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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JANUARY 26, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___________ TO ___________
COMMISSION FILE NUMBER 0-18225
CISCO SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 77-0059951
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
170 WEST TASMAN DRIVE
SAN JOSE, CALIFORNIA 95134
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE AND ZIP CODE)
(408) 526-4000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to filing requirements
for the past 90 days.
YES [X] NO [ ]
As of February 22, 2002, 7,321,504,303 shares of the registrant's common stock
were outstanding.
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CISCO SYSTEMS, INC.
FORM 10-Q FOR THE QUARTER ENDED JANUARY 26, 2002
INDEX
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
a) Consolidated Statements of Operations for the three and six months
ended January 26, 2002 and January 27, 2001 3
b) Consolidated Balance Sheets at January 26, 2002 and July 28, 2001 4
c) Consolidated Statements of Cash Flows for the six months ended
January 26, 2002 and January 27, 2001 5
d) Consolidated Statements of Shareholders' Equity for the six months
ended January 26, 2002 and January 27, 2001 6
e) Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 28
Item 3. Quantitative and Qualitative Disclosures About Market Risk 54
Part II. Other Information
Item 1. Legal Proceedings 55
Item 6. Exhibits and Reports on Form 8-K 55
Signature 56
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN MILLIONS, EXCEPT PER-SHARE AMOUNTS)
(UNAUDITED)
Three Months Ended Six Months Ended
------------------------- -------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
NET SALES:
Product $ 4,022 $ 6,064 $ 7,678 $11,975
Services 794 684 1,586 1,292
------- ------- ------- -------
Total net sales 4,816 6,748 9,264 13,267
------- ------- ------- -------
COST OF SALES:
Product 1,593 2,310 3,093 4,432
Services 253 271 509 527
------- ------- ------- -------
Total cost of sales 1,846 2,581 3,602 4,959
------- ------- ------- -------
GROSS MARGIN 2,970 4,167 5,662 8,308
OPERATING EXPENSES:
Research and development 862 1,012 1,779 1,959
Sales and marketing 1,071 1,434 2,167 2,796
General and administrative 148 196 299 392
Amortization of goodwill -- 169 -- 313
Amortization of purchased intangible assets 136 87 282 168
In-process research and development -- 237 37 746
------- ------- ------- -------
Total operating expenses 2,217 3,135 4,564 6,374
------- ------- ------- -------
OPERATING INCOME 753 1,032 1,098 1,934
Interest and other income (losses), net 179 275 (509) 695
------- ------- ------- -------
INCOME BEFORE PROVISION
FOR INCOME TAXES 932 1,307 589 2,629
Provision for income taxes 272 433 197 957
------- ------- ------- -------
NET INCOME $ 660 $ 874 $ 392 $ 1,672
======= ======= ======= =======
Net income per share--basic $ 0.09 $ 0.12 $ 0.05 $ 0.23
======= ======= ======= =======
Net income per share--diluted $ 0.09 $ 0.12 $ 0.05 $ 0.22
======= ======= ======= =======
Shares used in per-share calculation--basic 7,311 7,144 7,309 7,121
======= ======= ======= =======
Shares used in per-share calculation--diluted 7,496 7,556 7,480 7,567
======= ======= ======= =======
See Notes to Consolidated Financial Statements.
3
CISCO SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT PAR VALUE)
(UNAUDITED)
January 26, July 28,
2002 2001
----------- --------
ASSETS
Current assets:
Cash and cash equivalents $ 5,337 $ 4,873
Short-term investments 2,211 2,034
Accounts receivable, net of allowance for doubtful accounts
of $336 at January 26, 2002 and $288 at July 28, 2001 1,150 1,466
Inventories, net 1,023 1,684
Deferred tax assets 2,085 1,809
Lease receivables, net 389 405
Prepaid expenses and other current assets 570 564
-------- --------
Total current assets 12,765 12,835
Investments 12,299 10,346
Restricted investments 1,161 1,264
Property and equipment, net 2,504 2,591
Goodwill 3,326 3,189
Purchased intangible assets, net 1,224 1,470
Lease receivables, net 67 253
Other assets 3,358 3,290
-------- --------
TOTAL ASSETS $ 36,704 $ 35,238
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 371 $ 644
Income taxes payable 277 241
Accrued compensation 1,414 1,058
Deferred revenue 3,047 2,470
Other accrued liabilities 2,366 2,553
Restructuring liabilities 278 386
-------- --------
Total current liabilities 7,753 7,352
Deferred revenue 790 744
-------- --------
Total liabilities 8,543 8,096
-------- --------
Commitments and contingencies (Note 6)
Minority interest 18 22
Shareholders' equity:
Preferred stock, no par value: 5 shares authorized;
none issued and outstanding -- --
Common stock and additional paid-in capital, $0.001 par value:
20,000 shares authorized; 7,335 and 7,324 shares issued and
outstanding at January 26, 2002 and July 28, 2001, respectively 20,603 20,051
Retained earnings 7,246 7,344
Accumulated other comprehensive income (loss) 294 (275)
-------- --------
Total shareholders' equity 28,143 27,120
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 36,704 $ 35,238
======== ========
See Notes to Consolidated Financial Statements.
4
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)
Six Months Ended
-------------------------
January 26, January 27,
2002 2001
----------- -----------
Cash flows from operating activities:
Net income $ 392 $ 1,672
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 935 974
Provision for doubtful accounts 60 52
Provision for (benefit from) inventory (3) 338
Deferred income taxes (445) (661)
Tax benefits from employee stock option plans 49 1,662
In-process research and development 25 637
Net (gains) losses on investments and provision for losses 1,014 43
Change in operating assets and liabilities:
Accounts receivable 256 (1,261)
Inventories 570 (1,637)
Prepaid expenses and other current assets 15 (93)
Accounts payable (273) 193
Income taxes payable 35 54
Accrued compensation 356 (5)
Deferred revenue 623 608
Other accrued liabilities (110) 250
Restructuring liabilities (108) --
------- -------
Net cash provided by operating activities 3,391 2,826
------- -------
Cash flows from investing activities:
Purchases of short-term investments (2,762) (1,975)
Proceeds from sales and maturities of short-term investments 3,173 2,818
Purchases of investments (8,441) (9,866)
Proceeds from sales and maturities of investments 5,680 7,793
Purchases of restricted investments (61) (489)
Proceeds from sales and maturities of restricted investments 191 705
Acquisition of property and equipment (482) (1,208)
Acquisition of businesses, net of cash and cash equivalents 14 (24)
Change in lease receivables, net 202 145
Purchases of investments in privately held companies (37) (806)
Lease deposits (73) (320)
Purchase of minority interest of Cisco Systems, K.K. (Japan) (65) --
Other (43) (535)
------- -------
Net cash used in investing activities (2,704) (3,762)
------- -------
Cash flows from financing activities:
Issuance of common stock 384 698
Repurchase of common stock (601) --
Other (6) (2)
------- -------
Net cash provided by (used in) financing activities (223) 696
------- -------
Net increase (decrease) in cash and cash equivalents 464 (240)
Cash and cash equivalents, beginning of period 4,873 4,234
------- -------
Cash and cash equivalents, end of period $ 5,337 $ 3,994
======= =======
See Notes to Consolidated Financial Statements.
5
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN MILLIONS)
(UNAUDITED)
Common Stock Accumulated
and Other Total
Six Months Shares of Additional Retained Comprehensive Shareholders'
Ended January 27, 2001 Common Stock Paid-In Capital Earnings Income Equity
---------------------- ------------ --------------- -------- -------------- -------------
BALANCE AT JULY 29, 2000 7,138 $ 14,609 $ 8,358 $ 3,530 $ 26,497
Net income -- -- 1,672 -- 1,672
Change in unrealized gains and losses
on investments -- -- -- (2,263) (2,263)
Other -- -- -- (2) (2)
--------
Comprehensive loss -- -- -- -- (593)
--------
Issuance of common stock 74 698 -- -- 698
Tax benefits from employee stock
option plans -- 1,183 -- -- 1,183
Purchase acquisitions 29 1,648 -- -- 1,648
Amortization of deferred stock-based
compensation -- 65 -- -- 65
-------- -------- -------- -------- --------
BALANCE AT JANUARY 27, 2001 7,241 $ 18,203 $ 10,030 $ 1,265 $ 29,498
======== ======== ======== ======== ========
Common Stock Accumulated
and Other Total
Six Months Shares of Additional Retained Comprehensive Shareholders'
Ended January 26, 2002 Common Stock Paid-In Capital Earnings Income (Loss) Equity
---------------------- ------------ --------------- -------- ------------- -------------
BALANCE AT JULY 28, 2001 7,324 $ 20,051 $ 7,344 $ (275) $ 27,120
Net income -- -- 392 -- 392
Change in unrealized gains and losses
on investments -- -- -- 581 581
Other -- -- -- (12) (12)
--------
Comprehensive income -- -- -- -- 961
--------
Issuance of common stock 43 384 -- -- 384
Repurchase of common stock (40) (111) (490) -- (601)
Tax benefits from employee stock
option plans -- 49 -- -- 49
Purchase acquisitions 8 128 -- -- 128
Amortization of deferred stock-based
compensation -- 102 -- -- 102
-------- -------- -------- -------- --------
BALANCE AT JANUARY 26, 2002 7,335 $ 20,603 $ 7,246 $ 294 $ 28,143
======== ======== ======== ======== ========
See Notes to Consolidated Financial Statements.
6
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. DESCRIPTION OF BUSINESS
Cisco Systems, Inc. (the "Company" or "Cisco") is the worldwide leader in
networking for the Internet. Cisco Internet Protocol ("IP")-based networking
solutions are the foundation of the Internet and are installed at corporations,
public institutions, telecommunication companies, and in a growing number of
medium-sized commercial enterprises. Cisco provides a broad line of solutions
for transporting data, voice, and video within buildings, across campuses, or
around the world. Cisco solutions allow networks, both public and private, to
operate with flexibility, security, and performance.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Year
The Company's fiscal year is the 52 or 53 weeks ending on the last Saturday in
July. Fiscal 2002 and 2001 are 52-week fiscal years.
Basis of Presentation
The accompanying financial data as of January 26, 2002 and for the three and six
months ended January 26, 2002 and January 27, 2001 has been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission ("SEC"). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
rules and regulations. The July 28, 2001 Consolidated Balance Sheet was derived
from audited financial statements, but does not include all disclosures required
by generally accepted accounting principles. However, the Company believes that
the disclosures are adequate to make the information presented not misleading.
These Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the fiscal year ended July 28, 2001.
In the opinion of management, all adjustments (which include normal recurring
adjustments except as disclosed herein) necessary to present a fair statement of
financial position as of January 26, 2002, results of operations for the three
and six months ended January 26, 2002 and January 27, 2001, and cash flows and
shareholders' equity for the six months ended January 26, 2002 and January 27,
2001 have been made. The results of operations for the three and six months
ended January 26, 2002 are not necessarily indicative of the operating results
for the full fiscal year or any future periods.
Certain reclassifications have been made to prior period balances in order to
conform to the current period presentation.
7
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Computation of Net Income per Share
Basic net income per share is computed using the weighted-average number of
common shares outstanding during the period. Diluted net income per share is
computed using the weighted-average number of common shares and dilutive
potential common shares outstanding during the period. Dilutive potential common
shares primarily consist of employee stock options.
Goodwill and Purchased Intangible Assets
In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets" ("SFAS 142"). SFAS 142 requires goodwill to be tested for impairment
under certain circumstances, and written down when impaired, rather than being
amortized as previous standards required. Furthermore, SFAS 142 requires
purchased intangible assets other than goodwill to be amortized over their
useful lives unless these lives are determined to be indefinite.
SFAS 142 is effective for fiscal years beginning after December 15, 2001;
however, the Company elected to early-adopt the standard effective the beginning
of fiscal 2002. In accordance with SFAS 142, the Company ceased amortizing
goodwill totaling $3.2 billion as of the beginning of fiscal 2002, including $55
million of acquired workforce intangible previously classified as purchased
intangible assets, net of related deferred tax liabilities.
Purchased intangible assets are carried at cost less accumulated amortization.
Amortization is computed over the estimated useful lives of the respective
assets, generally two to five years.
