Just How Did Polycom Inc Grow Earnings by 28%?

By Markets Fool.com

Video-conferencing company Polycom Inc's first-quarter earnings were almost the stuff of a trivia question on a game show. Just how does a company report a 28% increase in non-GAAP EPS while its sales only rose 1%? The answer is obviously margin expansion.

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Just how did Polycom do it? Moreover, what are the underlying themes in its trading performance? Let's take a closer look.

Polycom reports first-quarter earnings
Firstly, a look at how Polycom's headlined numbers matched up to the company's guidance.

Q1 Guidance Q1 Actual Q2 Guidance
Revenue $328-$338 $330.7 $329-$339

Non-GAAP Gross Profit Margin

58.8%-59.2% 59.2% 59%-59.4%
Non-GAAP Operating Expenses 47.6%-48.2% 46.6% 46.9%-47.4%
Non-GAAP Operating Margin 10.6%-11.6% 12.6% 11.6%-12.5%
Non-GAAP EPS $0.19-$0.21 $0.23 $0.21-$0.23

Source: Polycom Inc Presentations. Revenue in millions of U.S. Dollars, EPS in U.S. Dollars.

In a nutshell, it's a similar story to the previous two earnings reports. In other words, Polycom is finding it difficult to generate meaningful revenue growth, but is managing to cut costs extensively. Indeed, as you can see in the table above, operating expenses came in lower than guidance, helping operating margin to come in significantly ahead of management's previous expectations.

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The question is, how much longer can Polycom rely on cost-cutting to generate earnings growth? When a company cuts costs, it's possible that it's taking the knife to parts of its operations responsible for generating revenue growth.

Revenue growth
Polycom competes in a highly competitive market with Cisco Systems, Inc,its highest profile competitor. As such, a combination of strong competition and sluggish end-market demand means Polycom is finding it hard to generate revenue growth.

For example, on the earnings call,Citigroup analyst Kim Watkins inquired as to whether Cisco becoming "a little more aggressive" was an issue in the first quarter. In response, Polycom CEO Peter Leav outlined his belief that Polycom had lost market share in the quarter in North America.

Furthermore, Leav stated, "Cisco's launch of new video endpoints, which was their first refresh of the Tandberg infrastructure that they had is having an impact, as you would imagine a new launch would have." In fact, Polycom's Americas sales -- its largest region, with 48% of sales in the quarter -- actually declined 4% year on year, and Leav outlined that he wasn't "pleased" with execution in North America.

Gross margin improvement
While its revenue growth remains paltry, margins continue to improve. Gross margin came in at the top of management's previous guidance -- not an easy thing to achieve given that revenue growth was below the midpoint of internal expectations. On the earnings call, CFO Laura Durr discussed why: "Our service gross margin was high during the quarter primarily because of the mix of revenue toward maintenance and continuing to be cost savings in that area."

Indeed, service margin came in at 62.3% compared to 60% for the first-quarter last year. However, it's notable that service revenue was flat in the quarter. On a more positive note, management's guidance of gross margin of 59% to 59.4% for the second quarter implies more margin improvement to come.

Operating expenses
The company significantly outperformed its own expectations for operating expenses in the first quarter, as the figure came in at 46.6% compared to the guidance range of 47.6% to 48.2%. However, the guidance for the second quarter implies a sequential increase in expenses.

Speaking on the issue on the earnings call, Durr argued:

The big driver in Q1 was commissions. And so we'll start to see some of that play in Q2. See some of that come up.

She also referenced "planned hires we have during the quarter."

In a nutshell, the improvement in operating margin looks set to reverse somewhat in the second quarter. Of course, this should not be an issue if revenue increases as a consequence of extra sales and marketing spending.

A familiar refrain
All told, it's a similar earnings report to those given in previous quarters; however management's outlook suggests some sequential increase in operating expenses. At some point, Polycom is going to have to generate revenue growth in order to really please investors, which is not an easy thing to do in a highly competitive marketplace, particularly when its performance in North America has been disappointing.

The article Just How Did Polycom Inc Grow Earnings by 28%? originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Polycom. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.