Highlights From CSCO's Q1 Conference Call: Q3 FY '09 Felt Like Bottom; Recent Acquisitions Help Increase Leverage in Video/Virtual Market

November 5, 2009 11:50 AM EST

Cisco Systems (NASDAQ: CSCO) reports Q1 2010 EPS of $0.36, 5 cents better than the analyst estimate of $0.31. Revenue for the quarter was $9 billion, which compares to the estimate of $8.74 billion. Up to $10 billion more added to share buyback. Shares are currently up 2%.

Highlights From CSCO's Q1 Conference Call:

• (CFO) For Q2 FY '10, we anticipate total revenue for the second quarter to be up approximately one to 4% year-over-year. From a sequential perspective, we expect to see approximately two to 5% growth.
  
• We believe total gross margin in Q2 will be approximately 64% to 65%.
  
• We believe Q2 operating expenses will be approximately 37.5% to 38.5% of revenue.
  
• Regarding cash flow from operations, we would expect to generate 1.8 billion to 2.1 billion during the second quarter. For the Q2 FY '10 GAAP earnings, we anticipate that GAAP EPS will be $0.06 to $0.08 per share lower than the non-GAAP EPS, primarily due to stock compensation expense and acquisition-related charges.
  
• (CEO) In my opinion, Q3 FY '09 felt like the bottom, as each of the three months in that quarter were in line with our normal order flow, granted with very tough year-over-year results.
  
• Almost all of our financial measurements were above or at the high end of our expectations.
  
• Revenue of nine billion year-over-year, a decrease of approximately 13%, was dramatically better than our expectations of down 15 to 17%.
  
• Non-GAAP earnings per share of $0.36 were, again, well above our expectations.
  
• Expense management was very solid, with non-GAAP OpEx decreasing approximately 10% year-over-year, while non-GAAP product gross margins were extremely strong at 66.3%, which was the best in nearly four years.
  
• Cash generated from operations in Q1 was approximately 1.5 billion and we repurchased 1.8 billion of stock during the quarter under our repurchase program.
  
• Non-GAAP operating income as a percentage of revenue was a very strong 29% versus Q4's 26%. Product book-to-bill was above one.
  
• Services continue to outpace other parts of our business with year-over-year revenue growth of approximately 7%.
  
• The sequential growth for financial measurements from Q4 to Q1 was very strong versus prior normal economic times.
  
• We also saw positive indicators in our year-over-year revenue trends. The growth rates improved from -18% in Q4 to down approximately 13% year-over-year in Q1.
  
• We are starting to see solid indications of economic recovery in most geographies around the world.
  
• While most markets around the world are starting to show signs of improvement, we were especially pleased with what we saw in the U.S.
  
• To put this in perspective, product orders from the last three quarters in the U.S. declined by an average of approximately 30% year-over-year. Therefore, to have Q1 orders in the U.S. grow year-over-year at a flat rate was, in our opinion, a major inflection point.
  
• Just to give you an idea of how our organizational structure translates into speed, scale, flexibility and replication, let me use the last month as an example. We announced intentions to acquire four companies, two of which were $3 billion transactions; a strategic partnership to drive the market transition around virtualization; launched a new product, the ISRG 2, that provides five times more performance, video ready capability and the richest set of virtual services with the lowest cost of ownership in the industry; all while executing on a strong quarter.
  
• Our revenue guidance for Q2 fiscal year 2010, including our usual caveats as discussed earlier and in our financial reports, is for revenue to increase in the one to 4% range year-over-year.
  
• We will continue to track sequential improvement quarter-to-quarter. To put this year-over-year revenue guidance into Q1 to Q2 sequential revenue growth terms, it would be in the two to 5% growth sequential range. Over the last five normal economic years, fiscal year 2004 through fiscal year 2008, the sequential revenue growth has averaged approximately 3% from Q1 to Q2.
  
• (CFO) Total revenue for the first quarter was $9 billion, a decrease of approximately 13% year-over-year, above the range provided last quarter of minus 15 to minus 17%.
  
• Total service revenue was $1.8 billion, up approximately 7% year-over-year. Total product revenue was $7.2 billion, down approximately 17% year-over-year.
  
• Switching revenue was $2.9 billion, a decrease of 21% year-over-year. Modular Switching revenue was down 19% year-over-year while Fixed Switching revenue declined 22% year-over-year. Routing revenue was $1.6 billion, down 17% year-over-year, representing a decrease of 15%, 19%, and 20% year-over-year in high-end, mid-range and low-end, respectively.
  
• Advanced Technologies revenue totaled $2.3 billion, representing a decrease of 15% year-over-year.
  
• We saw declines in Unified Communications of approximately 10%, Video Systems of approximately 29%, and Security of approximately 9%.
  
• Other product revenue totaled $481 million, an increase of 9% year-over-year.
  
• Year-over-year revenue ranged from a decline of 30% in Emerging Markets to growth of 2% for Japan theater, with revenue in the U.S. and Canada theater down 10%, Asia-Pacific down 6%, and European markets down 15%. We did see sequential improvement in all geographic segments except for Asia-Pacific, which was down less than 1% sequentially.
  