8
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table presents the impact of SFAS 142 on net income and net income
per share had the standard been in effect for the three and six months ended
January 27, 2001 (in millions, except per-share amounts):
Three Months Ended Six Months Ended
--------------------------- ---------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Net income--as reported $ 660 $ 874 $ 392 $ 1,672
Adjustments:
Amortization of goodwill -- 169 -- 313
Amortization of acquired
workforce intangible
previously classified as
purchased intangible assets -- 3 -- 5
Income tax effect -- (25) -- (45)
------- ------- ------- -------
Net adjustments -- 147 -- 273
------- ------- ------- -------
Net income--adjusted $ 660 $ 1,021 $ 392 $ 1,945
======= ======= ======= =======
Basic net income per
share--as reported $ 0.09 $ 0.12 $ 0.05 $ 0.23
Basic net income per
share--adjusted $ 0.09 $ 0.14 $ 0.05 $ 0.27
Diluted net income per
share--as reported $ 0.09 $ 0.12 $ 0.05 $ 0.22
Diluted net income per
share--adjusted $ 0.09 $ 0.14 $ 0.05 $ 0.26
The Company is required to perform goodwill impairment tests on an annual basis
and between annual tests in certain circumstances. As of January 26, 2002, no
impairment of goodwill has been recognized. There can be no assurance that
future goodwill impairment tests will not result in a charge to earnings.
9
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Recent Accounting Pronouncement
In October 2001, the FASB issued Statement of Financial Accounting Standards No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
144"). SFAS 144 establishes a single accounting model, based on the framework
established in Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of" ("SFAS 121"), for long-lived assets to be disposed of by sale, and resolves
implementation issues related to SFAS 121. The Company is currently assessing
the impact of SFAS 144 on its operating results and financial condition. The
Company is required to adopt SFAS 144 no later than the first quarter of fiscal
2003.
3. BUSINESS COMBINATIONS
During the first quarter of fiscal 2002, the Company completed the acquisitions
of Allegro Systems, Inc. ("Allegro") and AuroraNetics, Inc. ("AuroraNetics"). No
acquisitions were completed during the second quarter of fiscal 2002. A summary
of the purchase transactions completed in the first six months of fiscal 2002 is
outlined as follows (in millions):
Consideration Purchased
Including Assumed In-Process Intangible
Acquired Company Liabilities R&D Expense Goodwill Assets
----------------- ------------------ ------------ -------- -----------
Allegro $138 $ 28 $ 5 $105
AuroraNetics 51 9 16 14
---- ---- ---- ----
Total $189 $ 37 $ 21 $119
==== ==== ==== ====
In connection with the above purchase acquisitions, the Company may be required
to pay certain additional amounts of up to $145 million, payable in common stock
and to be accounted for under the purchase method, contingent upon Allegro and
AuroraNetics achieving certain agreed upon milestones.
The amounts allocated to in-process research and development ("in-process R&D")
were determined through established valuation techniques in the high-technology
communications equipment industry and were expensed upon acquisition because
technological feasibility had not been established and no future alternative
uses existed. Total in-process R&D expense for the first six months of fiscal
2002 and 2001 was $37 million and $746 million, respectively. The in-process R&D
expense that was attributable to stock consideration for the same periods was
$25 million and $637 million, respectively.
10
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The remaining purchase price was primarily allocated to tangible assets and
deferred stock-based compensation. At January 26, 2002 and July 28, 2001, the
total unamortized deferred stock-based compensation was $215 million and $293
million, respectively, and was reflected as a debit to additional paid-in
capital in the Consolidated Statements of Shareholders' Equity.
The Consolidated Financial Statements include the operating results of each
business from the date of acquisition. Pro forma results of operations have not
been presented because the effects of these acquisitions were not material on
either an individual or aggregate basis.
The following tables present details of the Company's total purchased intangible
assets (in millions):
Accumulated
January 26, 2002 Gross Amortization Net
---------------- ------ ------------ --------
Technology $1,096 $ (359) $ 737
Technology licenses 523 (259) 264
Patents 212 (62) 150
Other 135 (62) 73
------ ------ ------
Total $1,966 $ (742) $1,224
====== ====== ======
Accumulated
July 28, 2001 Gross Amortization Net
------------- ------ ------------ --------
Technology $1,053 $ (240) $ 813
Technology licenses 523 (191) 332
Patents 232 (44) 188
Acquired workforce 91 (20) 71
Other 117 (51) 66
------ ------ ------
Total $2,016 $ (546) $1,470
====== ====== ======
11
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table presents details of the amortization expense of purchased
intangible assets as reported in the Consolidated Statements of Operations (in
millions):
Three Months Ended Six Months Ended
------------------------- --------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ---------- ---------- ----------
Reported as:
Cost of sales $ 6 $ 6 $ 12 $ 10
Operating expenses 136 87 282 168
------ ------ ------ -------
Total $ 142 $ 93 $ 294 $ 178
====== ====== ====== =======
The estimated future amortization expense of purchased intangible assets as of
January 26, 2002 is as follows (in millions):
Fiscal Year: Amount
------------ -------
2002 (remaining six months) $ 268
2003 416
2004 291
2005 199
2006 49
2007 1
-------
Total $ 1,224
=======
The following table presents the changes in goodwill allocated to the reportable
segments during the first six months of fiscal 2002 (in millions):
Balance at Balance at
July 28, January 26,
2001 Acquired Adjustments 2002
--------- --------- ----------- -----------
Americas $2,177 $ 11 $ 38 $2,226
EMEA 531 6 12 549
Asia Pacific 110 2 4 116
Japan 371 63 1 435
------ ------ ------ ------
Total $3,189 $ 82 $ 55 $3,326
====== ====== ====== ======
12
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In the first six months of fiscal 2002, the Company purchased a portion of the
minority interest of Cisco Systems, K.K. (Japan). As a result, the Company
increased its ownership to 90.4% of the voting rights of Cisco Systems, K.K.
(Japan) and recorded goodwill of $61 million. The adjustments during the first
six months of fiscal 2002 were due to the reclassification of acquired workforce
intangible and the related deferred tax liabilities to goodwill as a result of
the adoption of SFAS 142.
4. RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES AND PROVISION FOR INVENTORY
On April 16, 2001, due to macroeconomic and capital spending issues affecting
the networking industry, the Company announced a restructuring program to
prioritize its initiatives around a focus on profit contribution, high-growth
areas of its business, reduction of expenses, and improved efficiency. This
restructuring program included a worldwide workforce reduction, consolidation of
excess facilities, and restructuring of certain business functions.
As a result of the restructuring program and decline in forecasted revenue in
the third quarter of fiscal 2001, the Company recorded restructuring costs and
other special charges of $1.2 billion and an additional excess inventory charge
of $2.2 billion. The following paragraphs provide detailed information relating
to the status of the restructuring liabilities and additional excess inventory
reserve as of January 26, 2002.
Worldwide Workforce Reduction, Consolidation of Excess Facilities, and Other
Special Charges
The following table summarizes the activity related to the restructuring
liabilities during the first six months of fiscal 2002 (in millions):
Balance at Cash Balance at
July 28, 2001 Reclassification(1) Payments January 26, 2002
------------- ------------------ -------- ----------------
Workforce reduction $ 61 $ (31) $ (21) $ 9
Consolidation of excess
facilities and other charges 325 31 (87) 269
----- ----- ----- -----
Total $ 386 $ -- $(108) $ 278
===== ===== ===== =====
Note 1: Due to changes in previous estimates, the Company reclassified $31
million of restructuring liabilities related to the workforce reduction charges
to consolidation of excess facilities and other charges.
13
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following is a summary of the restructuring liabilities from the third
quarter of fiscal 2001 to January 26, 2002 (in millions):
Total Non-Cash Cash Balance at
Charge Reclassification Charges Payments January 26, 2002
------ ---------------- -------- -------- ----------------
Workforce reduction $ 397 $ (31) $ (71) $ (286) $ 9
Consolidation of excess
facilities and other charges 484 31 (141) (105) 269
Impairment of goodwill and
purchased intangible assets 289 -- (289) -- --
------ ------ ------ ------ ------
Total $1,170 $ -- $ (501) $ (391) $ 278
====== ====== ====== ====== ======
The worldwide workforce reduction program started in the third quarter of fiscal
2001. As of January 26, 2002, approximately 5,300 regular employees have been
terminated and paid. Amounts related to the net lease expense due to the
consolidation of facilities will be paid over the respective lease terms through
fiscal 2007.
Provision for Inventory
The following is a summary of the change in the additional excess inventory
reserve during the second quarter of fiscal 2002 (in millions):
Excess Inventory Excess Inventory
Reserve Benefit
----------------- -----------------
Reserve balance as of October 27, 2001 $ 843 $ --
Usage:
Inventory scrapped (477) --
Sale of inventory (32) 10
Inventory utilized (140) 140
Settlement of purchase commitments (55) 45
----- -----
(704) $ 195
=====
-----
Remaining reserve balance as of January 26, 2002 $ 139
=====
14
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following is a summary of the additional excess inventory reserve from the
third quarter of fiscal 2001 to January 26, 2002 (in millions):
Excess Inventory Excess Inventory
Reserve Benefit
--------------- ----------------
Initial additional excess inventory charge $ 2,249 $ --
Usage:
Inventory scrapped (1,032) --
Sale of inventory (153) 23
Inventory utilized (423) 423
Settlement of purchase commitments (502) 226
------- -------
(2,110) $ 672
------- =======
Remaining reserve balance as of January 26, 2002 $ 139
=======
5. BALANCE SHEET DETAILS
The following tables provide details of selected balance sheet items (in
millions):
January 26, July 28,
2002 2001
--------- -------
Inventories, net:
Raw materials $ 64 $ 662
Work in process 339 260
Finished goods 537 669
Demonstration systems 83 93
------- -------
Total $ 1,023 $ 1,684
======= =======
Other assets:
Deferred tax assets $ 1,304 $ 1,314
Investments in privately held companies, net 683 775
Income tax receivable 443 443
Lease deposits 393 320
Structured loans, net 97 84
Other 438 354
------- -------
Total $ 3,358 $ 3,290
======= =======
15
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. BALANCE SHEET DETAILS (CONTINUED)
January 26, July 28,
2002 2001
---------- -------
Deferred Revenue:
Services $ 2,133 $ 2,027
Product 1,704 1,187
------- -------
Total 3,837 3,214
Less, current portion (3,047) (2,470)
------- -------
Long-term deferred revenue $ 790 $ 744
======= =======
6. COMMITMENTS AND CONTINGENCIES
Leases
The Company has entered into several agreements to lease sites, both completed
and under construction, with buildings totaling 8.8 million square feet of space
in San Jose, California and surrounding areas; Boxborough, Massachusetts; Salem,
New Hampshire; Richardson, Texas; and Research Triangle Park, North Carolina.
These lease agreements also cover 297 acres of land at these sites.
All of the leases have initial terms of five to seven years and options to renew
for an additional three to five years, subject to certain conditions. At any
time during the terms of these leases, the Company may, at its option, purchase
the land or both land and buildings. The Company may purchase the buildings at
approximately the amount expended by the lessors to construct the buildings. If
the Company elects not to purchase the land or both land and buildings at the
end of each of the leases, the Company has guaranteed a residual value of $1.6
billion at January 26, 2002. The lessors of the properties have committed to
fund up to a maximum of $2.3 billion, subject to reductions based on certain
conditions in the respective leases, with the portion of the committed amount
actually used to be determined by the Company. Rent obligations for the
buildings commenced on various dates and will expire at the same time as the
land leases.
As part of the above lease transactions, the Company restricted $1.2 billion of
its investment securities as collateral for specified obligations of the lessors
under the leases. These investment securities are restricted as to withdrawal.
16
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company also leases office space in other U.S. locations, as well as
locations in the Americas; Europe, the Middle East, and Africa ("EMEA"); Asia
Pacific; and Japan. Future annual minimum lease payments under all noncancelable
operating leases with an initial term in excess of one year as of January 26,
2002 are as follows (in millions):
Fiscal Year: Amount
------------ -------
2002 (remaining six months) $ 164
2003 317
2004 292
2005 250
2006 196
Thereafter 858
-------
Total $ 2,077
=======
Derivative Instruments
The Company conducts business on a global basis in several currencies. As such,
it is exposed to adverse movements in foreign currency exchange rates. The
Company enters into foreign exchange forward contracts to reduce the short-term
impact of foreign currency fluctuations on foreign currency receivables,
investments, and payables. The gains and losses on the foreign exchange forward
contracts offset the transaction gains and losses on the foreign currency
receivables, investments, and payables recognized in earnings.
The Company does not enter into foreign exchange forward contracts for trading
purposes. Gains and losses on the contracts are included in interest and other
income (losses), net, in the Company's Consolidated Statements of Operations and
offset foreign exchange gains or losses from the revaluation of intercompany
balances or other current assets, investments, and liabilities denominated in
currencies other than the functional currency of the reporting entity. The
Company's foreign exchange forward contracts related to current assets and
liabilities generally range from one to three months in original maturity.
Additionally, the Company enters into foreign exchange forward contracts related
to long-term financing commitments with maturities of up to three years. The
foreign exchange contracts related to investments generally have maturities of
less than one year.
