tbr 4q10 cisco initial response report

TBRT EC H N O LO G Y B U S I N ES S R ES EAR C H , I N C .

Cisco Systems Inc.

NETWORK BUSINESS QUARTERLYSM

4Q10 INITIAL RESPONSE

Publish Date: Feb. 10, 2011Author: Scott Dennehy ([email protected]), NBQ Engagement ManagerContent Editor: John Byrne, NBQ Director

Fourth Calendar Quarter 2010Second Fiscal Quarter 2011 Ended Jan. 29, 2011

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©2011 Technology Business Research, Inc.2 Cisco 4Q10 Initial Response | Network Business Quarterly

TBR Position:Lagging economic issues and sales of next‐generation products will negatively impact Cisco in the short term.• Cisco’s datacenter, collaboration and wireless products and related services are contributing more to the company’s total revenues than its traditional routers and switches.

• As a result, Cisco will have difficulty achieving its revenue and margin goals, as these new products offer more bang for the buck and have a higher cost of sales associated with them.

• However, TBR expects these effects to be short‐term in nature; as these technologies become more widely deployed, Cisco should begin to see improved margins and revenues more in line with what the market has come to expect.

• The challenges Cisco experienced in several key markets in 3Q10 were on display again in 4Q10, and will remain for at least the next several quarters; however, the company is positioning itself to weather the storm and take advantage of longer‐term opportunities.

Cisco’s Corporate Strategies• Achieve consistent revenue growth in the 12% to 17% range.

• Drive video traffic with new products and applications, which will increase demand for network equipment from service providers and enterprises.

• Make strategic investments and acquisitions to fuel long‐term growth.

• Hire industry experts to help the company expand into adjacent markets.

Executive Summary

Following another quarter of weak revenue and lower margins, Cisco appears to be a company in transition

$7,976 $8,436 $8,808 $8,700 $8,236

$1,839 $1,932 $2,028 $2,050 $2,171

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4Q09 1Q10 2Q10 3Q10 4Q10

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CISCO REVENUE BY SEGMENT

Service Product

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SOURCE: TBR AND CISCO

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Cisco’s investments in new market adjacencies are paying off, but continued struggles in key markets are stifling growth

Executive Summary

Key Developments

4Q10 revenue exceeds guidance but casts doubt on long‐term growth prospects

• Cisco achieved 6% year‐to‐year growth in 4Q10, which was slightly higher than the company’s 3Q10 guidance of 3% to 5%, but well short of its long‐term goal of 12% to 17%. As expected, Cisco continued to see weakness in its public sector, service provider set‐top and consumer businesses.

• Cisco believes its FY11 revenue will grow in the 9% to 10% range, which raises the question as to whether or not the company’s future growth prospects are as bright as they were just a few quarters ago. We believe that to achieve its long‐term revenue goals, Cisco must take a hard look at its organizational structure to ensure that it is getting the most out of its investments.

Non‐traditional products and services are becoming key drivers of Cisco’s revenue

• Cisco’s New Products and Services segments saw the strongest growth during 4Q10, increasing 15% and 18% year‐to‐year, respectively, as customers continue to deploy products and services related to video/collaboration, datacenter virtualization and mobility. In fact, these two segments generated more combined revenue than routers and switches for the first time in Cisco’s history – an indication that its core business is moving away from the products that made the company what it is today.

• While Cisco’s routing business grew slightly year‐to‐year in 4Q10, its switching business declined 8%, as customers transitioned to the company’s next‐generation platforms, which offer more functionality for the price. The decline in public sector spending did not help matters, as Cisco typically sees healthy demand for switching products from this market.

Declining margins are forcing Cisco to address issues with its execution

• Cisco’s operating margin dropped almost 600 basis points sequentially in 4Q10, as operating expenses grew much faster than orders during the quarter. Echoing a theme that is eerily reminiscent of the 2008‐2009 recession, Cisco said it will focus more on expense reduction and resource realignment moving forward.

