.4 percent, up from -4.7 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 Systems' stock price plunged over the course of the quarter from $33.06 to $24.50. The Value gauge, based on the latter price, soared from zero to 12 points.
The following measures all propelled this gauge upward.
- Enterprise Value/Cash Flow = 12.7, down from a five-year median of 15.8
- P/E = 18.8, down from its median value of 24.7; the P/E was 25.9 last year
- P/E to S&P 500 average P/E = 10 percent premium, up from a median value for the premium of 48.5 percent
- Price/Revenue ratio = 4.0, compared to its median of 5.1
The recent fall in technology stocks has brought the average P/E for the Computer Peripherals industry down to about 17.5 and the average Price/Revenue for the industry is currently 2.8.
Cisco Systems had a very good quarter: Revenue grew at the upper end of the company's long-term target, and Net Income in the last four quarter was nearly 25 percent above Net Income in the previous four quarters. However, Cash Flow from Operations rose at less than half that pace over the same period. Cisco is enviably profitable, but it doesn't seem to be cutting Operating Expenses/Revenue as much as hoped. Net Income expectations have been met, at least partially, by a lower Income Tax Rate. The other side of the story is that the stock price has already declined precipitously, and it is indicated to go down further. But, our Value gauge, by increasing 12 points in one quarter, is suggesting that the decline might be too much too fast. We're encouraged by the Overall gauge score of 47 points, which is pretty good. Cisco Systems makes a lot of money; it has minimal debt; and the shares now trade at modest levels.
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