The Company periodically hedges foreign currency forecasted transactions related
to certain operating expenses with purchased currency options. These
transactions are treated as cash flow hedges in accordance with Statement of
Financial Accounting Standards No. 133. These purchased currency options
generally have maturities of less than one year. The Company does not purchase
currency options for trading purposes.
17
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Foreign exchange forward and option contracts as of January 26, 2002 are
summarized as follows (in millions):
Notional Fair
Amount Value
-------- ------
Forward contracts:
Purchased $ 725 $ --
Sold $1,209 $ 10
Option contracts:
Purchased $ 403 $ 6
The Company has entered into forward sale agreements of equity securities as
fair value hedges of the changes in the fair value of equity securities. The
investments were classified as available for sale.
The Company's foreign exchange forward and option contracts and forward sale
agreements expose the Company to credit risk to the extent that the
counterparties may be unable to meet the terms of the agreement. The Company
minimizes such risk by limiting its counterparties to major financial
institutions. In addition, the potential risk of loss with any one party
resulting from this type of credit risk is monitored. Management does not expect
any material losses as a result of default by other parties.
Legal Proceedings
The Company is subject to legal proceedings, claims, and litigation arising in
the ordinary course of business. While the outcome of these matters is currently
not determinable, management does not expect that the ultimate costs to resolve
these matters will have a material adverse effect on the Company's consolidated
financial position, results of operations, or cash flows.
Beginning on April 20, 2001, a number of purported shareholder class action
lawsuits were filed in the United States District Court for the Northern
District of California against Cisco and certain of its officers and directors.
The lawsuits are essentially identical, purport to bring suit on behalf of those
who purchased the Company's publicly traded securities between August 10, 1999
and April 16, 2001, and have now been consolidated. Plaintiffs allege that
defendants have made false and misleading statements, purport to assert claims
for violations of the federal securities laws, and seek unspecified compensatory
damages and other relief. Cisco believes the claims are without merit and
intends to defend the actions vigorously.
In addition, beginning on April 23, 2001, a number of purported shareholder
derivative lawsuits were filed in the Superior Court of California, County of
Santa Clara, in addition to one filed in the Superior Court of California,
County of San Mateo. Those state court actions have been coordinated. Two
purported derivative suits have also been filed in the United States District
18
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Court for the Northern District of California, and those federal court actions
have been consolidated. The complaints in the various derivative actions include
claims for breach of fiduciary duty, waste of corporate assets, mismanagement,
unjust enrichment and violations of the California Corporations Code, seek
compensatory and other damages, disgorgement and other relief, and are based on
essentially the same allegations as the class actions.
Certain Investments in Privately Held Companies
Cisco has entered into investment agreements with four privately held,
development stage companies, pursuant to which Cisco has an option to acquire
the remaining interests not owned by Cisco in each company for consideration
consisting of shares of Cisco's common stock. In addition, each company has a
put option enabling them to require Cisco to acquire the remaining interests not
owned by Cisco in such company, subject to the fulfillment of various
conditions, including the achievement of specified technology and other
milestones.
In the case of three of the companies, the purchase prices for the remaining
interests are generally based on the achievement of certain technology or other
milestones by the companies. The maximum aggregate purchase price for the
acquisition of the remaining interests in all of these companies would be
approximately $500 million of Cisco common stock. Cisco anticipates that it will
acquire the remaining interests in these companies within the next six months.
To date, Cisco has funded an aggregate of $38 million of its $58 million
investment commitment in these companies. Since making its initial investments
in each of these companies, Cisco has expensed approximately $29 million of this
funding as research and development costs, which is Cisco's proportionate share
of net losses reported by the privately held companies, as if such losses
constituted development costs of Cisco. Cisco's proportionate share of the
losses is based on its percentage of the total cash invested in each company.
In the case of the fourth company, the purchase price for the remaining interest
would be based upon a valuation to be determined by applying a multiple to the
actual revenue generated from sales of the company's products during a specified
three-month period, on an annualized basis. The acquisition, if it occurs, is
expected to close no later than July 2004. The purchase price is not
determinable at this time, and will range from $0 to a maximum purchase price of
$2.5 billion in Cisco shares valued at the time of closing. The company's put
option is exercisable only if the company has satisfactorily completed the
development of a specified product by a specified date and commercial sales of
that product have commenced. As of January 26, 2002, Cisco had funded $42
million of its $84 million investment commitment to this company. Upon full
funding of its commitment, which is subject to termination if certain milestones
are not achieved, Cisco will hold a promissory note that is convertible into
approximately 44% of the equity of the company. If either Cisco's option or the
company's put option is exercised, Cisco is also committed to provide additional
funding to the company through the closing of the acquisition of approximately
$100 million. Since making its initial investment in the third quarter of fiscal
2001, Cisco has expensed $38 million as research and development costs, which
19
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
is equal to 100% of the net losses reported by the privately held company, as if
such losses constituted development costs of Cisco.
Purchase Commitments
The Company uses several supply partners to manufacture its products. During the
normal course of business, in order to reduce manufacturing lead times and
ensure adequate component supply, the Company enters into agreements with
certain supply partners which allow these partners to procure inventory based
upon criteria as defined by the Company. As of January 26, 2002, the Company may
be committed to purchase approximately $800 million of inventory.
Other Commitments
In fiscal 2001, the Company entered into an agreement to invest $1.05 billion in
the SOFTBANK Asia Infrastructure Fund, which is required to be funded upon
demand by the general partner of the fund. As of January 26, 2002, the Company
has funded $100 million of this investment commitment.
The Company provides financing to certain qualified customers to be used for the
purchase of equipment and other needs through its wholly-owned subsidiary, Cisco
Systems Capital Corporation. At January 26, 2002, the outstanding loan
commitments were approximately $1.7 billion, of which $1.0 billion is currently
eligible for draw down. These loan commitments may be funded over a two- to
three-year period provided these customers achieve specific business milestones
and financial covenants.
The Company has entered into several agreements to purchase or construct real
estate, subject to the satisfaction of certain conditions. As of January 26,
2002, the total amount of commitments, if certain conditions are met, was
approximately $650 million.
The Company has a commitment of approximately $240 million to purchase the
remaining portion of the minority interest of Cisco Systems, K.K. (Japan).
The Company also has certain other funding commitments of approximately $150
million related to its privately held investments.
20
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. SHAREHOLDERS' EQUITY
Stock Repurchase Program
In September 2001, the Board of Directors authorized a stock repurchase program
to acquire outstanding common stock in the open market or negotiated
transactions. Under the program, up to $3 billion of Cisco common stock could be
reacquired over two years. During the first six months of fiscal 2002, the
Company repurchased and retired approximately 40 million shares of Cisco common
stock for an aggregate purchase price of approximately $601 million.
Comprehensive Income (Loss)
The components of comprehensive income (loss), net of tax, are as follows (in
millions):
Three Months Ended Six Months Ended
-------------------------- ------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
---------- ----------- ---------- ----------
Net income $ 660 $ 874 $ 392 $ 1,672
Other comprehensive income (loss):
Change in unrealized gains and losses
on investments, net of tax 26 (1,134) 581 (2,263)
Other (10) 17 (12) (2)
------- ------- ------- -------
Total $ 676 $ (243) $ 961 $ (593)
======= ======= ======= =======
During the first six months of fiscal 2002, the Company recorded a charge of
$858 million related to the impairment of certain publicly traded securities in
its investment portfolio in accordance with Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." The impairment charge was related to the declines in the fair value
of the Company's publicly traded equity investments below the cost basis that
were judged to be other-than-temporary. The change in the unrealized gains and
losses on investments during the first six months of fiscal 2002 was primarily
related to the recognition of this impairment charge, net of tax.
21
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
8. INCOME TAXES
The Company paid net income taxes of $550 million for the first six months of
fiscal 2002 and received net income tax refunds of $118 million for the first
six months of fiscal 2001. The Company's income taxes currently payable for
federal and state purposes have been reduced by the tax benefits from employee
stock option transactions. These benefits totaled $49 million and $1.7 billion
in the first six months of fiscal 2002 and 2001, respectively, and were
reflected as a credit to additional paid-in capital in the Consolidated
Statements of Shareholders' Equity. In the first six months of fiscal 2001, the
Company's valuation allowance against gross deferred tax assets attributable to
employee stock option transactions increased by $479 million and was reflected
as a debit to additional paid-in capital in the Consolidated Statements of
Shareholders' Equity.
9. SEGMENT INFORMATION AND MAJOR CUSTOMERS
The Company's operations involve the design, development, manufacturing,
marketing, and technical support of networking products and services. The
Company offers end-to-end networking solutions for its customers. Cisco products
include routers, LAN and ATM switches, dial-up access servers, and
network-management software. These products, integrated by the Cisco IOS(R)
Software, link geographically dispersed LANs and WANs into complete end-to-end
networks.
The Company conducts business globally and is managed geographically. The
Company's management relies on an internal management system that provides sales
and standard cost information by geographic theater. Sales are attributed to a
theater based on the ordering location of the customer. The Company's management
makes financial decisions and allocates resources based on the information it
receives from this internal management system. The Company does not allocate
research and development, sales and marketing, or general and administrative
expenses to its geographic theaters in this internal management system, as
management does not use the information to measure the performance of the
operating segments. Management does not believe that allocating these expenses
is significant in evaluating a geographic theater's performance. Based on
established criteria, the Company has four reportable segments: the Americas;
Europe, the Middle East, and Africa ("EMEA"); Asia Pacific; and Japan.
22
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Summarized financial information by theater for the second quarter and first six
months of fiscal 2002 and 2001, as taken from the internal management system
previously discussed, is as follows (in millions):
Three Months Ended Six Months Ended
---------------------- ----------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
---------- ---------- ----------- ----------
Net sales:
Americas $ 2,781 $ 3,831 $ 5,577 $ 7,542
EMEA 1,212 1,823 2,267 3,583
Asia Pacific 435 672 827 1,282
Japan 388 422 593 860
-------- -------- -------- --------
Total $ 4,816 $ 6,748 $ 9,264 $ 13,267
======== ======== ======== ========
Gross margin:
Americas $ 2,076 $ 2,676 $ 4,095 $ 5,371
EMEA 968 1,362 1,782 2,683
Asia Pacific 353 451 658 890
Japan 325 323 478 676
-------- -------- -------- --------
Standard margin 3,722 4,812 7,013 9,620
Production overhead (160) (147) (351) (301)
Manufacturing variances and other
related costs (592) (498) (1,000) (1,011)
-------- -------- -------- --------
Total $ 2,970 $ 4,167 $ 5,662 $ 8,308
======== ======== ======== ========
Substantially all of the Company's assets at January 26, 2002 and July 28, 2001
were attributable to U.S. operations. In the second quarter and first six months
of fiscal 2002 and 2001, no single customer accounted for 10% or more of the
Company's net sales.
23
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Identification of Revenue Deferrals and Adjustments to Revenue Categories and
Resulting Reclassification
Historically, the Company's internal management system has not identified all
revenue adjustments and deferrals to geographic and product categories. Cisco
has been developing a process to attribute all adjustments and deferrals to each
revenue category which provides more useful and meaningful data relating to
specific revenue categories and resulting trends. Accordingly, the Company has
identified the revenue adjustments and deferrals to geographic theaters and
specific product categories, for each of the past six quarters, and reclassified
the reported amounts to reflect the adjustments to each revenue category.
The following table presents net sales by geographic theater on "as previously
reported" and "as reclassified" basis (in millions):
Three Months Ended Three Months Ended Six Months
--------------------------------------------- ------------------------ Ended
Oct. 28, Jan. 27, Apr. 28, July 28, Fiscal Oct. 27, Jan. 26, Jan. 26,
2000 2001 2001 2001 2001 2001 2002* 2002*
-------- -------- -------- -------- -------- -------- -------- --------
NET SALES (AS PREVIOUSLY REPORTED):
Americas $ 4,632 $ 4,197 $ 3,225 $ 3,076 $ 15,130 $ 3,007 $ 2,868 $ 5,875
EMEA 1,845 1,991 1,358 1,094 6,288 1,197 1,213 2,410
Asia Pacific 669 731 478 506 2,384 400 430 830
Japan 484 434 341 281 1,540 325 332 657
Revenue adjustments (608) (545) (515) (321) (1,989) (151) (72) (223)
Revenue deferrals (503) (60) (159) (338) (1,060) (330) 45 (285)
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 6,519 $ 6,748 $ 4,728 $ 4,298 $ 22,293 $ 4,448 $ 4,816 $ 9,264
======== ======== ======== ======== ======== ======== ======== ========
NET SALES (AS RECLASSIFIED):
Americas $ 3,711 $ 3,831 $ 2,635 $ 2,563 $ 12,740 $ 2,796 $ 2,781 $ 5,577
EMEA 1,760 1,823 1,303 1,017 5,903 1,055 1,212 2,267
Asia Pacific 610 672 453 458 2,193 392 435 827
Japan 438 422 337 260 1,457 205 388 593
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 6,519 $ 6,748 $ 4,728 $ 4,298 $ 22,293 $ 4,448 $ 4,816 $ 9,264
======== ======== ======== ======== ======== ======== ======== ========
* The financial data for the three and six months ended January 26, 2002 is
reported for the first time in the Form 10-Q.