• TBR believes that while reducing expenses will certainly help, Cisco’s ability to get back on track is more dependent on how the company anticipates and responds to future market trends.

TBR


Despite strong growth from next‐generation platforms, Cisco’s core business is no longer tied to routers and switches alone

Segment Key Changes & Drivers 4Q10 Revenue

Growth Y/Y Trends to Monitor

Router

• High‐ and low‐end platforms grew 5% and 6% year‐to‐year, while mid‐range platforms decreased slightly.

• Cisco’s ASR product family continues to be the top performer, led by the ASR9000 and ASR5000, which grew 500% and 100% year‐to‐year, respectively.

$1.7 billion 7.2%

Cisco’s ability to help service providers monetize their networks through investments in IP infrastructure should keep routing revenues relatively consistent.

Switch

• Switching revenue declined year‐to‐year for the third consecutive quarter, as the public sector continues to curtail spending and customers transition to Cisco’s next‐generation platforms (e.g., Nexus).

• Nexus 7000 revenues grew almost 100% in 4Q10, and the platform now has an annualized run rate of $1 billion.

$3.2 billion –8.2%

Switching revenue will remain stagnant over the next few quarters, at least until more customers transition to newer platforms and the public sector loosens its grip on capital spending.

Executive Summary

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Enterprise adoption of new technologies is causing a major shift in Cisco’s revenue split

Segment Key Changes & Drivers 4Q10 Revenue

Growth Y/Y Trends to Monitor

New Products

• Strong year‐to‐year growth in New Products was driven by Datacenter (59%), Collaboration (37%) and Wireless (34%).

• Video Connected Home and Security products decreased 4% and 9% year‐to‐year, respectively, as Cisco’s set‐top box and public sector businesses continue to struggle.

$3.2 billion 15.0%

New products revenue should continue to grow as customers look to take advantage of the benefits provided by investing in virtualization, cloud computing and mobility.

Services

Customers opted for more of Cisco’s advanced services in 4Q10 (30% year‐to‐year growth) to assist in the deployment of the company’s next‐generation products such as UCS.

$2.2 billion 18.1%

• Services revenue will benefit from continued growth in Cisco’s New Products segment.

• Service margins may decline to some extent, as these services are generally less profitable.

Other

While Cisco is not a market leader in the segment, the company is getting relatively consistent results from its optical business.

$211 million 7.1%

Unless Cisco makes an aggressive move, revenue will not grow significantly in the short term.

Executive Summary

TBR


Cisco’s revenue and margins are lagging slightly behind its investments, forcing the company to take its foot off the gas pedalRevenue• Cisco generated total revenue of $10.4 billion in 4Q10, an increase of 6% year‐to‐year.

• As in the previous quarter, Cisco provided conservative guidance, forecasting 1Q11 revenue in the 4% to 6% range.

Expense• Total operating expenses increased both year‐to‐year (14%) and sequentially (2%), as Cisco continued to invest in both R&D and sales and marketing.

• TBR believes Cisco will reduce operating expenses as a percentage of revenue over the next few quarters until it sees better results.

Margin• Gross margin dropped significantly both year‐to‐year (400 basis points) and sequentially (250 basis points), mostly as a result of the negative impact of pricing pressure and adverse inventory adjustments on Cisco’s consumer business.

• In particular, the 2010 holiday season proved a much tougher market for high‐end consumer products than Cisco had expected; Flip video sales grew only half as much as forecasted.

Financial Model Strategy

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While Cisco’s next‐generation routers continue to gain traction, the company is becoming more aggressive in the low‐end switch market

Go‐to‐Market & Product Strategies

Key Developments

Router

• Cisco announced several new customer wins in 4Q10 for its high‐end routers, namely the CRS and ASR9000:

• Hong Kong Broadband Network Limited (HKBN) will be deploying the CRS‐3 to accommodate an increase in traffic demand and to extend its network coverage, while du, a telecom service provider in the United Arab Emirates, will use the CRS to converge its fixed and mobile IP transport networks to facilitate new high‐end mobile and data services.