• Q1 FY '10 total non-GAAP gross margin was 66.3%, up one percentage point quarter-over-quarter and 0.7 percentage points year-over-year.
  
• On a year-over-year basis, non-GAAP product gross margins were relatively flat. Our non-GAAP service margin for the first quarter was 66.3%, down from 67.5% last quarter, and up from 62.4% in Q1 fiscal year '09.
  
• Total gross margin by theater ranged from approximately 52.8% for Emerging Markets to approximately 72.6% in Japan.
  
• Non-GAAP operating expenses were approximately $3.3 billion in Q1 fiscal '10, relatively flat quarter-over-quarter and down 10% year-over-year.
  
• Non-GAAP operating expenses as a percentage of revenue was 37% in Q1 fiscal year '10 versus 39.2% in Q4 FY '09.
  
• GAAP interest and other income was $115 million, which also includes a $42 million mark-to-market impact related to transactions to hedge a portion of the foreign currency consideration for our announced pending acquisition of TANDBERG.
  
• Non-GAAP interest and other income was $73 million for Q1, reflecting higher than normal realized gains of approximately $40 million from the sale of a privately held investment.
  
• Our Q1 FY '10 non-GAAP tax provision rate was 22%. Non-GAAP net income for the first quarter was $2.1 billion, representing a decline of 15% year-over-year. As a percentage of revenue, non-GAAP net income was 23.5%.
  
• The total cash, cash equivalents and investments for the quarter was $35.4 billion, up approximately $400 million from last quarter. Of this total balance, 4.7 billion was held within the United States at the end of Q1 fiscal year '10. During the quarter, cash flow from operations was approximately $1.5 billion.
  
• Moving on to accounts receivable, our receivables balance was 3.2 billion at the end of Q1. At the end of Q1, days sales outstanding or DSO was 32 days compared to 34 days in Q4 and 29 days in Q1 fiscal '09. Total inventory at the end of Q1 was $1.1 billion, relatively flat quarter-over-quarter.
  
• Non-GAAP inventory turns were 11.3 this quarter, flat compared to last quarter and down three tenths of a point from Q1 of last year.
  
• Inventory purchase commitments at the end of Q1 were $2.8 billion, an increase of approximately 30% from the end of Q4 '09 and a decrease of approximately 2% year-over-year.
  
• Deferred revenue was $9.3 billion at the end of Q1, an increase of approximately 5% compared with Q1 fiscal year '09.
  
• Deferred product revenue was 3.1 billion and deferred service revenue was approximately 6.2 billion, increases of approximately 7% and 4% year-over-year respectively.
  
• (CEO) We announced the Virtual Computing Environmental coalition formed by Cisco, EMC (NYSE: EMC), with VMware (NYSE: VMW), which represents a major breakthrough in the way that IT is delivered and consumed by customers. The key industry transition happening is the movement from the current data centers to next generation data centers and the journey to private clouds. It is really about bringing IT as a service to life.
  
• With these industry trends in mind, this announcement represents an unprecedented level of collaboration in development, services and partner enablement to deliver the industry's first completely integrated IT offering that combines best of breed networking, compute, storage, security and management technologies, with end-to-end vendor accountability. This move clearly signifies our focus on capturing the market transition around virtualization and private cloud infrastructures.
  
• I believe that video is the killer application that will drive next generation productivity and innovation.
  
• In Q1, we conducted 77,000 Cisco internal meetings, had another record quarter in terms of units sold, selling over 570 systems and adding approximately 85 new customers.
  
• Today we have over approximately 500 customers and almost 3,200 systems sold to date. You have also recently seen us make strategic announcements around TANDBERG in Norway, Digital Video Networks in China, Pure Digital early this year in the U.S.
  
• Our intentions to acquire TANDBERG is also about the integration of video into a broader $30 billion market for collaboration. By acquiring TANDBERG and expanding our video end point product line, we hope to grow business interests in video as part how enterprises communicate internally and between businesses.
  
• Asia-Pacific overall was down in the low single digits, with the public sector up over 30% year-over-year, while other segments were down between mid-single digits and mid-teens. The emerging markets, not including emerging countries in Asia, continue to experience challenges, with overall year-over-year orders decreasing in the high 20s.
  
• Advanced Technology revenues were down approximately 15% year-over-year. In terms of Advanced Technology, UC was down approximately 10%, Wireless showed an improvement at a positive 7% growth. The network home was down 18%, Security was down 9% and Storage was down 19%. Video was down 29% year-over-year, although orders year-over-year were down less than half of that amount. Application and Networking Systems were down 25% year-over-year.
  
