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Friday, February 5, 2010

Cisco and U.S. Employment: Pulling the Cart Ahead of the Horse?

Cisco Systems (CSCO, $23.53) reported strong results and provided better-than-expected guidance the other day - information can be found here. Cisco stated the following in its press release:
  • "Our outstanding Q2 results exceeded our expectations and we believe they provide a clear indication that we are entering the second phase of the economic recovery. During the quarter we saw dramatic across the board acceleration and sequential improvement in our business in almost all areas," said John Chambers, chairman and chief executive officer, Cisco.
Cisco also said it plans to hire a few thousand workers over the next several quarters (please see this WSJ article and/or the conference call transcript from SeekingAlpha.com for more).

Meanwhile, the Labor Department reported this morning that unemployment rate ticked down to 9.7% in January. This Reuters article noted that the improvement came on the back of "a sharp increase in the number of people giving up looking for work helped to depress the jobless rate", with "the number of 'discouraged job seekers' rose to 1.1 million in January from 734,000 a year ago". Payrolls actually dropped by 20,000 positions, which isn't good, and Market jitters are returning.

Still, can we draw a parallel between Cisco's rosy results/outlook and overall U.S. employment?

Based on our prior work as an Equity Analyst at Banc of America Securities, global technology spending/investment is driven by US GDP and non-farm payrolls (which are ~87% correlated with GDP). In fact, correlation with US GDP is north of 90% for global semiconductor revenue and connector/ components revenue.

Therefore, a GDP contraction has an immediate, negative impact on the broad tech sector and non-farm payrolls. The tight relationship is further explained by realizing that approximately 20-25% of global technology revenue is derived from the financial services sector. On the flip side, GDP expansion can have an immediate, positive effect on the broad tech sector and non-farm payrolls.

The below graph illustrates Cisco's revenue versus non-farm payrolls for 1997 – 2006 and the impact of the 2001 – 2003 downturn. Unfortunately, we don't have an updated graph, but the correlation is clear:
Relative to 2008-09 troubles (not illustrated in graph), we suspect the revenue decline during the tech bust was more pronounced for Cisco and other tech companies, where the entire sector was plagued by excess capacity and surplus inventory following abnormally inflated demand (obvious parallel to residential real estate in the more recent period, except that this time around, the excess was widespread and seemingly touches many more sectors of the economy).

We included current non-farm payrolls data in our "Which Way from Here?" presentation the other week. Below, we include one of the graphs from the Bureau of Labor Statistics that shows/implies initial stabilization in total employment:

Even with favorable Internet trends everywhere around us, Cisco no doubt benefits greatly from higher levels of U.S. (and global) employment. However, in this case, rather than the jobs coming first, perhaps the revenue is arriving first? That is, maybe the opposite of what is normally a chicken and egg scenario for Cisco (and many other companies) is happening? Cisco is pulling the cart before the horse? Hard to say. More likely than not -- as in the past -- we believe they'll move hand-in-hand despite the wall of macroeconomic worries and nagging job market weakness.

While we acknowledge that (1) near-term forecasting is near impossible (again, please see "Which Way from Here?") and (2) new hiring may remain constrained, we feel comfortable that Cisco's results and outlook are a step in the right direction.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2010 Jeffrey Walkenhorst
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