• Megafon, a Russian mobile operator, will utilize the ASR9000 platform for its network backbone, enabling the operator to meet future demand for next‐generation services.

• Cisco also announced it will participate in World IPv6 Day, an event scheduled for June 2011 that will allow vendors and service providers to show their customers that their products and services are IPv6. TBR believes Cisco will be demonstrating the IPv6 capabilities of its router product lines, which will help market these products to service provider customers.

Switch

• Cisco rolled out two new platforms for its Catalyst switch family in 4Q10, as the company looks to capitalize on what it sees as a significant opportunity in the low‐end/commodity switching market. The Catalyst 3560‐C and 2960‐C Compact Series (C‐Series) switches are targeted at organizations that need connectivity in locations that are space or wiring‐constrained, such as retail stores, hotel rooms and warehouses. By providing products with enterprise‐class features at a low‐end price, the company believes it can gain an advantage in a $1 billion market against competitors such as HP, D‐Link, Adtran and Netgear.

• As part of a broader portfolio that includes storage and security products, Cisco also announced the availability of the 200 Series Smart Switch. Designed to enable SMBs to easily to deploy and manage a network, these products provide good quality of service and security features at a very low price point.

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Cisco rolled out new solutions in 4Q10 to help service providers monetize consumer demand for video content

Go‐to‐Market & Product Strategies

Key Developments

New Products

• As part of its goal of capitalizing on the dramatic increase in video‐based Internet traffic, Cisco announced several new products and customer wins in the space during 4Q10, most notably:• At the 2011 International Consumer Electronics Show (CES) in Las Vegas, Cisco unveiled Videoscape, a new line of products and services designed to help service providers offer their subscribers a more compelling TV experience. In an environment in which consumers are increasingly watching video on PCs, laptops and smartphones, Cisco believes Videoscape will position the television as the best medium to interact with digital TV, Web content and social media applications on a single platform. In addition, with the number of mobile devices consumers use to access video content continuing to grow (notebook/netbooks, tablets, smartphones, etc.), Videoscape also promises to allow users to take their TV experience with them wherever they go.

• The Cisco IP NGN Video Optimized Transport solution, which will enable broadcasters and service providers to build networks that deliver high‐quality video experiences to consumers.

• Service providers AT&T and BT announced the successful completion of the first network operator TelePresence exchange, which will allow business customers to connect with other TelePresence users on either network. The announcement is significant in that it greatly expands the reach of Cisco’s TelePresence solution, of which AT&T and BT are key service provider channel partners.

ServicesCisco Services witnessed strong demand for green IT solutions in 4Q10. In particular, Cisco was selected by Shell to monitor its IT energy use with Cisco EnergyWise, while gradually transforming and consolidating Shell’s IT infrastructure with solutions that provide enhanced energy efficiency.

OtherWhile Cisco did not make any major announcements within its Other product segment, the company is continuing to invest in optical networking. TBR expects to see more customer‐ and product‐related activity from this segment in the near future.

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Cisco added just 300 new employees in 4Q10, as the company continues to make small acquisitions and cut costs

Cisco’s Worldwide Operations

Investments/R&D Focus• Cisco made three small acquisitions in 4Q10 –Linesider Technologies, Pari Networks and Inlet Technologies – as the company looks to enhance its offerings in key market adjacencies such as video and cloud computing.

• Cisco also committed to investing approximately $500 million over the next five years to help develop East London Tech City, a U.K.‐based technology development community similar to North Carolina’s Research Triangle Park (RTP).

Personnel Changes• Cisco named Blair Christie as Chief Marketing Officer of Worldwide Government Affairs. Christie had been the company’s Senior Vice President of Global Corporate Communications.

• Luanne Tierney, Cisco’s Vice President of Worldwide Partner Marketing, left the company to become VP of Global Partner Marketing at the company’s cross‐town rival Juniper Networks.