• (Q&A) Just on the ASR router product line, we've been hearing about some meaningful wins for you in that platform against your competitors over the carriers. Can you talk about how ASR is doing, and specifically how order trends are with the carrier segment of your business? (A)Yeah, the ASR 1000 is off to a great start. If I remember my data - I'll have somebody check it as we go - I think we've got over 1,000 customers for the ASR 1000 already. For the ASR 9000, the number of customers more than doubled during the quarter. And so both of them are off to a good start. As you know, like with ASR 1000, it takes a while in pilot situations before you begin volume. So it will probably be a couple more quarters before you see the ASR 9000 volumes be really meaningful in terms of direction. So in summary, ASR 1000 bookings were probably over $100 million. That obviously indicates a pretty good trend, probably in the $0.5 billion range for the fiscal year and a growth year-over-year obviously in the 100% plus-type range. ASR 9000, we're off to a good start, but I'll probably have better data for you in one more quarter.
  
• I was wondering if you could spend a little bit more time in telling us how not to extrapolate in the second half of your fiscal year. You're doing a little bit better than seasonal here in the fiscal second quarter. Therefore we should be modeling seasonality in the second half of the fiscal year. Is that the idea? (A)No, I would just wait to see. We clearly are ahead of most of our peers in seeing the activities in terms of growth. Q4 from Q3 was up a little bit over 10% in terms of sequential orders. Q1 was in a period that's normally down in mid-single digits or low-single digits, right in the pattern. Our revenue sequential growths were good. This next quarter looks strong. I just don't want to get ahead of ourselves and we're just saying wait another quarter to let us get the data because there are a lot of caveats on around job creation, sustainability. So it was a very strong Q1. We're projecting a strong Q2. And I would just encourage you to do exactly what we're doing at Cisco. Let's not get Q3 and Q4 modeled until we get further into that time period. So I'm just doing what I would do myself in terms of the direction. (A)As you mentioned, we've been modeling our year as far as looking at the two halves because of the situation that's going on in the economy, as you mentioned. So we've developed a plan really for the first two quarters. And after we finish this next quarter, we'll then look at our plan for second half of the year and invest accordingly. (A)I think that's the better part of optimism. We're being about as optimistic as I think you could be, given the challenges that are going on and backing it up with
  specific data with it. But I'd wait another quarter before I'd model Q3 and Q4 up off your current level.
  
• Quick question; two questions on the cost side. One with regards to the gross margin. Frank, we could go a little bit more in detail on the guidance. Why do you expect that big step-down sequentially? What is it about the mix that you expect to change, whether it be geographic or product-wise that will get you into that range. And then on the operating expenses side, just extrapolating from your guidance, it looks like a $200 million sequential increase. Maybe you could give us just a little bit more color where you intend to spend it. (A)Let me start with the first part of the question on the gross margin. So just looking at even some of the drivers from a Q4 to Q1 perspective, especially with the guidance that we provided last time. So we did see overall better volume and higher revenue as you can see. That does generate a portion of the higher margin that we saw. Again, we had several hundred million dollars of higher revenue than we anticipated. The other driver is we did see lower overall manufacturing costs than we had expected, really driven by a lot of the strong operational efficiency that we've been working through the manufacturing organization -- effective inventory management, value engineering, process efficiencies and so forth. And then the last point is our service margins. Although they were down quarter on quarter, they were better than we anticipated, primarily on the stronger revenue, but also from the standpoint of the ramp of our resources. We have been increasing that ramp because we do see opportunity for us in investment services. But it's not happening as fast as we would anticipate. So going into the second quarter, the major change from where we are at the end of Q1, one is the service piece that I just talked about. So we are anticipating our service margin to drop, primarily because of the investment, and we think that's good because we do see the opportunity for the advisory services to continue to provide growth opportunity for Cisco. And then the second piece has to do with the product mix. Now, we're going into the holiday timeframe for November, December. Therefore, we're anticipating a higher percentage of our business in the consumer. (A)And that means you can raise your forecast any time. (A)And then we also have mix, lower mix gross margin impact driven by the UCS product that we've talked about as that starts to ramp. And then also with our set-top box business, which does have lower margin. So mix does have a play as we move forward. It's something that if we model over the longer period of time, it's that which we have to take into consideration and it's part clearly of what we're looking at in Q2 as part of that 64 to 65% range that we provided. It is higher than we had guided coming into Q4 - sorry, into Q1. So we've taken some of the benefit that we saw in Q1 into consideration. Now on the OpEx, yeah, there were...(A)Got one more comment on that, Frank. Also you saw our numbers in emerging markets. The competition there on price is brutal and developed markets, we can usually earn the premium because of our ability to help them drive productivity and transform industries. In emerging markets, it is a very tough price game. And probably in hindsight if we'd been a little more aggressive, we could have picked up more, some more business there. And it's a nice way of saying we'll probably be more aggressive in the next quarter or two, Rob, in emerging markets in terms of pricing. (A)And then moving onto the operating expense. Clearly we've done a very good job over a number of quarters dealing with the challenges in the economy. We came into Q1 at a very low rate from a expense perspective. We are, as both John and I just mentioned as part of the call, planning to make selective investments in addition to supporting the market adjacency opportunities that we see. I think if you look back at Q1 and how aggressive we were with some of the announcements that we've made, we want to continue to be aggressive and take advantage of the momentum that we're seeing in the marketplace and the position that Cisco has. So we feel that making that investment in the second quarter, increasing our expenses is going to pay back in the long term.

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