24
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table presents standard margins by geographic theater on "as
previously reported" and "as reclassified" basis (in millions):
Three Months Ended Three Months Ended Six Months
---------------------------------------- ------------------- Ended
Oct. 28, Jan. 27, Apr. 28, July 28, Fiscal Oct. 27, Jan. 26, Jan. 26,
2000 2001 2001 2001 2001 2001 2002* 2002*
-------- -------- -------- -------- -------- -------- -------- --------
GROSS MARGIN (AS PREVIOUSLY REPORTED):
Americas $ 3,373 $ 3,003 $ 2,377 $ 2,287 $ 11,040 $ 2,197 $ 2,171 $ 4,368
EMEA 1,384 1,513 1,019 821 4,737 934 970 1,904
Asia Pacific 482 504 311 368 1,665 312 348 660
Japan 387 334 259 219 1,199 254 269 523
-------- -------- -------- -------- -------- -------- -------- --------
Standard margin 5,626 5,354 3,966 3,695 18,641 3,697 3,758 7,455
Revenue adjustments (608) (545) (515) (321) (1,989) (151) (72) (223)
Revenue deferrals (503) (60) (159) (338) (1,060) (330) 45 (285)
Cost of sales adjustments 293 63 113 112 581 75 (9) 66
Production overhead (154) (147) (150) (164) (615) (191) (160) (351)
Manufacturing variances and other
related costs (513) (498) (2,927) (548) (4,486) (408) (592) (1,000)
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 4,141 $ 4,167 $ 328 $ 2,436 $ 11,072 $ 2,692 $ 2,970 $ 5,662
======== ======== ======== ======== ======== ======== ======== ========
GROSS MARGIN (AS RECLASSIFIED):
Americas $ 2,695 $ 2,676 $ 1,886 $ 1,861 $ 9,118 $ 2,019 $ 2,076 $ 4,095
EMEA 1,321 1,362 973 757 4,413 814 968 1,782
Asia Pacific 439 451 290 328 1,508 305 353 658
Japan 353 323 256 202 1,134 153 325 478
-------- -------- -------- -------- -------- -------- -------- --------
Standard margin 4,808 4,812 3,405 3,148 16,173 3,291 3,722 7,013
Production overhead (154) (147) (150) (164) (615) (191) (160) (351)
Manufacturing variances and other
related costs (513) (498) (2,927) (548) (4,486) (408) (592) (1,000)
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 4,141 $ 4,167 $ 328 $ 2,436 $ 11,072 $ 2,692 $ 2,970 $ 5,662
======== ======== ======== ======== ======== ======== ======== ========
* The financial data for the three and six months ended January 26, 2002
is reported for the first time in the Form 10-Q.
25
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table presents net sales for groups of similar products and
services on "as previously reported" and "as reclassified" basis (in millions):
Three Months Ended Three Months Ended Six Months
-------------------------------------------- -------------------- Ended
Oct. 28, Jan. 27, Apr. 28, July 28, Fiscal Oct. 27, Jan. 26, Jan. 26,
2000 2001 2001 2001 2001 2001 2002* 2002*
-------- -------- -------- -------- -------- -------- -------- --------
NET SALES (AS PREVIOUSLY REPORTED):
Routers $ 2,818 $ 2,375 $ 1,747 $ 1,715 $ 8,655 $ 1,607 $ 1,600 $ 3,207
Switches 2,809 3,283 2,558 1,936 10,586 1,993 2,014 4,007
Access 810 616 452 455 2,333 316 266 582
Services 608 684 721 721 2,734 792 794 1,586
Other 642 619 400 458 2,119 479 431 910
Revenue adjustments (665) (769) (991) (649) (3,074) (409) (334) (743)
Revenue deferrals (503) (60) (159) (338) (1,060) (330) 45 (285)
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 6,519 $ 6,748 $ 4,728 $ 4,298 $ 22,293 $ 4,448 $ 4,816 $ 9,264
======== ======== ======== ======== ======== ======== ======== ========
NET SALES (RECLASSIFIED):
Routers $ 2,406 $ 2,060 $ 1,361 $ 1,352 $ 7,179 $ 1,361 $ 1,502 $ 2,863
Switches 2,455 2,947 2,069 1,508 8,979 1,731 1,882 3,613
Access 618 517 365 355 1,855 256 243 499
Services 608 684 721 721 2,734 792 794 1,586
Other 432 540 212 362 1,546 308 395 703
-------- -------- -------- -------- -------- -------- -------- --------
Total $ 6,519 $ 6,748 $ 4,728 $ 4,298 $ 22,293 $ 4,448 $ 4,816 $ 9,264
======== ======== ======== ======== ======== ======== ======== ========
* The financial data for the three and six months ended January 26, 2002 is
reported for the first time in the Form 10-Q.
26
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
10. NET INCOME PER SHARE
The following table presents the calculation of basic and diluted net income per
share (in millions, except per-share amounts):
Three Months Ended Six Months Ended
-------------------------- --------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Net income $ 660 $ 874 $ 392 $1,672
====== ====== ====== ======
Weighted-average shares--basic 7,311 7,144 7,309 7,121
Effect of dilutive securities:
Employee stock options 185 412 171 446
------ ------ ------ ------
Weighted-average shares--diluted 7,496 7,556 7,480 7,567
====== ====== ====== ======
Net income per share--basic $ 0.09 $ 0.12 $ 0.05 $ 0.23
====== ====== ====== ======
Net income per share--diluted $ 0.09 $ 0.12 $ 0.05 $ 0.22
====== ====== ====== ======
27
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements contained in this Quarterly Report on Form 10-Q, including,
without limitation, statements containing the words "believes," "anticipates,"
"estimates," "expects," "projections," and words of similar import, constitute
"forward-looking statements." You should not place undue reliance on these
forward-looking statements. Our actual results could differ materially from
those anticipated in these forward-looking statements for many reasons,
including the risks faced by us described below under the heading "Risk Factors"
and elsewhere in this Quarterly Report, and in other documents we file with the
Securities and Exchange Commission.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States requires
management to make judgments, assumptions and estimates that affect the amounts
reported in the Consolidated Financial Statements and accompanying notes. Note 2
to the Consolidated Financial Statements in the Annual Report on Form 10-K for
the fiscal year ended July 28, 2001 describes the significant accounting
policies and methods used in the preparation of the Consolidated Financial
Statements. Estimates are used for, but not limited to, the accounting for the
allowance for doubtful accounts and sales returns, inventory allowances,
warranty costs, investment impairments, goodwill impairments, contingencies,
restructuring costs and other special charges and taxes. Actual results could
differ from these estimates. The following critical accounting policies are
impacted significantly by judgments, assumptions and estimates used in the
preparation of the Consolidated Financial Statements.
The allowance for doubtful accounts is based on our assessment of the
collectibility of specific customer accounts and the aging of the accounts
receivable. If there is a deterioration of a major customer's credit worthiness
or actual defaults are higher than our historical experience, our estimates of
the recoverability of amounts due us could be adversely affected.
A reserve for sales returns is established based on historical trends in product
returns. If the actual future returns do not reflect the historical data, our
revenue could be affected.
Inventory purchases and commitments are based upon future demand forecasts. If
there is a sudden and significant decrease in demand for our products or there
is a higher risk of inventory obsolescence because of rapidly changing
technology and customer requirements, we may be required to increase our
inventory allowances and our gross margin could be adversely affected.
We accrue for warranty costs based on the expected material and labor usage
costs to provide warranty services. If we experience an increase in warranty
claims which are higher than our historical experience, our gross margin could
be adversely affected.
We have experienced significant volatility in the market prices of our publicly
traded equity investments. These investments are recorded on the balance sheet
at fair value and we recognize an impairment charge when the decline in the fair
value below the cost basis is judged to be other-than-temporary. We consider
various factors in determining whether we should recognize
28
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
an impairment charge including, but not limited to, the length of time and
extent to which the market value has been less than our cost basis, the
financial condition and near-term prospects of the issuer and our intent and
ability to hold the investment for a period of time sufficient to allow for any
anticipated recovery in market value. The ultimate value realized on these
equity investments is subject to market volatility until they are sold.
We will perform goodwill impairment tests on an annual basis and between annual
tests in certain circumstances. In response to changes in industry and market
conditions, we may strategically realign our resources and consider
restructuring, disposing of, or otherwise exiting businesses, which could result
in an impairment of goodwill.
We are subject to the possibility of various loss contingencies arising in the
ordinary course of business. We consider the likelihood of the loss or
impairment of an asset or the incurrence of a liability as well as our ability
to reasonably estimate the amount of loss in determining loss contingencies. An
estimated loss contingency is accrued when it is probable that a liability has
been incurred or an asset has been impaired and the amount of loss can be
reasonably estimated. We regularly evaluate current information available to us
to determine whether such accruals should be adjusted.
Net Sales and Gross Margin
The net sales and gross margin for the second quarter and first six months of
fiscal 2002 and 2001 were as follows (in millions, except percentages):
Three Months Ended Six Months Ended
--------------------------- ---------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Net Sales:
Product $ 4,022 $ 6,064 $ 7,678 $ 11,975
Services 794 684 1,586 1,292
--------- --------- --------- ---------
Total $ 4,816 $ 6,748 $ 9,264 $ 13,267
========= ========= ========= =========
Gross Margin:
Product 60.4% 61.9% 59.7% 63.0%
Services 68.1% 60.4% 67.9% 59.2%
--------- --------- --------- ---------
Total 61.7% 61.8% 61.1% 62.6%
========= ========= ========= =========
Net product revenue in the second quarter of fiscal 2002 decreased by 33.7% from
the second quarter of fiscal 2001. Net product revenue in the first six months
of fiscal 2002 decreased by 35.9% from the first six months of fiscal 2001. The
decrease in net product revenue for the second quarter and first six months of
fiscal 2002 compared to the same periods last year was
29
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
primarily a result of decreased unit sales of router, switch, and access
products due to the unfavorable economic conditions and capital spending
environment compared to the period a year ago. Net product revenue in the second
quarter of fiscal 2002 increased by 10.0% compared with net product revenue of
$3.7 billion in the first quarter of fiscal 2002.
The decrease in product gross margin for the second quarter and first six months
of fiscal 2002 compared to the same periods last year was primarily due to lower
shipment volumes and the absorption of related manufacturing overhead partially
offset by an excess inventory benefit. Excluding the excess inventory benefit,
product gross margin was 55.5% in the second quarter of fiscal 2002 compared
with 51.0% in the first quarter of fiscal 2002.
Due to a sudden and significant decrease in demand for our products in the third
quarter of fiscal 2001, inventory levels exceeded our estimated requirements
based on demand forecasts and an additional excess inventory charge of $2.2
billion was recorded in accordance with our accounting policy. This additional
excess inventory charge was subsequently reduced in the fourth quarter of fiscal
2001 by a $187 million benefit primarily related to lower settlement charges for
purchase commitments. In the first and second quarter of fiscal 2002, this
additional excess inventory charge was further reduced by a $290 million and
$195 million benefit, respectively, primarily related to inventory used to
manufacture products sold and the settlement of purchase commitments for less
than the estimated amount, which was credited to the provision for inventory. As
of January 26, 2002, the remaining additional excess inventory reserve balance
was $139 million. For additional information regarding the additional excess
inventory reserve, see Note 4 "Restructuring Costs and Other Special Charges and
Provision for Inventory" to the Consolidated Financial Statements.
Net service revenue in the second quarter of fiscal 2002 increased by 16.1% from
the second quarter of fiscal 2001. Net service revenue in the first six months
of fiscal 2002 increased by 22.8% from the first six months of fiscal 2001. The
increase in net service revenue for the second quarter and first six months of
fiscal 2002 compared to the same periods last year was primarily due to the
increase in support revenue related to a higher installed base of networking
equipment. Service revenue is generally deferred and, in most cases, recognized
ratably over the service period obligations, which are typically one to three
years. Net service revenue in the second quarter of fiscal 2002 remained
relatively constant compared to net service revenue of $792 million in the first
quarter of fiscal 2002. The increase in service margin for the second quarter
and first six months of fiscal 2002 compared to the same periods last year was
primarily due to cost efficiencies in our technical assistance centers. Service
margin was 67.7% in the first quarter of fiscal 2002.