Cisco continues to focus its hiring efforts on sales, as two‐thirds of the company’s 4Q10

hires were new account teams.

Resource Management Strategy

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72,605 72,935

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HEADCOUNT AND HEADCOUNT SEQUENTIAL CHANGE

Number of Employees Sequential Change

SOURCE: TBR AND CISCO

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Appendix – Income StatementConsolidated Income Statement(in $ Thousands)

CALENDAR QUARTER 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 Est.FISCAL QUARTER 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 Est.Net Sales 9,815,000$ 10,368,000$ 10,836,000$ 10,750,000$ 10,407,000$ 11,031,000$ Cost of Sales 3,483,000 3,738,000 4,043,000 3,995,000 4,146,000 4,300,000Gross Profit 6,332,000 6,630,000 6,793,000 6,755,000 6,261,000 6,731,000

R&D 1,247,000 1,411,000 1,391,000 1,431,000 1,478,000 1,450,000Sales and Marketing 2,110,000 2,260,000 2,351,000 2,402,000 2,444,000 2,410,000General and Administrative 467,000 497,000 595,000 458,000 452,000 442,000SG&A 2,577,000 2,757,000 2,946,000 2,860,000 2,896,000 2,852,000Amortization of Goodwill and Purchased Intangible Assets 138,000 117,000 131,000 113,000 203,000 185,000Operating Income 2,370,000$ 2,345,000$ 2,325,000$ 2,351,000$ 1,684,000$ 2,244,000$ Interest and Other Income, Net ‐15,000 58,000 93,000 74,000 46,000 67,000Earnings Before Taxes 2,355,000 2,403,000 2,418,000 2,425,000 1,730,000 2,311,000Provision for Income Taxes 502,000 211,000 483,000 495,000 209,000 471,240Net Income 1,853,000$ 2,192,000$ 1,935,000$ 1,930,000$ 1,521,000$ 1,839,760$ PERCENTAGE OF REVENUE 0.213163482 0.087806908 0.199751861 0.204123711 0.120809249Net Sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%Cost of Sales 35.5% 36.1% 37.3% 37.2% 39.8% 39.0%Gross Profit 64.5% 63.9% 62.7% 62.8% 60.2% 61.0%R&D 12.7% 13.6% 12.8% 13.3% 14.2% 13.1%Sales and Marketing 21.5% 21.8% 21.7% 22.3% 23.5% 21.8%General and Administrative 4.8% 4.8% 5.5% 4.3% 4.3% 4.0%SG&A 26.3% 26.6% 27.2% 26.6% 27.8% 25.9%Operating Income 24.1% 22.6% 21.5% 21.9% 16.2% 20.3%Realized Gain on Sale of Investment 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Interest and Other Income, Net ‐0.2% 0.6% 0.9% 0.7% 0.4% 0.6%Earnings Before Taxes 24.0% 23.2% 22.3% 22.6% 16.6% 21.0%Provision for Income Taxes 5.1% 2.0% 4.5% 4.6% 2.0% 4.3%Net Income 18.9% 21.1% 17.9% 18.0% 14.6% 16.7%

YEAR‐TO‐YEAR GROWTHNet Sales 8.0% 27.0% 27.0% 19.2% 6.0% 6.4%Cost of Sales 3.5% 27.4% 31.5% 27.5% 19.0% 15.0%Gross Profit 10.6% 26.8% 24.4% 14.7% ‐1.1% 1.5%R&D ‐2.5% 13.5% 8.7% 16.9% 18.5% 2.8%Sales and Marketing ‐2.1% 15.5% 17.0% 20.4% 15.8% 6.6%General and Administrative 22.9% 64.6% 21.9% 4.1% ‐3.2% ‐11.1%SG&A 1.7% 22.1% 18.0% 17.5% 12.4% 3.4%Operating Income 33.7% 45.9% 59.2% 10.7% ‐28.9% ‐4.3%Net Income 23.2% 61.5% 79.0% 8.0% ‐17.9% ‐16.1%SOURCE: TBR ESTIMATES AND CISCO

