Cisco: A Growth-and-Guidance Disconnect

Also, product bookings were well below the 11%-15% growth that had been anticipated.
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A number of months ago, I indicated that any time a CEO characterizes a quarter as "solid," you have to watch out. In the case of

Cisco Systems

(CSCO) - Get Report

, the results for the first quarter of fiscal 2006 were essentially in line and "solid," according to CEO John Chambers. It was the guidance that disappointed and became the focal point of the conference call.

Revenue in the quarter was $6.55 billion, which was a gain of 10% year on year and a decline of 1% quarter on quarter. Pro forma earnings per share were 25 cents (GAAP EPS was 20 cents).

That compares with the Wall Street consensus of $6.58 billion and 24 cents. The company's gross margins rose 20 basis points sequentially to 68.1%, with operating margins slipping 80 basis points to 31.2%, due to headcount increases.

The balance sheet remains quite strong, but cash did decline about $2.6 billion because of a large stock-repurchase program during the quarter. (The 140 million shares repurchased were above plan, and were responsible for the $0.01/share "upside.")

Cash from operations was $1.4 billion. Accounts receivable rose $126 million, increasing days sales' outstanding by two to 32. Inventory also increased $21 million, adding one day to days of inventory (now 68 days).

From a product perspective, revenue from routers increased 13% year on year, Switches +3% YY, Advanced Technologies +25% YY and Services +13%. However, the book-to-bill ratio was slightly less than 1 in the quarter.

Management discusses its geographic regions in terms of "orders," not revenue. North America (53% of orders) was very balanced, with 14% YY growth. Asia/Pacific (12% of orders) and Emerging Markets (10% of orders) were this quarter's standouts at +32% YY and +22% YY, respectively. Europe (20% of orders) declined 5% and perennial problem Japan (5%) decline 22% YY.

New Approach to Guidance

Cisco instituted a new approach to guidance last quarter that included its outlook for the fiscal year as well as the subsequent quarter. Long term, management believes the company will grow in the 10%-15% range. Obviously, this is quite a change from those thrilling days of yesteryear. But given its size and a maturing industry, this is not all that bad.

Guidance for fiscal 2006 (ends July 31, 2006) is for revenue growth of 10%-12%, with order growth for the year of 10%-15%. Both figures are unchanged from the fiscal year guidance provided on the last call. The outlook for the second quarter of fiscal 2006 is for YY revenue growth of 8%-9%, with order growth of 10%-14%.

Gross margins are expected to be about 67%, and a slight increase in spending would bring operating margins in at about 30%. With a tax rate of about 28%, this should bring the second quarter of 2006 in at about $6.58 billion in revenue and 24 cents in EPS. The current Street consensus is $6.73 billion and 25 cents.

Back-End Loaded Guidance

The grinding of teeth surrounds the disconnect between the long-term growth rate, the guidance for the fiscal year, and the strong growth Cisco will need just to hit the midpoint of guidance. The company will have to grow 13% in the second half, making fiscal 2006 very back-end loaded.

Despite all the statistics, product revenue growth slowed in the quarter (+9.1% YY and down 120 basis points sequentially). With a book-to-bill ratio of less than 1, product bookings obviously were well below the 11%-15% growth that had been anticipated. Management made a number of cautionary comments about Europe. Germany and France were down on a YY basis and the U.K. was up only marginally. Because the major service providers in Europe have not suggested any deterioration in capital spending plans, it raises the question whether or not CSCO is beginning to see competitive pressures from the likes of

Huawei

and/or

Juniper

(JNPR) - Get Report

.

Management is convinced its architecture and product integration strategy will win the day with customers over the long term, compared with specific products from its competitors. But tomorrow the Street will be reducing estimates.

At the time of publication, Faulkner had no positions in stocks mentioned.

Bob Faulkner has been in the investment business for 18 years with an exclusive focus on technology stocks. He started as a sell-side analyst with Wood Gundy and Alex. Brown & Sons. In 1990, he moved to the asset management side with portfolio management/analytical positions at 1838 Investment Advisors and Merrill Lynch. Bob has an M.B.A. from Seton Hall and a B.S. from Waynesburg College.