30
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
We manage our business based on four geographic theaters: the Americas; Europe,
the Middle East, and Africa ("EMEA"); Asia Pacific; and Japan. Financial
information by theater for the second quarter and first six months of fiscal
2002 and 2001 is summarized in the following table (in millions):
Three Months Ended Six Months Ended
-------------------------- --------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Net sales:
Americas $ 2,781 $ 3,831 $ 5,577 $ 7,542
EMEA 1,212 1,823 2,267 3,583
Asia Pacific 435 672 827 1,282
Japan 388 422 593 860
-------- -------- -------- --------
Total $ 4,816 $ 6,748 $ 9,264 $ 13,267
======== ======== ======== ========
Gross margin:
Americas $ 2,076 $ 2,676 $ 4,095 $ 5,371
EMEA 968 1,362 1,782 2,683
Asia Pacific 353 451 658 890
Japan 325 323 478 676
-------- -------- -------- --------
Standard margin 3,722 4,812 7,013 9,620
Production overhead (160) (147) (351) (301)
Manufacturing variances and other
related costs (592) (498) (1,000) (1,011)
-------- -------- -------- --------
Total $ 2,970 $ 4,167 $ 5,662 $ 8,308
======== ======== ======== ========
The following table shows the standard margin for each theater:
Three Months Ended Six Months Ended
-------------------------- --------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Standard margin:
Americas 74.6% 69.9% 73.4% 71.2%
EMEA 79.9% 74.7% 78.6% 74.9%
Asia Pacific 81.1% 67.1% 79.6% 69.4%
Japan 83.8% 76.5% 80.6% 78.6%
---- ---- ---- ----
Total 77.3% 71.3% 75.7% 72.5%
==== ==== ==== ====
31
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Product gross margin may be adversely affected in the future by increases in
material or labor costs, excess inventory, obsolescence charges, changes in
shipment volume, loss of cost savings, price competition, and changes in
channels of distribution or in the mix of products sold. If product or related
warranty costs associated with our products are greater than we have
experienced, product gross margin may also be adversely affected. Product gross
margin may also be impacted by geographic mix, as well as the mix of
configurations within each product group. We continue to utilize third-party or
indirect-distribution channels, which generally results in a lower product gross
margin. These distribution channels are generally given privileges to return
inventory and participate in various cooperative marketing programs. In
addition, increasing third-party and indirect-distribution channels generally
result in greater difficulty in forecasting the mix of our products, and to a
certain degree, the timing of orders from our customers. We recognize revenue to
two-tier distributors based on information provided by our distributors and also
maintain accruals and allowances for all cooperative marketing and other
programs. Service gross margin will typically experience some variability over
time due to various factors such as the changes in mix between support and
professional services, as well as the timing of support contract renewals.
Research and Development, Sales and Marketing, and General and Administrative
Expenses
Research and development ("R&D"), sales and marketing, and general and
administrative ("G&A") expenses are summarized in the following table (in
millions, except percentages):
Three Months Ended Six Months Ended
------------------------------ ------------------------------
January 26, January 27, January 26, January 27,
2002 2001 2002 2001
----------- ----------- ----------- -----------
Research and development $ 862 $ 1,012 $ 1,779 $ 1,959
Percentage of net sales 17.9% 15.0% 19.2% 14.8%
Sales and marketing $ 1,071 $ 1,434 $ 2,167 $ 2,796
Percentage of net sales 22.2% 21.3% 23.4% 21.1%
General and administrative $ 148 $ 196 $ 299 $ 392
Percentage of net sales 3.1% 2.9% 3.2% 3.0%
In the third quarter of fiscal 2001, we announced a restructuring program to
prioritize our initiatives around a focus on profit contribution, high-growth
areas of our business, reduction of expenses, and improved efficiency. This
restructuring program included a worldwide workforce reduction, consolidation of
excess facilities, and restructuring of certain business functions. For
additional information regarding the restructuring program, see Note 4
"Restructuring Costs and Other Special Charges and Provision for Inventory" to
the Consolidated Financial Statements.
R&D, sales and marketing, and G&A expenses as a percentage of net sales have
increased compared with the second quarter and first six months of fiscal 2001
primarily due to the decline
32
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
in net sales. R&D, sales and marketing, and G&A expenses decreased in absolute
dollars from the prior year primarily due to the impact of the restructuring
program and cost control measures to contain hiring and reduce discretionary
spending. As a result, these expenses have been reduced on a quarterly basis by
approximately $600 million compared to the high point in the second quarter of
fiscal 2001.
R&D expenses in the second quarter of fiscal 2002 decreased by 14.8% from the
second quarter of fiscal 2001. R&D expenses in the first six months of fiscal
2002 decreased by 9.2% from the first six months of fiscal 2001. R&D expenses in
the second quarter of fiscal 2002 decreased by 6.0% compared with R&D expenses
of $917 million in the first quarter of fiscal 2002. A significant portion of
the decrease in R&D expenses for the second quarter and first six months of
fiscal 2002 compared to the same periods last year was due to lower expenditures
on prototypes, lower depreciation on lab equipment, and reduced discretionary
spending. R&D includes efforts in a wide variety of areas such as data, voice,
and video over IP; advanced access technologies such as cable and other
broadband technologies; advanced enterprise switching; optical transport;
storage networking; content networking; security; network management; advanced
core and edge routing technologies; among others. We have also continued to
purchase technology in order to bring a broad range of products to the market in
a timely fashion. If we believe that we are unable to enter a particular market
in a timely manner with internally developed products, we may license technology
from other businesses or acquire businesses as an alternative to internal R&D.
All of our R&D costs have been expensed as incurred.
Sales and marketing expenses in the second quarter of fiscal 2002 decreased by
25.3% from the second quarter of fiscal 2001. Sales and marketing expenses in
the first six months of fiscal 2002 decreased by 22.5% from the first six months
of fiscal 2001. Sales and marketing expenses in the second quarter of fiscal
2002 decreased by 2.3% compared with sales and marketing expenses of $1.1
billion in the first quarter of fiscal 2002. The decrease in sales and marketing
expenses for the second quarter and first six months of fiscal 2002 compared to
the same periods last year was principally due to the decrease in the size of
our sales force and marketing organization, reduced marketing and advertising
investments associated with existing and new product introductions, and reduced
investments in general corporate branding. However, we have continued our
efforts to invest in certain key areas, such as expansion of our end-to-end
networking strategy and service provider coverage, in order to be positioned to
take advantage of future market opportunities.
G&A expenses in the second quarter of fiscal 2002 decreased by 24.5% from the
second quarter of fiscal 2001. G&A expenses in the first six months of fiscal
2002 decreased by 23.7% from the first six months of fiscal 2001. G&A expenses
in the second quarter of fiscal 2002 decreased by 2.0% compared with G&A
expenses of $151 million in the first quarter of fiscal 2002. The decrease in
G&A expenses for the second quarter and first six months of fiscal 2002 compared
to the same periods last year was primarily related to the reductions in
investments in infrastructure, personnel in support and administrative
functions, and discretionary spending.
33
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Amortization of Goodwill
We elected to early-adopt Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets" ("SFAS 142") effective the beginning of
fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are
required to perform goodwill impairment tests on an annual basis and between
annual tests in certain circumstances. As of January 26, 2002, no impairment of
goodwill has been recognized. There can be no assurance that future goodwill
impairment tests will not result in a charge to earnings. For additional
information regarding SFAS 142, see Note 2 "Summary of Significant Accounting
Policies" to the Consolidated Financial Statements.
Amortization of Purchased Intangible Assets
Amortization of purchased intangible assets included in operating expenses was
$136 million in the second quarter of fiscal 2002, compared to $87 million in
the second quarter of fiscal 2001. Amortization of purchased intangible assets
included in operating expenses was $282 million in the first six months of
fiscal 2002, compared to $168 million in the first six months of fiscal 2001.
Amortization of purchased intangible assets in the first quarter of fiscal 2002
was $146 million. The increase in the amortization of purchased intangible
assets for the second quarter and first six months of fiscal 2002 compared to
the same periods last year was primarily related to the additional amortization
from recent acquisitions and accelerated amortization for certain technology and
patent intangibles due to a reduction in their estimated useful lives. For
additional information regarding purchased intangible assets, see Note 3
"Business Combinations" to the Consolidated Financial Statements.
In-Process Research and Development
The amount expensed to in-process research and development ("in-process R&D")
arose from purchase acquisitions (see Note 3 to the Consolidated Financial
Statements). The fair values of the existing purchased technology and patents,
as well as the technology currently under development, were determined using the
income approach, which discounts expected future cash flows to present value.
The discount rates used in the present value calculations were typically derived
from a weighted-average cost of capital analysis and venture capital surveys,
adjusted upward to reflect additional risks inherent in the development life
cycle. We consider the pricing model for products related to these acquisitions
to be standard within the high-technology communications equipment industry.
However, we do not expect to achieve a material amount of expense reductions or
synergies as a result of integrating the acquired in-process technology.
Therefore, the valuation assumptions do not include significant anticipated cost
savings.
The development of these technologies remains a significant risk due to the
remaining efforts to achieve technical viability, rapidly changing customer
markets, uncertain standards for new products, and significant competitive
threats from numerous companies. The nature of the efforts to develop these
technologies into commercially viable products consists principally of
34
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
planning, designing, experimenting, and testing activities necessary to
determine that the technologies can meet market expectations, including
functionality and technical requirements. Failure to bring these products to
market in a timely manner could result in a loss of market share or a lost
opportunity to capitalize on emerging markets and could have a material adverse
impact on our business and operating results.
The following table summarizes the key assumptions underlying the valuations for
our purchase acquisitions completed in the first six months of fiscal 2002 (in
millions, except percentages):
Estimated Cost to Risk-Adjusted
Complete Technology at Discount Rate for
Acquired Company Time of Acquisition In-Process R&D
---------------- ---------------------- -----------------
Allegro Systems, Inc. $ 5 52.5%
AuroraNetics, Inc. $ 2 35.0%
Regarding our purchase acquisitions, actual results to date have been
consistent, in all material respects, with our assumptions at the time of
acquisitions except for certain purchase acquisitions where the purchased
intangible assets have been impaired and written-down as reflected in the
Consolidated Statements of Operations. The assumptions primarily consist of an
expected completion date for the in-process projects, estimated costs to
complete the projects, and revenue and expense projections assuming the products
have entered the market. Failure to achieve the expected levels of revenue and
net income from these products will negatively impact the return on investment
expected at the time that the acquisitions were completed and may result in
impairment charges.
Interest and Other Income (Losses), Net
Interest and other income (losses), net, were $179 million in the second quarter
of fiscal 2002, compared with $275 million in the second quarter of fiscal 2001.
Interest and other income (losses), net, were ($509) million in the first six
months of fiscal 2002, compared with $695 million in the first six months of
fiscal 2001. The decrease in interest and other income (losses), net, for the
second quarter of fiscal 2002 compared to the same period last year was
primarily due to the impact of lower average interest rates and lower net gains
on investments. Interest and other income (losses), net, for the first six
months of fiscal 2002 included a charge of $858 million related to the
impairment on certain publicly traded securities in our investment portfolio. In
accordance with Statement of Financial Accounting Standards No. 115, "Accounting
for Certain Investments in Debt and Equity Securities," we have recorded an
impairment charge related to the declines in the fair value of our publicly
traded equity investments below their cost basis that were judged to be
other-than-temporary.
Provision for Income Taxes
The effective tax rate was 29.2% for the second quarter of fiscal 2002 and 33.4%
for the first six months of fiscal 2002. The effective tax rate differs from the
statutory rate primarily due to the
35
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
impact of nondeductible in-process R&D, acquisition-related costs, research and
experimentation tax credits, and the tax impact of foreign operations. Our
future effective tax rates could be adversely affected if earnings are lower
than anticipated in countries where we have lower statutory rates or by
unfavorable changes in tax laws and regulations.
36
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Liquidity and Capital Resources
Cash and cash equivalents and total investments, including restricted
investments, were $21.0 billion at January 26, 2002, an increase of $2.5 billion
from July 28, 2001. The increase was primarily a result of cash provided by
operating activities of $3.4 billion and cash provided by the issuance of common
stock of $384 million. This increase was partially offset by cash used in
capital expenditures of $482 million, cash used for the repurchase of common
stock of $601 million, and a net decrease of $118 million in the fair value of
investments. We expect our cash provided by operating activities may fluctuate
in future periods as a result of fluctuations in our operating results, shipment
linearity and accounts receivable collections, inventory management, and the
timing of payments, among others. For additional discussion, see also the Risk
Factors section below.
