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The Alpha Male of Tech Stocks Reports Earnings - Thoughts on Cisco

Posted on | November 6, 2008 Time: 7:11 am |

Cisco has long been one of the best barometers for corporate spending levels, small business growth, bandwidth growth, and the technology sector as a whole. They also have about a 50/50 split between domestic and international revenues, so their quarterly reports and guidance also ping the international markets quite well.

Boilerplate Numbers

The headline figures for the 1st quarter of Cisco’s FY2009 were $10.3 billion revenue (in-line with estimates) and $.42 (vs. $.39 est) of net income, or $2.2 billion. Not bad overall, with total revenues up 8% year-over-year. Within that figure, however, is quite the disparity between the U.S./Eurozone and the rest of the world. Revenue growth was just 1% for the domestic markets and 16% for the ROW in the quarter ending October 24th.

As to the major operating segments, switch revenue (representing about 35% of sales) was up 8%, while routers (18% of sales) were essentially flat. Stronger performances were turned in from services (10% revenue growth) and the Advanced Technology segment, which includes the products related to the convergence theme of video, voice, and teleconference. The latter segment notched 17% growth YoY with particular strength in video systems and security, and now contributes a full 25% to Cisco’s top line.

Guidance a Big After-Hours Drag

Shareholders were spooked by John Chambers’ comments in the after-hours session, as CSCO shares fell 6%. He noted that global markets experienced increasing weakness as the financial crisis spreads outward from the U.S. and Europe.

The number that really got folks’ attention was the 9% decrease in orders for October. The total revenue estimate for Q2 now calls for sales to drop 5-10%, whereas the prior estimate was for modest growth YoY. Based on 2007’s 2nd quarter revenue of $9.554 billion, we can now expect revenue to come in between $8.6 and $9.01 billion.

As to the effect on margins, right now Cisco is calling for gross margins of 64%; They reported 65.6% gross margins in the latest quarter, an improvement of 70 basis sequentially and 40 bp year-over-year.

Can We Model Trough Earnings Soon?

Let’s consider an important question - shouldn’t a slowdown of this magnitude be incorporated into the stock at these levels? Shares are down over 35% YTD while EPS is up over each of the past four quarters. For argument’s sake, let’s assume a scenario where sales weaken 15% in 2009 and gross margins fall to 60% (both below current projections).

This would produce gross profits of just over $20 billion, a level the company was achieving in on a run-rate basis in late 2006/early 2007; in this period the company had a rolling EPS of $1.10. If Cisco could duplicate the same operational performance, we can begin to model P/Es in the range of 16-17x on what could easily become trough-level earnings.

2009 Estimates all Written in Pencil

Myself and many others have noted that top-down estimates from S&P strategists are 20-25% lower than the aggregate of sell-side estimates for individual companies. Cisco’s revenue warning of 10% lower than 2007 should be expected; did we really think that Cisco would be able to grow revenues in a quarter that includes the month of October, when markets were frozen, and business literally stopped in many of the fundamental “gear centers” of the market. What company manager is going to pull the trigger on a $2 million hardware upgrade when they’re not sure if their credit lines are going to be open the next morning? That’s how bad it was in the first two weeks of October, and in that brief period I wouldn’t be surprised if the dropoff had been 30% or more.

A 10% drop in a month that includes October doesn’t seem outside the ranges that markets have “agreed” upon, or at least acknowledged.

Competitors Should See it Worse

Considering the quality and market leadership of a company like Cisco, I feel bad for investors in other parts of the networking space. The numbers from Cisco’s competitors are likely to be worse, and if they want to pick up share during this period it will come at a huge cost to margins.

I can’t see a lot of upside surprise coming in the next few months, except for maybe the Telepresence hardware, which Cisco’s sales crew may be able to package as a great way to cut costs from executive budgets. And a weak day Thursday for the tech sector seems unavoidable. There will be at least a dozen major downgrades and earnings cuts coming out before the end of the week; expect to see names like Juniper, Brocade, 3Com, Oracle, EMC, along with any of the downstream suppliers to the group.

But Cisco could do many things in the next six months to increase its long-term value to shareholders. Acquisitions could be aplenty, as Chambers noted that many small companies are choosing to remain private rather than go the IPO route. This trend along with lower valuations across the board could turn Cisco’s $26 billion cash war chest into an EPS accretion weapon.

disclosure: author does not hold a position in CSCO

More on this topic (What's this?)
Cisco’s Surprise: the CRS-3 (Telecom Ramblings, 3/9/10)
Cisco Systems, Inc. (CSCO) New Router and Markets (Short-Term Trading, 3/10/10)
Closed CSCO Position (My Trader's Journal, 3/8/10)
Read more on Cisco Systems at Wikinvest
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