remain, the quarter offered further encouragement on a number of fronts. I think that the shares could have more upside if its P/E matches historical standards.
Here we can see all the "Gurus" that hold CSCO in their portoflios:
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Margins. With regard to what I view as the single most important issue for an investment decision in Cisco, the quarter offered yet further encouragement regarding Cisco’s margin structure. In the wake of the extraordinary decline in gross and operating margin during fiscal 2011, for the first time in Cisco’s history investors needed to contemplate Cisco's gross and operating margin structure. Moreover, there was little if any visibility as to where this margin structure would ultimately settle out. While the issues not yet laid to rest, the quarter offered a third straight quarter of encouragement. Including the 62.4% nadir established in the second quarter of fiscal 2011, the quarter marks the fourth consecutive quarter of gross margin greater than 62%. Similarly, operating margin rebounded to over 26%, and almost 100 basis point sequential improvement from the preceding quarter and in over 100 basis point improvement from the 24.5% nadir established in the second quarter fiscal 2011. I see further room for improvement in both gross and operating margin.
Gross Margin. As previously noted gross margin exceeded 62% and product gross margin exceeding 61% for a fourth consecutive quarter. Management's guidance in commentary suggests further upside to these numbers. Most notably, Cisco’s enterprise switching platforms notched significant improvement in gross margin and appear poised for further upside. Cisco noted that its overall switching gross margin has returned to the level Cisco enjoyed in the year ago quarter. This level is well above Cisco's overall product gross margin. As for details, Cisco drove a two percentage point increase in gross margin for its Nexus 7000 platform in a five percentage point increase in margins for the Nexus 2000 3000 4000 and 5000 platforms collectively. Cisco also noted that it sees
further room for improvement in gross margin for its Nexus 7000 platform. With respect to Cisco's second most important product line in terms of overall profitability, Cisco noted that the China routing deals’ adverse impact on gross margin should conclude in the current second fiscal quarter. Cisco's gross margin would have been higher in the fiscal first quarter but for the impact of these extraordinarily low margin transactions. Cisco expects the bulk of the impact to hit the current fiscal second-quarter. Cisco also noted that it believes it has the opportunity for additional margin improvement in its routing products via "value engineering." In service provider switching Cisco noted that aggressively ramping volumes of its ASR 5000 and, even more so, ASR 9000 platforms should also contribute incremental margin improvement. With respect to pricing in general, while pricing continues to decline--a given in all product markets within the communications equipment industry--Cisco noted that has a “better gauge and handle” on pricing and the competitive environment that's had in quite some time. In short Cisco believes it has the ability to keep pace with the rate of price for corrosion primarily via “value engineering.”
Operating Margin. As previously noted, Cisco’s operating margin rebounded by almost 100 basis points to just over 26% driven by the relatively stable gross margin together with the start of an absolute decline in operating expenses as a result of the recently implemented staff reductions. Relatively stable to potentially modestly improving gross margin together with the ongoing impact on operating expense from the force reduction should drive a further increase in operating margin.
Growth. Regarding the second key issue—a revival of Cisco’s growth rate—the quarter also suggests revenue growth will be at the high-end to above Cisco’s 5 – 8% longer-term guidance and reduced Street estimates. Cisco generated 5% year-over-year revenue growth in the quarter compared to its 1 – 4% guidance and the Street consensus 3% estimate. Its 7 – 8% year-over-year revenue growth guidance for the current second fiscal quarter is at the high-end of Cisco’s reduced longer-term 5 – 8% guidance.
Cisco has embedded in this 7 – 8% guidance an appropriately healthy degree of conservatism. Most of the leading indicators of Cisco’s business appear to be trending in a positive direction. Cisco noted that its Product Book-to-Bill of approximately 1.0 was “at the very high end of the range of what [Cisco] traditionally sees in the first quarter.” Cisco also noted linearity almost perfectly in-line with historical first quarter linearity. While a portion ships during the quarter, overall product orders increased 13% yearover- year, five percentage points above Cisco’s 7 – 8% revenue growth guidance, with Cisco noting strong balance across its five key foundation
Surprisingly, given the macroeconomic environment, all customer segments posted double digit year-over-year product order growth. From a year-over-year order growth perspective, each of Cisco’s customer markets offered reason for optimism as to future revenue trends.
