CISCO SYSTEMS, INC. quarterly report, Q3 FY2019

Full document

Cisco Systems, Inc. — Q3 FY2019 Form 10-Q

Reporting period: Quarter ended April 27, 2019; financial statements are unaudited. Amounts are in U.S. dollars; financial-statement amounts are in millions unless otherwise stated.

Business context

Cisco designs and sells networking and related technology, including infrastructure platforms, applications, security, and services. Management described continued investment in innovation, security and applications, and a shift toward software and subscriptions. Cisco completed its acquisition of Duo Security and Luxtera during the first nine months of FY2019 and sold its Service Provider Video Software Solutions (SPVSS) business in October 2018.

Financial performance

  • Q3 revenue: $12.958 billion, up 4% year over year as reported. Product revenue was $9.722 billion (+4%) and service revenue was $3.236 billion (+2%). Excluding SPVSS revenue in the prior-year comparison, total revenue grew 6% and product revenue grew 7%. Adoption of ASC 606 added $146 million to Q3 revenue.
  • Q3 earnings and margins: Gross margin was $8.173 billion, or 63.1% of revenue, versus 62.3% a year earlier. Operating income was $3.513 billion, up 12%, with a 27.1% operating margin versus 25.1%. Net income was $3.044 billion, up 13%; diluted EPS was $0.69 versus $0.56.
  • First nine months: Revenue was $38.476 billion (+5%); gross margin was $24.092 billion (62.6%); operating income was $10.529 billion (27.4% margin); and net income was $9.415 billion. Diluted EPS was $2.09. The prior-year nine-month period recorded a $3.693 billion net loss and a $0.76 diluted loss per share, principally due to the Tax Act charge.
  • Product mix: Q3 Infrastructure Platforms revenue was $7.545 billion (+5%), Applications $1.431 billion (+9%), and Security $707 million (+21%). Other Products fell to $39 million, primarily reflecting the SPVSS divestiture. Growth in Security also reflected the Duo acquisition.
  • Cash flow: Nine-month operating cash flow was $11.889 billion, compared with $9.566 billion. Capital expenditures were $701 million, yielding company-defined free cash flow of $11.188 billion versus $8.946 billion. Cash flow comparisons include period-specific working-capital and tax-payment movements.
  • Liquidity and debt: Cash, cash equivalents, and investments totaled $34.643 billion at April 27, 2019, down from $46.548 billion at July 28, 2018. Total debt carrying value was $23.698 billion ($7.777 billion short-term and $15.921 billion long-term), versus $25.569 billion at fiscal year-end. Cisco had $3.283 billion of commercial paper outstanding and an unused $3.0 billion revolving credit facility; it reported compliance with debt covenants.
  • Capital returns: In the first nine months, Cisco repurchased $16.042 billion of shares under its program and paid $4.489 billion in dividends. The board authorized an additional $15 billion of repurchases in February; approximately $18 billion remained authorized at quarter-end.

Changes, outlook, and material items

  • Q3 revenue increased in the Americas and EMEA but declined 6% in APJC; product revenue in China declined 21%. Management also reported a 15% aggregate product revenue decline in the BRICM emerging markets for the quarter. It cited strength in public sector, enterprise, and commercial markets, partly offset by service-provider weakness.
  • Management attributed the Q3 gross-margin improvement to productivity and the SPVSS divestiture, partly offset by pricing and product mix. Q3 gross margin also benefited from the disposal of the lower-margin business. Nine-month operating results benefited from a $400 million Arista litigation settlement recognized in G&A in Q1.
  • ASC 606, adopted at the start of FY2019 using the modified retrospective method, accelerated recognition for certain software arrangements and distributor sales. It increased revenue by $662 million for the first nine months and reduced deferred revenue at adoption; the prior-year figures were not recast. The reported FY2018 nine-month tax rate and loss are not representative of ordinary operating performance because of the one-time Tax Act charge.
  • Cisco gave no specific forward revenue or earnings guidance in the supplied filing text. Management characterized the environment as challenging and uncertain, while stating its belief that available liquidity, operating cash generation, capital-market access, and committed credit lines would meet requirements for at least the next 12 months. The FY2018 restructuring plan was expected to be substantially completed in the first half of FY2020; estimated pretax charges were approximately $600 million, with $390 million incurred cumulatively by quarter-end.
  • Contingencies: Brazilian tax authorities asserted claims aggregating $2.506 billion, including taxes, interest, and penalties. Cisco disputed the claims, but said it could not assess the likelihood of an unfavorable outcome or reasonably estimate a loss range. Separately, the Federal Circuit vacated an enhanced-damages award in the SRI patent matter and remanded part of the infringement finding; Cisco said it did not expect the matter to be material. The filing describes other intellectual-property and ordinary-course litigation risks.
  • Other risks highlighted include economic and geopolitical uncertainty, intense competition and pricing pressure, service-provider spending volatility, supply constraints and inventory exposure, execution of the software/subscription transition, foreign-exchange and investment-market movements, cybersecurity and product vulnerabilities, and tax uncertainty. Approximately $0.7 billion of U.S. transition tax was payable within one year; total transition-tax payable was $7.4 billion.

Most important facts for investors to verify

  • How much of reported growth reflects underlying demand versus ASC 606 timing effects, acquisitions, and the SPVSS divestiture.
  • Whether growth in Applications and Security can continue, and whether weakness in service providers, APJC, and China persists.
  • Whether gross-margin gains from productivity and portfolio mix can offset pricing pressure and product-mix headwinds.
  • How sustainable operating cash flow and free cash flow are, considering tax payments, working-capital timing, debt maturities, and continued large share repurchases and dividends.
  • Developments in the Brazilian tax claims and other litigation, and the financial effect, if any, of adverse outcomes.
  • Whether the FY2018 restructuring is completed on schedule and within its estimated charge, and whether investment in priority areas produces expected returns.