Accounts receivable decreased 21.6% from July 28, 2001 to January 26, 2002. Days
sales outstanding in receivables decreased to 22 days at January 26, 2002 from
31 days at July 28, 2001. The decrease in accounts receivable and days sales
outstanding were primarily due to shipment linearity and process improvements in
billing and collections.
Inventories decreased 39.3% from July 28, 2001 to January 26, 2002. Inventory
turns, excluding the additional excess inventory benefit previously discussed,
were 7.0 for the second quarter of fiscal 2002 and 5.5 for the first quarter of
fiscal 2002. The inventory levels and inventory turns reflected our ongoing
effort to reduce our manufacturing inventory balance. Inventory management
remains an area of focus as we balance the need to maintain strategic inventory
levels to ensure competitive lead times versus the risk of inventory
obsolescence because of rapidly changing technology and customer requirements.
We have entered into several agreements to lease sites in San Jose, California
(where our headquarters are established) and surrounding areas; Boxborough,
Massachusetts; Salem, New Hampshire; Richardson, Texas; and Research Triangle
Park, North Carolina where we have pledged $1.2 billion of our investments as
collateral for certain obligations under the leases. We may occupy more leased
property in the future that will require similar pledged securities; however, we
do not expect the impact of this activity to be material to our liquidity
position.
We have entered into investment agreements with four privately held, development
stage companies, pursuant to which we have an option to acquire the remaining
interests not owned by us in each company for consideration consisting of shares
of Cisco common stock. In addition, each company has a put option enabling them
to require us to acquire the remaining interests not owned by us in such
company, subject to the fulfillment of various conditions, including the
achievement of specified technology and other milestones.
In the case of three of the companies, the purchase prices for the remaining
interests are generally based on the achievement of certain technology or other
milestones by the companies. The maximum aggregate purchase price for the
acquisition of the remaining interests in all of
37
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
these companies would be approximately $500 million of Cisco common stock. We
anticipate that we will acquire the remaining interests in these companies
within the next six months. To date, we have funded an aggregate of $38 million
of our $58 million investment commitment in these companies. Since making our
initial investments in each of these companies, we have expensed approximately
$29 million of this funding as research and development costs, which is our
proportionate share of net losses reported by the privately held companies, as
if such losses constituted our development costs. Our proportionate share of the
losses is based on our percentage of the total cash invested in each company.
In the case of the fourth company, the purchase price for the remaining interest
would be based upon a valuation to be determined by applying a multiple to the
actual revenue generated from sales of the company's products during a specified
three-month period, on an annualized basis. The acquisition, if it occurs, is
expected to close no later than July 2004. The purchase price is not
determinable at this time, and will range from $0 to a maximum purchase price of
$2.5 billion in Cisco shares valued at the time of closing. The company's put
option is exercisable only if the company has satisfactorily completed the
development of a specified product by a specified date and commercial sales of
that product have commenced. As of January 26, 2002, we have funded $42 million
of our $84 million investment commitment to this company. Upon full funding of
our commitment, which is subject to termination if certain milestones are not
achieved, we will hold a promissory note that is convertible into approximately
44% of the equity of the company. If either our option or the company's put
option is exercised, we are also committed to provide additional funding to the
company through the closing of the acquisition of approximately $100 million.
Since making our initial investment in the third quarter of fiscal 2001, we have
expensed $38 million as research and development costs, which is equal to 100%
of the net losses reported by the privately held company as though such losses
constituted our development costs.
We use several supply partners to manufacture our products. During the normal
course of business, in order to reduce manufacturing lead times and ensure
adequate component supply, we enter into agreements with certain supply partners
which allow these partners to procure inventory based upon criteria as defined
by us. As of January 26, 2002, we may be committed to purchase approximately
$800 million of inventory.
In fiscal 2001, we entered into an agreement to invest $1.05 billion in the
SOFTBANK Asia Infrastructure Fund, which is required to be funded upon demand by
the general partner of the fund. As of January 26, 2002, we have funded $100
million of this investment commitment.
We provide financing to certain qualified customers to be used for the purchase
of equipment and other needs through our wholly-owned subsidiary, Cisco Systems
Capital Corporation. At January 26, 2002, the outstanding loan commitments were
approximately $1.7 billion, of which $1.0 billion is currently eligible for draw
down. These loan commitments may be funded over a two- to three-year period
provided these customers achieve specific business milestones and financial
covenants.
38
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
We have entered into several agreements to purchase or construct real estate,
subject to the satisfaction of certain conditions. As of January 26, 2002, the
total amount of commitments, if certain conditions are met, was approximately
$650 million.
We have a commitment of approximately $240 million to purchase the remaining
portion of the minority interest of Cisco Systems, K.K. (Japan).
We also have certain other funding commitments of approximately $150 million
related to our privately held investments.
In September 2001, the Board of Directors authorized a stock repurchase program
to acquire outstanding common stock in the open market or negotiated
transactions. Under the program, up to $3 billion of Cisco common stock could be
reacquired over two years. During the first six months of fiscal 2002, we
repurchased and retired approximately 40 million shares of Cisco common stock
for an aggregate purchase price of approximately $601 million.
We believe that our current cash and cash equivalents, short-term investments,
and cash generated from operations will satisfy our expected working capital
needs, capital expenditures, investment requirements, stock repurchases,
commitments (see Note 6 to the Consolidated Financial Statements) and other
liquidity requirements associated with our existing operations through at least
the next 12 months. In addition, there are no transactions, arrangements and
other relationships with unconsolidated entities or other persons that are
reasonably likely to affect materially liquidity or the availability of or
requirements for capital resources.
39
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
Set forth below and elsewhere in this Quarterly Report and in the other
documents we file with the SEC are risks and uncertainties that could cause
actual results to differ materially from the results contemplated by the
forward-looking statements contained in this Quarterly Report.
YOU SHOULD EXPECT THAT OUR OPERATING RESULTS MAY FLUCTUATE IN FUTURE PERIODS
The results of operations for any quarter or fiscal year are not necessarily
indicative of results to be expected in future periods. Our operating results
have been in the past, and will continue to be, subject to quarterly and annual
fluctuations as a result of a number of factors. These factors include:
- Overall information technology spending
- Changes in general global economic conditions and specific market
conditions in the communications and networking industries
- Fluctuations in demand for our products and services
- The effects of terrorist activity and armed conflict, such as disruptions
in general global economic activity, changes in logistics and security
arrangements, and reduced customer demand for our products and services
- The long sales and implementation cycle for our products and the reduced
visibility into our customers' spending plans and associated revenue
- Inventory levels and purchase commitments exceeding our estimated
requirements based upon future demand forecasts
- Existing network capacity, sharing of existing network capacity, and
network capacity utilization rates of our customers
- Price and product competition in the networking industry
- The overall trend toward industry consolidation
- The introduction and market acceptance of new technologies and products,
as well as the adoption of new networking standards
- Variations in sales channels, product costs, or mix of products sold
- The timing of orders, timing of shipments, and the ability to satisfy all
contractual obligations in customer contracts
- Manufacturing lead times
- The impact of acquired businesses and technologies
- The geographical mix of our revenue and the associated impact on gross
margin
- Our ability to achieve targeted cost reductions
- Adverse changes in the public and private equity and debt markets
- The ability of our customers and suppliers to obtain financing or to fund
capital expenditures
- The trend toward sales of integrated network solutions
- The timing and amount of employer payroll tax to be paid on employees'
gains on stock options exercised
40
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
- Actual events, circumstances, outcomes and amounts differing from
judgments, assumptions and estimates used in determining the amounts of
certain assets (including the amounts of related valuation allowances),
liabilities and other items reflected in our financial statements.
As a consequence, operating results for a particular future period are difficult
to predict, especially in recent periods. Any of the foregoing factors, or any
other factors discussed elsewhere herein, could have a material adverse effect
on our business, results of operations, and financial condition.
In response to changes in industry and market conditions, we may strategically
realign our resources and consider restructuring, disposing of, or otherwise
exiting businesses. Any decision to limit investment in or to dispose of or
otherwise exit businesses may result in the recording of special charges, such
as workforce reduction costs. Estimates with respect to the useful life or
ultimate recoverability of our carrying basis of assets, including purchased
intangible assets, could change as a result of such assessments and decisions.
Additionally, we are required to perform goodwill impairment tests on an annual
basis and between annual tests in certain circumstances. There can be no
assurance that future goodwill impairment tests will not result in a charge to
earnings.
WE ARE EXPOSED TO GENERAL GLOBAL ECONOMIC AND MARKET CONDITIONS
Our business is subject to the effects of general economic conditions in the
United States and globally, and, in particular, market conditions in the
communications and networking industries. In recent quarters, our operating
results have been adversely affected as a result of unfavorable economic
conditions and reduced capital spending in the United States, Europe, and Asia.
If the economic conditions in the United States and globally do not improve, or
if we experience a worsening in the global economic slowdown, we may continue to
experience material adverse impacts on our business, operating results, and
financial condition.
OPERATING RESULTS FOR A PARTICULAR QUARTER ARE DIFFICULT TO PREDICT
As a result of a variety of factors discussed herein, operating results for a
particular quarter are extremely difficult to predict. Given the continued
uncertainty surrounding many variables that may impact the industry we compete
in, our visibility into future periods is limited. Our net sales may grow at a
slower rate than experienced in past periods and, in particular periods, may
decline. Our ability to meet financial expectations could also be adversely
affected if the nonlinear sales pattern seen in certain of our past quarters
recurs in future periods. We generally have had at least one quarter of the
fiscal year when backlog has been reduced. In addition, in response to customer
demand, we continue to attempt to reduce our product manufacturing lead times,
which may result in corresponding reductions in order backlog. A decline in
backlog
41
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
levels could result in more variability and less predictability in our
quarter-to-quarter net sales and operating results going forward. On the other
hand, for certain products, lead times are longer than our goal. If we cannot
reduce manufacturing lead times for such products, our customers may place the
same orders within our various sales channels, cancel orders, or not place
further orders if shorter lead times are available from other vendors.
We plan our operating expense levels primarily based on forecasted revenue
levels. These expenses and the impact of long-term commitments are relatively
fixed in the short-term. A shortfall in revenue could lead to operating results
being below expectations as we may not be able to quickly reduce these fixed
expenses in response to short-term business changes.
Any of the above factors could have a material adverse impact on our operations
and financial results. For example, from time to time, we have made acquisitions
that result in in-process research and development expenses being charged in an
individual quarter. These charges may occur in any particular quarter resulting
in variability in our quarterly earnings. Additionally, the operating results
for a quarter could be materially adversely affected if a number of large orders
are either not received or are delayed, for example, due to cancellations,
delays, or deferrals by customers.
WE EXPECT GROSS MARGIN VARIABILITY OVER TIME
Product gross margin may be adversely affected in the future by increases in
material or labor costs, excess inventory, obsolescence charges, changes in
shipment volume, loss of cost savings, price competition, and changes in
channels of distribution or in the mix of products sold. If product or related
warranty costs associated with our products are greater than we have
experienced, product gross margin may also be adversely affected. Product gross
margin may also be impacted by geographic mix, as well as the mix of
configurations within each product group. We continue to utilize third-party or
indirect-distribution channels, which generally results in a lower product gross
margin. These distribution channels are generally given privileges to return
inventory and participate in various cooperative marketing programs. In
addition, increasing third-party and indirect-distribution channels generally
results in greater difficulty in forecasting the mix of our products, and to a
certain degree, the timing of orders from our customers. We recognize revenue to
two-tier distributors based on information provided by our distributors and also
maintain accruals and allowances for all cooperative marketing and other
programs. Service gross margin will typically experience some variability over
time due to various factors such as the changes in mix between support and
professional services, as well as the timing of support contract renewals.
42
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
WE ARE DEPENDENT UPON ADEQUATE COMPONENT SUPPLY AND MANUFACTURING CAPACITY
Our growth and ability to meet customer demands also depend in part on our
ability to obtain timely deliveries of parts from our suppliers. We have
experienced component shortages in the past that have adversely affected our
operations. Although we work closely with our suppliers to avoid these types of
shortages, there can be no assurance that we will not encounter these problems
in the future. Although we generally use standard parts and components for our
products, certain components are presently available only from a single source
or limited sources.
While our suppliers have performed effectively and have been relatively flexible
to date, we believe that we may be faced with the following challenges going
forward:
- New markets that we participate in may grow quickly and thus, consume
significant component capacity
- As we continue to acquire companies and new technologies, we are
dependent, at least initially, on unfamiliar supply chains or relatively
small supply partners
- We face competition for certain components, which are supply constrained,
from existing competitors and companies in other markets
Manufacturing capacity and component supply constraints could be significant
issues for us. We use several supply partners to manufacture our products.