Service Provider. In the Service Provider market, Cisco enjoyed greater than 15% yearover- year order growth for a second straight quarter after less than 10% growth in each of the first three quarters of fiscal 2011. Consistent with consensus analyst expectations for low single digit growth, Cisco’s CEO, John Chambers, expects Service Provider capital expenditures in 2012 to be “a little up.”
Enterprise (Excluding Public Sector). Cisco’s Enterprise (Excluding Public Sector) segment posted greater than 10% year-over-year order growth for a fifth straight quarter. Mr. Chambers noted that he expects Enterprise IT spend to be “flat to down” in calendar 2012, with most enterprises, consistent with Cisco’s own approach, opting to enter the year with a conservative budget with the option of adjusting upwards should market demand improve.
Public Sector. Cisco’s Public Sector order growth returned to 10% for the first time in the past 10 quarters and follows two straight quarters of negative year-over-year growth. The Public Sector’s strong order growth was unexpected given the prevailing debt and deficit issues plaguing the public sector throughout most of the world. Cisco noted that the U.S. Public Sector saw 5% year-over-year order growth. Outside the U.S., Cisco obviously experienced particularly impressive greater-than-10% year-over-year order growth. Cisco noted U.S. Public Sector order growth broke into two different camps: Federal defense, state government, and higher education saw positive year-over-year order growth while Federal civilian, local government, and K-12 education suffered year-over-year order declines. Changes in public sector revenues have an even greater impact on Cisco’s bottom line as the public sector enjoys high gross margin relative to Cisco’s other customer end-markets. Cisco noted that its guidance assumes overall decreased levels of public sector spending despite this quarter’s positive year-over-year order growth.
Commercial. While down from 19% in the preceding quarter, the 12% year-over-year order growth posted in Cisco’s Commercial segment represents the eighth consecutive quarter of greater than 10% growth
Cash. Cisco generated $2.3 billion in operating cash flow, which is an increase of almost $700 million, or 40%, above the year-ago level and the third highest first quarter level of operating cash flow since Cisco’s inception. Net cash sequentially decreased by ($230) million to $27.5 billion from $27.8 billion in the preceding quarter as the $2.3 billion of operating cash flow was more than offset by the use of $1.5 billion to repurchase 100 million shares of stock (at an average price of $15.37 per share), $322 million to pay a quarterly dividend and an increase in working capital. In per share terms, net cash increased by $0.04 to $5.09 from $5.05 in the preceding quarter as the decrease in net cash was offset by the reduction in outstanding shares. Less than 10% -- $3.8 billion to be exact -- of Cisco’s $44 billion in gross cash resides in the U.S.
Turnaround Consistent with its planned 10,000 employee reduction announced in the fourth quarter of fiscal 2011, Cisco continued to reduce employment levels in the quarter to drive its goal of $1 billion in annualized operating expense savings. Total headcount decreased in the quarter by approximately 8,400 employees sequentially, or by more than (12.0)%, to 63,000. The headcount reduction includes the completion of the sale of the Juarez, Mexico manufacturing facilities in the quarter and continued reductions due to restructuring.
Cisco’s Valuation Relatively Low Vs S&P 500
Cisco’s valuation premium versus the S&P 500 is now below average historical levels in the past 5 years. Cisco is now trading at ~10x NTM earnings versus the S&P 500 trading at 12x. The current valuation discount versus the S&P 500 is now at ~15%, versus its average premium since 2005 of 5%. If investors assume Cisco’s valuation relationship versus the S&P 500 is supposed to remain more inline with historical levels, it indicates Cisco’s current valuation likely has little downside, my view.
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