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Edited by Adam Isaac

Cisco Systems (NASDAQ:CSCO) is one of the largest networking companies in the world. The company designs, manufactures and sells internet protocol-based networking and other products related to the communications and information technology industry worldwide. Cisco also offers routers that interconnect public and private IP networks for mobile, data, voice, and video applications. In my previous article, I analyzed the funds from operations [FFO], operating cash flows and free cash flows of Cisco. In addition, I also analyzed essential ratios involving FFO, capital spending requirements and debt service coverage.

In this article, I have tried to analyze the composition of components through common size analysis. Common size analysis helps us understand the change in the composition of the components in the statement of operations. This analysis is performed by dividing each component of income statement with total revenue. This analysis is ideal to determine the earnings sustainability. In addition, common size analysis also evaluates the quality of earnings. For any business, it is ideal to have more of its earnings in cash and less in accruals.

Common Size Analysis:

2012

Common Size

2011

Common Size

2010

Common size

Net Sales

Product

$36,326

78.86%

$34,526

79.89%

$32,420

80.97%

Service

$9,735

21.14%

$8,692

20.11%

$7,620

19.03%

Total Net Sales

$46,061

100.00%

$43,218

100.00%

$40,040

100.00%

Cost of Sales

Product

$14,505

31.49%

$13,647

31.58%

$11,620

29.02%

Service

$3,347

7.27%

$3,035

7.02%

$2,777

6.94%

Total cost of sales

$17,852

38.76%

$16,682

38.60%

$14,397

35.96%

Gross Margin

$28,209

61.24%

$26,536

61.40%

$25,643

64.04%

Operating Expenses:

Research and Development

$5,488

11.91%

$5,823

13.47%

$5,273

13.17%

Sales and Marketing

$9,647

20.94%

$9,812

22.70%

$8,782

21.93%

General and administrative

$2,322

5.04%

$1,908

4.41%

$1,933

4.83%

Amortization

$383

0.83%

$520

1.20%

$491

1.23%

Restructuring and other charges

$304

0.66%

$799

1.85%

$0

0.00%

Total Operating Expenses

$18,144

39.39%

$18,862

43.64%

$16,479

41.16%

Operating Income

$10,065

21.85%

$7,674

17.76%

$9,164

22.89%

Interest Income

$650

1.41%

$641

1.48%

$635

1.59%

Interest Expense

$596

1.29%

$628

1.45%

$623

1.56%

other income, net

$40

0.09%

$138

0.32%

$239

0.60%

Interest and other Income, net

$94

0.20%

$151

0.35%

$251

0.63%

Income before provision for taxes

$10,159

22.06%

$7,825

18.11%

$9,415

23.51%

Provision for Income taxes

$2,118

4.60%

$1,335

3.09%

$1,648

4.12%

Net Income

$8,041

17.46%

$6,490

15.02%

$7,767

19.40%

Source: SEC filings.

For my analysis, I used the data from three most recent annual reports of the company. The first thing I noticed in the revenue decomposition is the trend in business segments. The contribution from product sales is decreasing, whereas the weight of services segment is moving upward. In the previous three years, the products segment has decreased by 2%. I think that indicates a change in company's primary focus to services segment.

However, cost of sales component gives mixed results; products related cost of sales have been fluctuating. An increase was followed by a decrease and this ratio currently stands at 31.49%, while the cost of sales for services component has been steadily increasing. Overall, cost of sales for Cisco keeps going up and now stands at close to 39% of revenues. Thus, the gross margin has come down to 61%. Over the past three years, research and development expenses have also decreased and now stand at just over 11%.

Total operating expenses have been fluctuating between 39% and 44% of sales, and the operating margin currently stands at 21.85%. However, the current operating margin showed a decline of 1.04% from the levels of 2010. Furthermore, the interest expense has also showed a declining trend and now stands at 1.29% of total revenues. Net profit margin has followed operating margin and shows a mixed trend. At the moment, net profit margin is 17.46% for Cisco, which is 1.94% less than the level of 2010. During the past two years, Cisco also absorbed over $1 billion in restructuring expenses.

Earnings Quality:

Accruals

Balance Sheet accruals

2012

2011

2010

2009

Operating Assets

$43,043

$42,510

$41,269

$40,256

Operating Liabilities

$24,130

$23,014

$21,561

$20,655

Net Operating Assets

$18,913

$19,496

$19,708

$19,601

Accruals

-$583

-$212

$107

Accruals Ratio

-3.04%

-1.08%

0.54%

Cash Flow Based

Net Income

$8,041

$6,490

$7,767

N/A

CFO( Operating Cash flow)

$11,491

$10,079

$10,173

CFI( Investing Cash Flow)

-$3,815

-$2,934

-$11,931

Accruals

$365

-$655

$9,525

Accruals Ratio

1.90%

-3.34%

48.46%

Source: SEC Filings.

In order to measure the earnings quality of Cisco, I have used balance sheet and cash flow accruals ratios. For the balance sheet accruals ratio, beginning net operating assets are subtracted from the year end net operating assets and divided by average net assets. Net operating assets are calculated by subtracting operating liabilities (total liabilities - total debt, including short term debt) from operating assets (total assets - cash, cash equivalents and marketable securities).

In accruals analysis, cash component is separated from the accruals component of earnings, and a lower accruals ratio indicates higher quality earnings. The performed accruals analysis suggests intriguing results as the current balance sheet ratio is negative. In addition, both of the ratios were negative in 2011. It is not unusual to have negative accruals ratios, but no business can sustain negative accrual ratios as it implies that the firm is generating more cash than its accounting earnings.

Looking at the balance sheet of Cisco, it is clear that the cash and cash equivalents have increased by more than $4.5 billion from the year end balances of 2011. That is a very good sign for the dividend safety. Cisco has enough cash to cover its dividend for the next 10 years at least.

The cash flow ratio is in the positive territory and currently stands at 1.90%. A closer look at the cash flow statement indicates that there has not been much capital expenditure by the company in the past two years. In addition, cash and cash equivalents have increased enormously during the past three years and currently stand at $9.7 billion; cash and cash equivalents stood at just above $4.5 billion at the end of 2010.

Summary:

The above analysis suggests Cisco is a strong cash generating machine. In fact it is generating significantly higher cash than the reported earnings. Moreover, the firm has strong asset base and impressive operations. Cisco is in a strong financial position, and the firm should not have any trouble in paying its debt and interest obligations. Along with a steady progress in its revenue, the firm has also shown impressive growth in its EPS and current EPS stands at $1.50.

Compared its closest competitor, Juniper (NYSE:JNPR), Cisco stock is trading at a deep discount. Cisco's trailing P/E is only 13, whereas Juniper has a trailing P/E of 40. Cisco is an established giant which has been given a new direction by its management, and I expect the company to carry on its impressive revenue and earnings growth backed by its strong balance sheet. Analysts also agree with me. The forward P/E ratio of 9.33 indicates almost 40% increase in expected earnings for the next year.

Source: Cisco Demonstrates Impressive Earnings Quality