Cisco: Too Much Of A Decline?

| About: Cisco Systems, (CSCO)

Last week, Cisco Systems (NASDAQ:CSCO) reported its fiscal third quarter earnings. The company beat slightly on both the top and bottom line, but forward looking guidance was below estimates. That caused a large drop in the stock, and shares have ticked a little lower since then. However, I believe the drop is a bit of an overreaction, and this is a very good buying opportunity in the name.

First, here were the headline numbers. Revenues of $11.59 billion, up 6.64% from the year ago period, beat by $20 million. Non-GAAP earnings per share of $0.48 beat by a penny, and were up from $0.42 in the 2011 period. I've provided a breakdown of the key numbers by segment in the following table, showing the year over year increases in revenues, cost of sales, and gross margin for their two major segments, products and services.

Revenues Q3 2011 Q3 2012 Change
Product $8,669 $9,106 5.04%
Service $2,197 $2,482 12.97%
Total $10,866 $11,588 6.64%
Costs Of Q3 2011 Q3 2012 Change
Product $3,437 $3,563 3.67%
Service $770 $856 11.17%
Total $4,207 $4,419 5.04%
Gross Margin Q3 2011 Q3 2012 Change
Product $5,232 $5,543 5.94%
Service $1,427 $1,626 13.95%
Total $6,659 $7,169 7.66%

Cisco did a nice job of increasing revenues, while being able to keep associated costs from rising just as fast. That provided a bit of help when it came to gross margins. But the "cost of goods sold" numbers weren't the only thing Cisco did well during the quarter. It was able to control its other operating expenses very well. In fact, total operating expenses, detailed in the table below, were down year over year. Large drops in R&D spending and sales expenses were only partially offset by increases in general and administrative expenses.

Expenses Q3 2011 Q3 2012 Change
R&D $1,430 $1,358 -5.03%
Sales/Marketing $2,446 $2,383 -2.58%
General/Admin $466 $562 20.60%
Amortization $103 $96 -6.80%
Restructuring $31 $20 -35.48%
Total $4,476 $4,419 -1.27%

When you are not only able to increase your revenues and gross margin, but actually decrease your operating expenses from the year ago period, you are going to see a nice increase in operating profit. Cisco's operating profit (income) was up 26% over last year's period. That is a remarkable increase. Cisco did see a higher effective tax rate, rising from 18% to 22.1% for the third quarter, which meant profit margins did not rise as fast as operating margins. I've detailed the three primary margins in the table below.

Q3 Margins 2009 2010 2011 2012
Gross 64.07% 63.95% 61.28% 61.87%
Operating 19.69% 22.62% 20.09% 23.73%
Profit 16.52% 21.14% 16.63% 18.68%

Gross margins were up, but still trail those from a few years ago. Operating margins soared in the period and are at a four year high. Net profit margins rose nicely, but still were a bit below 2010's quarter.

Cisco is doing very well right now, and that has helped its balance sheet to become even stronger than in recent years. The following table shows some key numbers at the end of the fiscal third quarter over the last four years. The current ratio and working capital balance are at four year highs. The debt (liabilities to assets) ratio declined nicely from last year's period. Cisco's cash and investments pile remains strong, and has increased nearly 45% in the past three years.

Financials 4/25/09 5/1/10 4/30/11 4/28/12
Current Ratio 3.21 2.70 3.43 3.57
Debt Ratio 42.35% 44.70% 44.69% 43.64%
Working Capital $28,475 $31,319 $39,094 $44,088
Cash+Investments $33,551 $39,106 $43,367 $48,412

A strong balance sheet will help Cisco to maintain future growth, especially through acquisitions. Cisco announced a large one during the quarter when it reported its plans to acquire NDS, a provider of video software and content security solutions.

A strong balance sheet will also allow the company to maintain and increase its dividend. The company initiated a dividend in 2011, paying 6 cents each quarter. This year, the dividend was hiked to 8 cents per quarter. With that raise, and the recent stock price decline, the yield is almost up to 2%. The yield isn't as much as Microsoft's (NASDAQ:MSFT) or Intel's (NASDAQ:INTC). Unless we get new information, it will be higher than the initial dividend yield you will see from Apple (NASDAQ:AAPL), which will start later this year.

Cisco is also buying back stock. During the quarter, the company repurchased about 27 million shares, at a cost of $550 million. They have approximately $7.7 billion left on the current buyback plan, and have retired 3.6 billion shares at a cost of $74.3 billion since the plan started. Unfortunately, the buyback has been a sore point with some investors, and it still is. Cisco bought back shares this quarter at an average price of $20.28. Unfortunately, shares traded below that price for most of the quarter. With the recent decline, Cisco should be able to repurchase shares cheaper this quarter. It would be a lot better if they could buy them back at $16 than $20.

Now, the forward guidance is what did in Cisco's shares. The company guided for fiscal Q4 revenue growth of 2% to 5%, a bit below the 7.1% analysts had expected at that time. Currently, analysts are expecting 3.9% growth. Earnings per share guidance was a range of $0.44 to $0.46, which was also below street estimates for $0.49. The current estimate is $0.46. Cisco noted on the conference call that European and public sector spending remains weak, and that longer sales cycles and smaller deal sizes are occurring. Fortunately, Europe is not Cisco's largest revenue generator, but any weakness in the region will be felt, and that seems to be why their guidance was so low.

Cisco reported a very good quarter, but it was the guidance that took it down. I don't believe that the drop was warranted, not this much anyway. Remember, Cisco was above $21 at the beginning of April. I would recommend getting into Cisco while it is low, but it does not remain one of my top three picks in technology. I prefer Apple, Microsoft, and Intel ahead of it. The following table shows why. Now, you do need to realize that these companies have different fiscal years, which does make some of the data quasi-comparable (Cisco - July end, AAPL - September end, MSFT - June end, INTC - calendar).

Current Year Revenue Growth 6.4% 50.0% 6.2% 5.8%
Next Year Revenue Growth 5.1% 20.2% 8.4% 7.4%
Current Year EPS Growth 12.3% 69.8% 1.1% 4.6%
Next Year EPS Growth 4.9% 14.7% 11.8% 7.6%
P/E (Current Fiscal Year) 9.18 11.88 11.28 10.80
P/E (Next Fiscal Year) 8.74 10.35 10.09 10.04
Current Dividend Yield 1.92% N/A* 2.61% 3.33%
Stock Buyback? Yes No* Yes Yes
Cash + Investments Pile $48.4 B $110.2B $68.6B $15.1B

Microsoft and Intel are buying back a lot more stock than Cisco now. Cisco bought back more than half a billion during the quarter. However, Microsoft and Intel are buying back at least a billion a quarter currently. Also, Intel just announced a dividend raise, and Microsoft should raise theirs later this year. Apple also is growing a lot faster, and remains my top growth pick in the tech sector currently. Intel is my top value pick in the sector right now. Would you rather buy Cisco at 9.2 times this year's earnings or Apple at 11.9 times? I think that seems rather obvious. I would even buy Microsoft and Intel at their higher valuations. Why? Well, you are getting more of a dividend, more stock buybacks, and more revenue growth.

In summary, Cisco reported a very good quarter, but guidance took it down. With Cisco coming down from more than $21 to under $17, I think that it is a buy, but that there are some other names to purchase ahead of it.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL over the next 72 hours.