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Cisco Systems’ (CSCO - Free Report) fourth quarter 2011 earnings (excluding one-time items and including stock based compensation) beat the Zacks Consensus estimate by 3 cents, or 9.4%. Revenue exceeded the consensus by 2.0%.


Revenue of $11.20 billion was up 3.0% sequentially and 3.3% year over year, better than management’s expectations of a 0-2% year-over-year increase.

Products, which generated 80% of revenue, grew 2.9% sequentially and 1.3% year over year. Services accounted for the remaining 20%, up 3.5% sequentially and 12.1% year over year. Services are growing in importance at Cisco, with technical support services and advanced services growing 11% and 17%, respectively from the comparable prior-year quarter.

The U.S. & Canada was the largest revenue contributor, with a 53% revenue share in the last quarter. It was followed by Europe with a 19% share, the Asia/Pacific with 16% and emerging markets 12%. Revenues were up sequentially across all regions with the exception of Europe, which declined 2.2%.

The greatest increase was in the Asia Pacific (up 14.8%), followed by the U.S. & Canada (up 2.2%) and the emerging markets (up 1.7%). The U.S. and Canada, Europe, emerging makets and the Asia Pacific were up 0.6%, 1.2%, 2.5% and 17.1%, respectively, from the year-ago quarter.

Product Revenue by Category

Routers were 16% of total revenue, down 6.2% sequantially and flat with the year-ago quarter. The ASR edge routers (1,000 and 9,000) saw orders growing 40% and 156%, respectively, from the year-ago quarter. Overall, Cisco stated that revenue from high-end routers (around 70% of total routing revenue) was down 3% year over year.

Switching revenue accounted for a 31% revenue share, growing 2.0% sequentially, but declining 4.7% year over year. Fixed switching revenue grew 5% from a year ago, while modular switching revenue declined 14%. Cisco attributed the decline to lower pricing per port, increased competition and lower spending in the public sector.

Excluding the public sector, Cisco switching would have grown 13% from a year ago. The ASP declines were attributed to ongoing product transitions. Orders for fixed switches grew 13% year over year, while orders for modular switches declined 2%. Management stated that the company expected to hold a 50% share of switching ports and a high 60% revenue share  in the switching market.

New Products generated 31% of revenue, up 6.0% sequentially and 35.6% year over year. Wireless, data center and collaboration products grew very strongly from last year (33%, 32% and 11%, respectively). Security declined 21%, while video connected home increased 1%.

The Other segment brought in 3% of revenue, up 35.7% sequentially and down 68.1% year over year.


Cisco’s order growth rates were strong in the last quarter, which resulted in a book-to-bill ratio of over 1. The fourth quarter is usually its strongest in terms of orders.

Cisco stated that total orders were up 11% from last year (compared to 8% in the previous quarter), with the U.S. & Canada, Europe, emerging markets and Asia Pacific growing 9%, 9%, 12% and 19%, respectively. Russia, Brazil, China, Mexico and India were particularly strong, growing 50%, 35%, 26%, 16% and 7%, respectively.

Cisco also highlights orders generated by the targeted segments of enterprise (including public sector), service provider, commercial and consumer. Of these, the consumer segment appears to have fared the worst in the last quarter, declining 41% from last year. Cisco has taken initiatives to turn the situation around and management is optimistic about stronger performance in the future.

Public sector was the other segment that performed poorly, recording a year-over-year decline of 4%. Cisco stated that the company’s was strongly positioned at all government customers that were however curtailing expenses or diverting to other areas, such as cloud computing.

Cisco believes that the company has not lost ground with any customer yet, although its switching revenue is suffering. Management has decided to revamp the portfolio to better target these customers.

Other areas of the enterprise segment remained strong for Cisco, with total enterprise orders (including public sector) growing 25% year over year. The commercial segment is also turning around, going by the 16% order increase, which was just slightly lower than the service provider segment growth rate of 19% and overall Cisco order growth rate of 11%.

Gross Margin

Cisco generated a gross margin of 62.2% in the last quarter and 115 bps sequentially, but down 137 bps on a year-over-year basis.

The product gross margin of 59.9% was down 47 bps sequentially and 255 bps year over year. The sequential decline was due to a combination of unfavorable mix, higher manufacturing-related costs as Cisco continues to transition to a new switching portfolio, partially offset by component cost savings.

