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Cisco Systems (CSCO - Analyst Report) reported first quarter 2013 earnings of 44 cents (excluding one-time items and including stock based compensation), which beat the Zacks Consensus Estimate by 3 cents, or 7.3%. Revenue was more or less in line with the consensus.

Revenue

Revenue increased 5.5% year over year to $11.69 billion and was better than management’s expectations (up 2-4%). Products (78.3% of total revenue) were up 3.9% year over year to $9.30 billion. Services (21.7% of total revenue) jumped 11.9% year over year to $2.58 billion.

Revenue grew year-over-year across most of the geographies. The Americas region (59.1% of total revenue) increased 6.6% year over year, while Asia-Pacific, Japan and China collectively known as APJC (16.9% of total revenue) surged 10.4% from the year-ago quarter. Europe, Middle East and Africa (EMEA) remained flat on a year over year basis during the quarter.

Product Revenue by Category

Switching (30.4% of total revenue), NGN Routing (17.3% of total revenue) and Collaboration (8.6% of total revenue) segment revenue declined 1.6%, 2.7% and 6.7% year over year, respectively. Other revenue also declined 14.1% compared with the prior-year quarter.

However, this decline was fully offset by strong performances from Service Provider Video (9.7% of total revenue), Wireless (4.1% of total revenue), Data Center (61.0% to total revenue) and Security (4.1% of total revenue) segments, which increased 30.6%, 34.3%, 61.0% and 5.6%, respectively.

Orders

Cisco’s product orders in the quarter remained flat year over year. The APJC region saw the strongest growth at 7%, with the Americas growing 2% and EMEA declining 10% from the year-ago quarter (consistent with broad market trends).

In the APJC region, India grew 50%, Japan was up in the mid-single digits, while China remained flat compared with the year-ago quarter.

In the America region, Latin America grew 3.0%, primarily driven by strong orders in Brazil (up 24.0%) and Mexico (up 11.0%), which fully offset a sluggish trend in Canada (down 12.0%) in the quarter.

Within the U.S., positive growth was noticed, with service providers’ order up 13.0%, enterprise up 9% and commercial orders increasing 5.0%. However, federal government orders declined 15.0% from the year-ago quarter.

Russia and other emerging markets in the EMEA region remained challenging, with enterprise declining in the mid-teens and service provider declining in the high teens.

Gross Margin

Cisco generated gross margin of 61.0% in the last quarter, up 40 bps sequentially but down 20 bps on a year-over-year basis. Management has been strengthening its portfolio and improving margins within each product category, which has enabled it to generate strong margins overall.

Product gross margin of 59.7% was up 50 bps sequentially but down 50 bps year over year. Services gross margin of 65.5% was flat sequentially, while expanding 40 bps year over year.

Operating Performance

Cisco’s operating expenses of $4.41 billion were 3.0% lower than $4.54 billion incurred in the previous quarter. Operating margin was 23.8%, up 210 bps sequentially and 150 bps year over year.

Research and development expense (“R&D”) increased 1.1% sequentially while sales and marketing expense (“S&M”) remained flat sequentially. General and administrative expense (“G&A”) decreased 21.2% sequentially. The 20 bps year-over-year increase in cost of sales was fully offset by declines of 20 bps, 150 bps and 20 bps in R&D, S&M and G&A expenses, respectively.

On a pro forma basis, Cisco generated net income of $2.35 billion, or a 19.8% net income margin compared to $2.31 billion, or 19.7% in the previous quarter and $2.07 billion or 18.4% net income margin in the same quarter last year.

Our pro forma estimate for the last quarter excludes restructuring charges, acquisition-related costs and intangibles amortization charges on a tax-adjusted basis but includes stock based compensation expenses. Our pro forma calculations may differ from management’s presentation due to the inclusion/exclusion of some items that were not considered by management.

On a fully diluted GAAP basis, the company reported a net income of $2.09 billion (39 cents per share) compared with $1.92 billion (36 cents per share) in the previous quarter and $1.78 billion (33 cents per share) in the comparable prior-year quarter.

Balance Sheet

Cisco ended with cash and investments balance of $48.7 billion, down $3.7 billion during the quarter. The company generated $2.47 billion in operating cash flow and spent $1.00 billion on share repurchases and dividends. The net cash position at quarter-end was $28.67 billion, compared with $32.39 billion at the end of the fiscal fourth quarter.

Guidance

For second quarter of fiscal 2013, Cisco expects revenue to increase in the range of 3.5% to 5.5% on a year-over-year basis. Non-GAAP gross margin is expected to be 61-62% and non-GAAP operating margin is expected to be 26.5-27.5% of revenue. The company expects a non-GAAP tax rate of 22%, yielding non-GAAP earnings of 47 to 48 cents per share.

Our Take

Cisco reported strong first quarter result and its outlook remains positive. However, sluggish macro-environment is the primary headwind going forward.

It is apparent that Cisco’s strategy of pursuing opportunities in international markets and focusing on new products and markets is paying off. Cisco is already the best entrenched company across the world and despite growing competition from several smaller players; the company appears to be holding its own.

Additionally, the focus on new products resulted in continued market share gains and margin expansion in the last quarter. Order growth in the last quarter was quite encouraging and the trend is reflective of Cisco’s superior strategy and innovation. 

Of course, competitors like Hewlett Packard Company (HPQ - Analyst Report) and the Chinese company Huawei have manufacturing operations in low-cost countries, which make them more competitive. They are also interested in sacrificing margins for market share gains. This remains a major concern for Cisco in the near term.

Cisco shares therefore carry a Zacks #4 Rank, which translates to a Sell rating in the near term (1-3 months). We remain Neutral on a long term (3-6 month) basis.

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