During the normal course of business, in order to reduce manufacturing lead
times and ensure adequate component supply, we enter into agreements with
certain supply partners which allow these partners to procure inventory based
upon criteria as defined by us. For additional information regarding our
purchase commitments, see Note 6 "Commitments and Contingencies" to the
Consolidated Financial Statements. A reduction or interruption in supply, a
significant increase in the price of one or more components, or a decrease in
demand of products could materially adversely affect our business, operating
results and financial condition and could materially damage customer
relationships.
WE COMPETE IN THE HIGHLY COMPETITIVE TELECOMMUNICATIONS EQUIPMENT MARKET
We compete in the Internet infrastructure market, providing solutions for
transporting data, voice, and video traffic across intranets, extranets, and the
Internet. The market is characterized by rapid change, converging technologies,
and a conversion to networking solutions that offer superior advantages. These
market factors represent both an opportunity and a competitive threat to us. We
compete with numerous vendors in each product category. The overall number of
competitors providing niche product solutions may increase due to the market's
long-term attractive growth. On the other hand, we expect the number of vendors
supplying end-to-end
43
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
networking solutions will decrease, due to consolidations in and accompanying
economic pressure upon the industry.
Our competitors include Alcatel, Ciena, Ericsson, Extreme Networks, Foundry
Networks, Juniper, Lucent, Nortel Networks, Redback Networks, Siemens AG, and
Sycamore Networks, among others. Some of our competitors compete across many of
our product lines, while others do not offer as wide a breadth of solutions.
Several of our current and potential competitors may have greater resources,
including technical and engineering resources, than we do.
The principal competitive factors in the markets in which we presently compete
and may compete in the future are:
- The ability to provide end-to-end networking solutions and support
- Performance
- Price
- The ability to provide new technologies and products
- The ability to provide value-added features such as security,
reliability, and investment protection
- Conformance to standards
- Market presence
- The ability to provide financing
We also face competition from customers to whom we license technology and
suppliers from whom we transfer technology. The inherent nature of networking
requires interoperability. As such, we must cooperate and at the same time
compete with these companies. Our inability to effectively manage these
complicated relationships with customers and suppliers, or the uncontrollable
and unpredictable acts of others, could have a material adverse effect on our
business, operating results, and financial condition.
WE HAVE INVESTED IN AND WILL CONTINUE TO INVEST IN NEW AND EXISTING MARKET
OPPORTUNITIES
We have made investments in headcount, inventory, manufacturing capacity, and
product development through internal efforts and acquisitions, as a result of
growth in existing opportunities and new or emerging opportunities in our target
markets over the past years. We will continue to invest in these markets either
through additional investments or through re-alignment of existing resources. If
we are unable to meet expected revenue levels in a particular quarter, it could
have a material, negative impact on our operating results for that period as we
may not be able to react quickly enough to scale back expenses.
44
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
WE DEPEND UPON THE DEVELOPMENT OF NEW PRODUCTS AND ENHANCEMENTS TO EXISTING
PRODUCTS AND ARE SUBJECT TO RAPID CHANGES IN TECHNOLOGY AND THE MARKET
Our operating results may depend on our ability to develop and introduce new
products into existing and emerging markets and to reduce the costs to produce
existing products. The success of new products is dependent on several factors,
including proper new product definition, product cost, timely completion and
introduction of new products, differentiation of new products from those of our
competitors, and market acceptance of these products. The markets for our
products are characterized by rapidly changing technology, evolving industry
standards, new product introductions, and evolving methods of building and
operating networks. There can be no assurance that we will successfully identify
new product opportunities, develop and bring new products to market in a timely
manner, and achieve market acceptance of our products, or that products and
technologies developed by others will not render our products or technologies
obsolete or noncompetitive.
OUR BUSINESS SUBSTANTIALLY DEPENDS UPON THE CONTINUED GROWTH OF THE INTERNET AND
INTERNET-BASED SYSTEMS
A substantial portion of our business and revenue depends on the continued
growth of the Internet and on the deployment of our products by customers that
depend on the growth of the Internet. As a result of the economic slowdown and
the reduction in capital spending, spending on Internet infrastructure has
declined, which has had a material adverse effect on our business. To the extent
that the economic slowdown and reduction in capital spending continue to
adversely affect spending on Internet infrastructure, we could continue to
experience material adverse effects on our business, operating results, and
financial condition.
We believe that there will be certain performance problems with Internet
communications in the future, which could receive a high degree of publicity and
visibility. As we are a large supplier of networking products, we may be
materially adversely affected, regardless of whether or not these problems are
due to the performance of our products. Such an event could also result in a
material adverse effect on the market price of our common stock and could
materially adversely affect our business, operating results, and financial
condition.
45
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
WE EXPECT TO MAKE FUTURE ACQUISITIONS WHERE ADVISABLE AND ACQUISITIONS INVOLVE
NUMEROUS RISKS
The networking business is highly competitive, and as such, our growth is
dependent upon market growth, our ability to enhance our existing products, and
our ability to introduce new products on a timely basis. One of the ways we have
addressed and will continue to address the need to develop new products is
through acquisitions of other companies and technologies. Acquisitions involve
numerous risks, including the following:
- Difficulties in integrating the operations, technologies, and products of
the acquired companies
- The risk of diverting management's attention from normal daily operations
of the business
- Potential difficulties in completing projects associated with in-process
research and development
- Risks of entering markets in which we have no or limited direct prior
experience and where competitors in such markets have stronger market
positions
- Initial dependence on unfamiliar supply chains or relatively small supply
partners
- Insufficient revenues to offset increased expenses associated with
acquisitions
- The potential loss of key employees of the acquired companies
Mergers and acquisitions of high-technology companies are inherently risky, and
no assurance can be given that our previous or future acquisitions will be
successful and will not materially adversely affect our business, operating
results, or financial condition. We must also manage any growth effectively.
Failure to manage growth effectively and successfully integrate acquisitions we
make could harm our business and operating results in a material way.
THE ENTRANCE INTO NEW OR DEVELOPING MARKETS EXPOSES OUR BUSINESS AND OPERATIONS
TO RISKS
As we focus on new market opportunities, such as transporting data, voice, and
video traffic across the same network, we will increasingly compete with large
telecommunications equipment suppliers such as Alcatel, Ericsson, Lucent,
Nortel, and Siemens AG, among others, and several startup companies. Several of
our current and potential competitors may have greater resources, including
technical and engineering resources, than we do. Additionally, as customers in
these markets complete infrastructure deployments, they may require greater
levels of service, support, and financing than we have experienced in the past.
We expect that demand for these types of service contracts may increase in the
future. There can be no assurance that we can provide products, service,
support, and financing to effectively compete for these market opportunities.
Further, provision of greater levels of services by us may result in less
favorable timing of revenue recognition than we have historically experienced.
46
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
SALES TO THE SERVICE PROVIDER MARKET ARE SUBJECT TO VARIATION
Sales to the service provider market have been characterized by large and often
sporadic purchases. We have experienced decreases in sales to the service
provider market. Sales activity in this industry depends upon the stage of
completion of expanding network infrastructures, the availability of funding,
and the extent that service providers are affected by regulatory, economic, and
business conditions in the country of operations. Continued declines or delays
in sales orders from this industry could have a material adverse effect on our
business, operating results, and financial condition. The slowdown in the
general economy, over-capacity, changes in the service provider market, and the
constraints on capital availability have had a material adverse effect on many
of our service provider customers, with a number of such customers going out of
business or substantially reducing their expansion plans. These conditions have
had a material adverse effect on our business and operating results, and we
expect that these conditions may continue for the foreseeable future.
THE INDUSTRY IN WHICH WE COMPETE IS SUBJECT TO CONSOLIDATION
There has been a trend toward industry consolidation in our markets for several
years. We expect this trend toward industry consolidation to continue as
companies attempt to strengthen or hold their market positions in an evolving
industry. We believe that industry consolidation may result in stronger
competitors that are better able to compete as sole-source vendors for
customers. This could lead to more variability in operating results as we
compete to be a single or primary vendor solution and could have a material
adverse effect on our business, operating results, and financial condition.
OUR BUSINESS IS SUBJECT TO RISKS FROM INTERNATIONAL OPERATIONS
We conduct business globally. Accordingly, our future results could be
materially adversely affected by a variety of uncontrollable and changing
factors including, among others, foreign currency exchange rates; regulatory,
political, or economic conditions in a specific country or region; trade
protection measures and other regulatory requirements; service provider and
government spending patterns; and natural disasters. Any or all of these factors
could have a material adverse impact on our future international business.
WE ARE EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY
As a global concern, we face exposure to adverse movements in foreign currency
exchange rates. These exposures may change over time as business practices
evolve and could have a material adverse impact on our financial results and
cash flows. Historically, our primary exposures have related to
nondollar-denominated sales in Japan, Canada, and Australia and
nondollar-denominated operating expenses in Europe, Latin America, and Asia
where we sell primarily in U.S. dollars. Additionally, we have exposures to
emerging market currencies which can have
47
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
extreme currency volatility. We will continue to monitor our exposures and may
hedge against these or any other emerging market currencies as necessary.
At the present time, we hedge only those currency exposures associated with
certain assets and liabilities denominated in nonfunctional currencies and
periodically will hedge anticipated foreign currency cash flows. The hedging
activity undertaken by us is intended to offset the impact of currency
fluctuations on certain nonfunctional currency assets and liabilities.
The formal adoption of the euro on January 1, 2002 as the common currency for
members of the European Union did not have a material adverse effect on our
internal systems, operating results, or financial condition.
WE ARE EXPOSED TO THE CREDIT RISK OF SOME OF OUR CUSTOMERS AND TO CREDIT
EXPOSURES IN WEAKENED MARKETS
A portion of our sales is derived through our resellers in two-tier distribution
channels. These resellers/customers are generally given privileges to return
inventory, receive credits for changes in selling prices, and participate in
cooperative marketing programs. We maintain estimated accruals and allowances
for such exposures. However, such resellers tend to have access to more limited
financial resources than other resellers and end-user customers and therefore
represent potential sources of increased credit risk. We have experienced
increased demands for customer financing, including loan financing and leasing
solutions. We expect demands for customer financing may continue. We believe
customer financing is a competitive factor in obtaining business, particularly
in supplying customers involved in significant infrastructure projects. Our loan
financing arrangements may include not only financing the acquisition of our
products but also providing additional funds for soft costs associated with
network installation and integration of our products and for working capital
purposes. Due to the current slowdown in the economy, the credit risks relating
to these resellers/customers have increased. Although we have programs in place
to monitor and mitigate the associated risk, there can be no assurance that such
programs will be effective in reducing our credit risks. We also continue to
monitor credit exposures from weakened financial conditions in certain
geographic regions, and the impact that such conditions may have on the
worldwide economy. We have experienced losses due to customers failing to meet
their obligations. Although these losses have not been significant, future
losses, if incurred, could harm our business and have a material adverse effect
on our operating results and financial condition.
OUR BUSINESS DEPENDS UPON OUR PROPRIETARY RIGHTS AND THERE IS A RISK OF
INFRINGEMENT
Our success is dependent upon our proprietary technology. We generally rely upon
patents, copyrights, trademarks, and trade secret laws to establish and maintain
our proprietary rights in our technology and products. We have a program to file
applications for and obtain patents in the United States and in selected foreign
countries where a potential market for our products
48
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
exists. We have been issued a number of patents; other patent applications are
currently pending. There can be no assurance that any of these patents will not
be challenged, invalidated, or circumvented, or that any rights granted
thereunder will provide competitive advantages to us. In addition, there can be
no assurance that patents will be issued from pending applications, or that
claims allowed on any future patents will be sufficiently broad to protect our
technology. Furthermore, the laws of some foreign countries may not permit the
protection of our proprietary rights to the same extent as do the laws of the
United States. Although we believe the protection afforded by our patents,
patent applications, copyrights, and trademarks has value, the rapidly changing
technology in the networking industry makes our future success dependent
primarily on the innovative skills, technological expertise, and management
abilities of our employees rather than on patent, copyright, and trademark
protection.
The industry in which we compete is characterized by the existence of a large
number of patents and frequent claims and related litigation regarding patent
and other intellectual property rights. From time to time, third parties have
asserted exclusive patent, copyright, trademark and other intellectual property
rights to technologies and related standards that are important to us. These
claims have increased recently as a result of our acquisitions of businesses and
technologies. Such parties have pursued and may in the future assert claims or
initiate litigation against us or our manufacturers, suppliers, or customers
alleging infringement of their proprietary rights with respect to our existing
or future products. Regardless of the merit of these claims, they could be
time-consuming, result in costly litigation and diversion of technical
management personnel, or require us to develop a non-infringing technology or
enter into royalty or license agreements. If any infringement or other
intellectual property claim made against us by any third party is successful, or
if we fail to develop non-infringing technology or license the proprietary
rights, our business could be materially and adversely affected.
