Cisco Holds Steady in Q2

After announcing disappointing guidance last quarter, Cisco Systems Inc. (Nasdaq: CSCO) didn't quite redeem itself when sharing earnings for its second fiscal quarter of 2005 (see Cisco Reports Q2).

For the second quarter ended Jan. 29, Cisco reported profits of $1.4 billion, or 21 cents per share, on revenues of $6.1 billion -- very close to the previous quarter's profits of $1.4 billion, or 21 cents per share, on revenues of $6 billion (see Cisco Disappoints With Q1).

Cisco's pro forma net income came to 22 cents per share, exactly matching analyst expectations as tallied by Reuters Research. Revenues likewise matched analyst expectations.

That's not a bad thing at all, to be sure, but investors had gotten used to Cisco beating estimates by a penny per share, a pattern the company has been breaking of late. In early after-hours trading, Cisco stock fell 46 cents (2.5%) to $17.78.

Worse, Cisco predicted revenue growth of zero to 2 percent for the third quarter, which ends in April. Analysts were expecting the company's revenues to grow 2 percent. Chambers noted that the third quarter will have one less week than usual -- but it's likely analysts already knew that.

Investors might take heart that Cisco's product gross margins stopped their fall, holding even at 67.3 percent. Gross margins have been eroding, which is a worry because Cisco's routing and switching talents are expected to become more commoditized over time.

In fact, CEO John Chambers noted that investors have been asking him if Cisco is due for a margin-killing price war as competition accelerates. On today's conference call with analysts, Chambers deflected that scenario by noting that Cisco has a wide product base and is working to become more than a hardware vendor. "Most companies that we study where these challenges have occurred only had one or two primary products, were often focused on one industry segment, and were primarily hardware companies," he said.

As an example of Cisco's new thinking, Chambers pointed to the strong ramp of Cisco's Integrated Services Routers (ISR), which last quarter hit a run rate of $1 billion per year in terms of orders and $600 million in terms of shipments. The routers were introduced in September and have helped Cisco become the point of origin for applications (see Cisco Takes Apps on Board).

That's key because Cisco believes it needs to integrate services into its routers in order to fend off low-cost competition from Asia (see Chinese Competitors Chew at Cisco). Cisco is hoping to battle that competition with a company-wide integration strategy.

"An integrated architecture has to be designed into the product from the initial product phase, not as an afterthought," Chambers said.

Gross margins on services dropped, to 64.4 percent from 67 percent the previous quarter. That's because Cisco is pumping extra money into this area, especially related to the "advanced technologies" Cisco is pursuing, which include wireless LANs, storage, optical, home networking, IP telephony, and security. In particular, Cisco is bringing in specialized employees to help in those areas, CFO Dennis Powell said.

The advanced technologies also gave Cisco some hints of future growth, as they averaged 15 percent order growth from the previous quarter and 40 percent growth compared with last year. Storage was a star, up 70 percent from the previous year. Overall, advanced technologies represent 19 percent of Cisco's revenues.

— Craig Matsumoto, Senior Editor, Light Reading
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