Management stated that discounting and pricing were neutral to the comparison. The year-over-year decline was driven by discounts that impacted pricing and mix, partially offset by cost savings. Competition has stiffened over the past few months, increasing pricing pressure and forcing management to offer heavy discounts.

The services gross margin of 66.8% was up 185 bps sequentially and 299 bps year over year. The sequential variation in services gross margins is generally attributable to the mix of business (higher-cost advanced versus lower-cost technical support), as well as the timing of contract initiations. Gross margins in both areas improved in the last quarter.

Operating Performance

Cisco’s operating expenses of $4.53 billion went up from the previous quarter’s $4.30 billion. The operating margin was 21.7%, down 205 bps sequentially and 328 bps year over year.

Both the sequential and year-over-year comparisons were largely impacted by gross margin weakness. However, G&A as a percentage of sales also increased significantly. Specifically, R&D was up 10 bps sequentially, S&M flat and G&A up 81 bps. Compared to the year-ago quarter, R&D, S&M and G&A increased 42 bps, 81 bps and 68 bps, respectively.

Cisco has decided to reduce headcount, although strategic additions are likely to continue. Management stated that a reduction in the workforce by 6,500 in 2012 would lower expenses by around $1 billion. In the last quarter, the workforce went down by 1,600, mostly reflecting the consumer restructuring and those opting for voluntary retirement.

On a pro forma basis, Cisco generated a net income of $1.92 billion, or a 17.2% net income margin compared to $ 2.10 billion, or 19.3% in the previous quarter and $2.22 billion or 20.5% net income margin in the same quarter last year.

Our pro forma estimate for last quarter excludes restructuring charges, acquisition-related costs, intangibles and 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 $1.23 billion ($0.22 per share) compared to $1.84 billion ($0.33 per share) in the previous quarter and $1.94 billion ($0.33 per share) in the prior-year quarter.

Balance Sheet

Cisco ended with a cash and investments balance of $44.6 billion, up $1.22 billion during the quarter. The company generated $2.82 billion in operating cash flow, spent $244 million on capex, $1.33 billion on share repurchases and $329 million on dividends.

The net cash position at quarter-end was $27.76 billion, up from $26.62 billion at the end of the fiscal third quarter. Including short-term debt and long term liabilities, the debt-cap ratio was a mere 32.7%.

Inventories grew 3.1% to $1.49 billion, with inventory turns increasing slightly from 11.1X to 11.4X. Days sales outstanding (DSOs) were up from 37 to around 38.

First Quarter Guidance

In the first quarter, Cisco expects revenue to increase 0-4%. The operating margin is expected to be 24-25% of revenue, the tax rate 22%, yielding a non-GAAP EPS of 38-41 cents a share, including stock based compensation and excluding restructuring and acquisition-related charges and early retirement-related charges of 10 to 14 cents a share.

Key Takeaways

Despite pockets of strength, Cisco’s results and guidance indicate a slowdown in the core routing and switching businesses, which it attributed to important product transitions. While there may be some truth to this and Cisco is no doubt the networking giant, competitors, such as Juniper Networks (JNPR - Free Report) , Hewlett Packard Company (HPQ - Free Report) through its 3Com acquisition and F5 Networks (FFIV - Free Report) are very slowly picking up market share.

Also, Cisco’s stellar margins have come as the result of its innovations, something that we may expect to continue going forward. But the company will see increasing pricing pressure as the number of players increase.

We are however encouraged by management’s initiatives to lower the cost structure by reducing headcount. These initiatives are expected to take out a billion dollars of expenses in 2012, which will help stem margin shrinkage resulting from slower revenues due to product transitions and spending levels in the market.

We think management’s decision to reduce headcount is commendable (and long overdue), but there will be near-term severance costs that will impact the bottom line. Additionally, we expect strategic hirings to continue.

Cisco has at last admitted to its inefficient decision-making structure and management has stated that it intends to streamline the process. We also welcome this change, but prefer to take a wait-and-see approach to execution.

We think the real challenge facing Cisco right now is the possibility of material share losses, as public sector spending shrinks or shifts away from Cisco technology. Given the company’s existing relationships and technological strength, we expect it to ultimately win the war (at the cost of margins). However, near term revenue will be under pressure.

Cisco shares currently have a Zacks #3 Rank (short-term Neutral recommendation).

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