Many of our products are designed to include software or other intellectual
property licensed from third parties. While it may be necessary in the future to
seek or renew licenses relating to various aspects of our products, we believe
that based upon past experience and standard industry practice, such licenses
generally could be obtained on commercially reasonable terms. Because of the
existence of a large number of patents in the networking field and the rapid
rate of issuance of new patents, it is not economically practical to determine
in advance whether a product or any of our components infringe patent rights of
others. From time to time, we receive notices from or are sued by third parties
regarding patent infringement claims. If infringement claims are found to have
merit, we believe that, based upon industry practice, any necessary license or
rights under such patents may be obtained on terms that would not have a
material adverse effect on our financial condition. Nevertheless, there can be
no assurance that the necessary licenses would be available on acceptable terms,
if at all. The inability to obtain certain licenses or other rights or to obtain
such licenses or rights on favorable terms, or the need to engage in litigation
regarding these matters could have a material adverse effect on our business,
operating results, and financial condition.
49
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
WE FACE RISKS FROM THE UNCERTAINTIES OF REGULATION OF THE INTERNET
There are currently few laws or regulations that apply directly to access or
commerce on the Internet. We could be materially adversely affected by
regulation of the Internet and Internet commerce in any country where we
operate. Such regulations could include matters such as voice over the Internet,
encryption technology, and access charges for Internet service providers. Our
business could be materially adversely affected by the changes in the
regulations surrounding the telecommunications industry. The adoption of
regulation of the Internet and Internet commerce could decrease demand for our
products, and at the same time increase the cost of selling our products, which
could have a material adverse effect on our business, operating results, and
financial condition.
OUR SUCCESS LARGELY DEPENDS ON OUR ABILITY TO RETAIN AND RECRUIT KEY PERSONNEL
Our success has always depended in large part on our ability to attract and
retain highly skilled technical, managerial, sales, and marketing personnel. In
spite of the economic slowdown, competition for these personnel is intense,
especially in the Silicon Valley area of Northern California. Volatility or lack
of positive performance in our stock price may also adversely affect our ability
to retain key employees, all of whom have been granted stock options. The loss
of services of any of our key personnel, the inability to retain and attract
qualified personnel in the future, or delays in hiring required personnel,
particularly engineers and sales personnel, could make it difficult to meet key
objectives, such as timely product introductions. In addition, companies in the
networking industry whose employees accept positions with competitors frequently
claim that competitors have engaged in improper hiring practices. We have
received these claims in the past and may receive additional claims to this
effect in the future.
WE FACE CERTAIN LITIGATION RISKS
We are a party to lawsuits in the normal course of our business. Litigation can
be expensive, lengthy and disruptive to normal business operations. Moreover,
the results of complex legal proceedings are difficult to predict. An
unfavorable resolution of a particular lawsuit could have a material adverse
effect on our business, results of operations, or financial condition. For
additional information regarding certain of the lawsuits in which we are
involved, see Note 6 "Commitments and Contingencies" to the Consolidated
Financial Statements.
50
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
OUR BUSINESS IS SUBJECT TO THE RISKS OF EARTHQUAKES, FLOODS, AND OTHER
CATASTROPHIC EVENTS
Our corporate headquarters, including certain of our research and development
operations and our manufacturing facilities, are located in the Silicon Valley
area of Northern California, a region known for seismic activity. Additionally,
certain of our facilities, which include one of our manufacturing facilities,
are located near rivers that have experienced flooding in the past. A
significant natural disaster, such as an earthquake or a flood, could have a
material adverse impact on our business, operating results, and financial
condition. In addition, despite our implementation of network security measures,
our servers are vulnerable to computer viruses, break-ins, and similar
disruptions from unauthorized tampering with our computer systems. Any such
event could have a material adverse effect on our business, operating results,
and financial condition. In addition, the effects of war or acts of terrorism
could have a material adverse effect on our business, operating results, and
financial condition. The recent terrorist attacks in New York and Washington,
D.C. on September 11, 2001 disrupted commerce throughout the world and
intensified the uncertainty of the U.S. economy and other economies around the
world. The continued threat of terrorism and heightened security and military
action in response to this threat, or any future acts of terrorism, may cause
further disruptions to these economies and create further uncertainties. To the
extent that such disruptions or uncertainties result in delays or cancellations
of customer orders, or the manufacture or shipment of our products, our
business, operating results and financial condition could be materially and
adversely affected.
THE ENERGY CRISIS IN CALIFORNIA COULD DISRUPT OUR BUSINESS AND THE BUSINESSES OF
OUR SUPPLIERS AND SUPPLY PARTNERS AND COULD INCREASE OUR EXPENSES
The western United States (and California in particular) has experienced
repeated episodes of diminished electrical power supply, and we anticipate that
this situation could continue or worsen in the near future. As a result of these
episodes, certain of our operations or facilities have been and may continue to
be subject to "rolling blackouts" or other unscheduled interruptions of
electrical power. The prospect of such unscheduled interruptions may continue
for the foreseeable future, and we are unable to predict their occurrence or
duration. Certain of our suppliers and supply partners are also located in this
area and their operations may also be materially and adversely affected by such
interruptions. These suppliers and manufacturers may be unable to manufacture
sufficient quantities of our products to meet our demands, or they may increase
the costs of such products, which in turn could have a material adverse effect
on our business or results of operations.
51
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
WE ARE EXPOSED TO FLUCTUATIONS IN THE MARKET VALUES OF OUR PORTFOLIO INVESTMENTS
AND IN INTEREST RATES
We maintain an investment portfolio of various holdings, types, and maturities.
These securities are generally classified as available for sale and,
consequently, are recorded on the balance sheet at fair value with unrealized
gains or losses reported as a separate component of accumulated other
comprehensive income (loss), net of tax. Part of this portfolio includes equity
investments in several publicly traded companies, the values of which are
subject to market price volatility. Recent events have adversely affected the
public equities market and general economic conditions may continue to worsen.
As a result, we may recognize in earnings declines in fair value of our publicly
traded equity investments below the cost basis that are judged to be
other-than-temporary. For information regarding the sensitivity of and risks
associated with the market value of portfolio investments and interest rates,
see the section titled "Quantitative and Qualitative Disclosures About Market
Risk" contained in this Quarterly Report.
WE ARE SUBJECT TO RISKS ASSOCIATED WITH STRATEGIC ALLIANCES
We have a number of strategic alliances with large and complex organizations and
our ecosystem partners. These arrangements are generally limited to specific
projects, the goal of which is generally to facilitate product compatibility and
adoption of industry standards. If successful, these relationships may be
mutually beneficial and result in industry growth. However, these alliances
carry an element of risk because, in most cases, we must compete in some
business areas with a company with which we have a strategic alliance and, at
the same time, cooperate with that company in other business areas. Also, if
these companies fail to perform or if these relationships fail to materialize as
expected, we could suffer delays in product development or other operational
difficulties.
WE FACE RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATIONS REGULATION AND
TARIFFS
Changes in domestic and international telecommunications requirements could
affect the sales of our products. In particular, we believe it is possible that
there may be changes in domestic telecommunications regulation in the future
that could slow the expansion of the service providers' network infrastructures
and materially adversely affect our business, operating results, and financial
condition. Future changes in tariffs by regulatory agencies or application of
tariff requirements to currently untariffed services could affect the sales of
our products for certain classes of customers. Additionally, in the United
States, our products must comply with various Federal Communications Commission
requirements and regulations. In countries outside of the United States, our
products must meet various requirements of local telecommunications authorities.
Changes in tariffs or failure by us to obtain timely approval of products could
have a material adverse effect on our business, operating results, and financial
condition.
52
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RISK FACTORS
OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE
Our common stock has experienced substantial price volatility, particularly as a
result of variations between our actual and anticipated financial results, the
published expectations of analysts, and as a result of announcements by our
competitors and us. In addition, the stock market has experienced extreme price
and volume fluctuations that have affected the market price of many technology
companies, in particular, and that have often been unrelated to the operating
performance of these companies. These factors, as well as general economic and
political conditions, may materially adversely affect the market price of our
common stock in the future. Additionally, volatility or a lack of positive
performance in our stock price may adversely affect our ability to retain key
employees, all of whom have been granted stock options.
53
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We maintain an investment portfolio of various holdings, types, and maturities.
These securities are generally classified as available for sale and,
consequently, are recorded on the balance sheet at fair value with unrealized
gains or losses reported as a separate component of accumulated other
comprehensive income (loss), net of tax. Part of this portfolio includes equity
investments in several publicly traded companies, the values of which are
subject to market price volatility. During the first six months of fiscal 2002,
we recorded a charge of $858 million related to the impairment of certain
publicly traded securities in our investment portfolio, in accordance with
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." The impairment charge was related to
the declines in the fair value of our publicly traded equity investments below
their cost basis that were judged to be other-than-temporary. We have also
invested in numerous privately held companies, many of which can still be
considered in the start-up or development stages. These investments are
inherently risky as the market for the technologies or products they have under
development are typically in the early stages and may never materialize. We
could lose our entire initial investment in these companies. We also have
certain real estate lease commitments with payments tied to short-term interest
rates. At any time, a sharp rise in interest rates could have a material adverse
impact on the fair value of our investment portfolio while increasing the costs
associated with our lease commitments. Conversely, declines in interest rates
could have a material impact on interest earnings for our investment portfolio.
We do not currently hedge these interest rate exposures.
Readers are referred to pages 21 to 22 of the fiscal 2001 Annual Report to
Shareholders for a more detailed discussion of quantitative and qualitative
disclosures about market risk.
The following analysis presents the hypothetical changes in fair values of
public equity investments that are sensitive to changes in the stock market (in
millions):
Valuation of Securities Valuation of Securities
Given X% Decrease Fair Value Given X% Increase
in Each Stock's Price as of in Each Stock's Price
------------------------------------ Jan. 26, --------------------------------------
(75%) (50%) (25%) 2002 25% 50% 75%
------- ------- ------- ---------- ------- ------- -------
Corporate equities $ 334 $ 667 $ 1,001 $ 1,335 $ 1,669 $ 2,002 $ 2,336
These equity securities are held for purposes other than trading. The modeling
technique used measures the hypothetical change in fair values arising from
selected hypothetical changes in each stock's price. Stock price fluctuations of
plus or minus 25%, 50%, and 75% were selected based on the probability of their
occurrence. Our equity portfolio consists of securities with characteristics
that most closely match the S&P Index or companies traded on the NASDAQ National
Market. The NASDAQ Composite Index has shown a 25% and 50% movement in each of
the last three years and a 75% movement in at least one of the last three years.
54
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to legal proceedings, claims, and litigation arising in
the ordinary course of business. While the outcome of these matters is currently
not determinable, management does not expect that the ultimate costs to resolve
these matters will have a material adverse effect on the Company's consolidated
financial position, results of operations, or cash flows.
Beginning on April 20, 2001, a number of purported shareholder class action were
filed in the United States District Court for the Northern District of
California against Cisco and certain of its officers and directors. The lawsuits
are essentially identical, purport to bring suit on behalf of those who
purchased the Company's publicly traded securities between August 10, 1999 and
April 16, 2001, and have now been consolidated. Plaintiffs allege that
defendants have made false and misleading statements, purport to assert claims
for violations of the federal securities laws, and seek unspecified compensatory
damages and other relief. Cisco believes the claims are without merit and
intends to defend the actions vigorously.
In addition, beginning on April 23, 2001, a number of purported shareholder
derivative lawsuits were filed in the Superior Court of California, County of
Santa Clara, in addition to one filed in the Superior Court of California,
County of San Mateo. Those state court actions have been coordinated. Two
purported derivative suits have also been filed in the United States District
Court for the Northern District of California, and those federal court actions
have been consolidated. The complaints in the various derivative actions include
claims for breach of fiduciary duty, waste of corporate assets, mismanagement,
unjust enrichment and violations of the California Corporations Code, seek
compensatory and other damages, disgorgement and other relief, and are based on
essentially the same allegations as the class actions.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
10.12 Professional and Leadership Incentive Plan -- Fiscal Year 2002
(b) Reports on Form 8-K
None
55
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Cisco Systems, Inc.
Date: March 11, 2002 By /s/ Larry R. Carter
---------------------------------------
Larry R. Carter, Senior Vice
President, Finance and
Administration, Chief Financial
Officer and Secretary
56
Exhibit Index
Exhibit Number Description
-------------- -----------
10.12 Professional and Leadership Incentive Plan --
Fiscal Year 2002