Does an article on Cisco Systems (NASDAQ:CSCO) even require an introduction? I think not. Cisco reports its fiscal Q3 2006 numbers tomorrow after close of market.

What analysts say:

  • Buy, sell, or waffle? Thirty-five analysts follow Cisco, and it's a veritable lovefest up there on Wall Street. Twenty-seven of the analysts rate the stock a buy. Only six say hold, and only two, sell.
  • Revenues. Analysts expect 15.8% revenue growth, to $7.17 billion.
  • Earnings. Profits are expected to grow by 13% year over year, to $0.26 per share.

What management says:
Cisco last reported earnings in February. Back then, CEO John Chambers sounded particularly optimistic about the news we'll be hearing tomorrow, and about the future in general. Said Chambers: "We're pleased with the solid revenue and earnings per share results Cisco delivered during its second quarter, but also especially pleased with our strong order momentum.... This proves our strategy is working.... [T]he next generation of IT ... is transforming the way our customers create business models and design new forms of communication-based services for their customers, employees, and citizens. Cisco anticipated the need for intelligence throughout the network five years ago, and today those dividends are beginning to pay off."

What management does:
So far, however, the payoff isn't apparent in the company's margins. While none of the trends looks particularly serious, we have seen Cisco's rolling gross and operating margins erode somewhat over the last 18 months. The net margin is looking a little better, but that appears to owe more to the company paying lower taxes over the last couple of quarters than to any operational improvements.

Margins %

6/04

9/04

12/04

3/05

6/05

9/05

Gross

68.2

67.8

67.3

67.2

67.2

67.4

Op.

29.1

29.6

30

30

28.6

27.7

Net

20.6

22.8

23

23.1

22.1

21.5
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ending in the named months.

One Fool says:
So what exactly is going on at Cisco that has the company's margins eroding? In a word, SG&A. OK, I cheated -- that should actually be four words. SG&A is short for "selling, general, and administrative expenses," and they're running rampant at Cisco. Over the last six months, sales are up 10% versus last year, with cost of goods sold up only 9%. Meanwhile, SG&A have jumped an outrageous 27%, poking a sizeable hole in operating margins.

It's also true that research and development costs have skyrocketed -- up 21% against the aforementioned 10% rise in sales. But like Chambers said, "Those dividends are beginning to pay off." Er, I think the man meant "those investments are beginning to pay off." But you get the point. Cisco sees which way the world is heading, and it's laying out sizeable investments to ensure that its technology is the one chosen to get the world where it's going.

That's why, if we see R&D again outpacing sales tomorrow, I'll worry not a whit. Few companies can afford to keep up with cash-rich Cisco at the invest-in-your-future game, so the way I see it, the more Cisco pays on R&D, the better. If SG&A continues to outpace sales, however, that'll be another matter entirely.

Competitors:

  • 3Com (NASDAQ:COMS)
  • Alcatel (NYSE:ALA)
  • Nortel (NYSE:NT)
  • Lucent (NYSE:LU)
  • Avaya (NYSE:AV)
  • Ciena (NASDAQ:CIEN)

Fool contributor Rich Smith does not own shares of any company named above.