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Appendix – Balance SheetCISCO SYSTEMS, INC.Consolidated Balance Sheets(in $ Thousands)

CALENDAR QUARTER 4Q09 1Q10 2Q10 3Q10 4Q10FISCAL QUARTER 2Q10 3Q10 4Q10 1Q11 2Q11ASSETSCash and Equivalents 4,710,000$ 3,961,000$ 4,581,000$ 3,796,000$ 4,924,000$ Investments 34,928,000 35,145,000 35,280,000 35,129,000 35,305,000 Accounts Receivable, Net 4,237,000 4,078,000 4,929,000 4,471,000 4,620,000 Inventories 1,215,000 1,250,000 1,327,000 1,523,000 1,602,000 Deferred Tax Assets 2,233,000 2,277,000 2,126,000 1,992,000 2,054,000 Prepaid Expenses and Other Current 2,816,000 3,047,000 3,178,000 3,495,000 3,561,000 Total Current Assets 50,139,000 49,758,000 51,421,000 50,406,000 52,066,000 Property and Equipment, Net 3,958,000 3,994,000 3,941,000 3,984,000 4,031,000 Goodwill 14,423,000 16,668,000 16,674,000 16,742,000 16,746,000 Purchased intangible assets, net 2,661,000 3,448,000 3,274,000 3,176,000 2,799,000 Other Assets 5,222,000 5,424,000 5,820,000 5,707,000 6,339,000 Total Assets 76,403,000$ 79,292,000$ 81,130,000$ 80,015,000$ 81,981,000$

LIABILITIES AND EQUITYAccounts Payable 750,000$ 902,000$ 895,000$ 945,000$ 796,000$ Income Taxes Payable 103,000 167,000 90,000 126,000 163,000 Accrued Compensation 2,207,000 2,709,000 3,129,000 2,497,000 2,607,000 Short‐Term Debt ‐ 3,127,000 3,096,000 3,064,000 3,089,000 Deferred Revenue 6,751,000 7,154,000 7,664,000 7,420,000 7,878,000 Other Accrued Liabilities 4,594,000 4,380,000 4,359,000 4,068,000 3,972,000 Total Current Liabilities 14,405,000 18,439,000 19,233,000 18,120,000 18,505,000 Long‐Term Debt 15,194,000 12,119,000 12,188,000 12,214,000 12,152,000 Deferred revenue 2,906,000 3,149,000 3,419,000 3,316,000 3,929,000 Deferred Tax Liabilities 1,941,000 1,054,000 1,353,000 940,000 968,000 Other Long Term Liabilities 425,000 679,000 652,000 730,000 741,000 Total Stockholders' Equity 41,532,000 43,852,000 44,285,000 44,695,000 45,686,000 Total Liabilities and Equity 76,403,000$ 79,292,000$ 81,130,000$ 80,015,000$ 81,981,000$

FINANCIAL RATIOSDays Sales Outstanding 42.27 37.39 42.79 37.13 38.68Turns on Inventory 11.13 11.76 11.83 11.83 10.77Days Inventory Outstanding 32.80 31.04 30.86 30.85 33.90Fixed Asset Turnover 9.04 9.87 10.46 10.91 10.79Days Cash Outstanding 395.46 358.59 346.02 323.30 336.80Total Asset Turnover 0.51 0.52 0.53 0.54 0.53Debt/Asset Ratio 0.43 0.43 0.44 0.43 0.43Current Ratio 3.48 2.70 2.67 2.78 2.81Return on Assets 8.6% 8.7% 9.5% 10.3% 10.2%Return on Equity 15.0% 15.3% 16.9% 18.4% 18.2%Average Annual Revenue per Employee 543,042$ 572,347$ 595,572$ 601,497$ 594,899$ Employee Count 65,874 68,574 70,714 72,605 72,935 SOURCE: TBR AND CISCO

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