<PAGE> 1
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 OCTOBER 24, 1998
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 December 2, 1998, 1,579,044,305 shares of the Registrant's common stock
were outstanding.
<PAGE> 2
CISCO SYSTEMS, INC.
FORM 10-Q FOR THE QUARTER ENDED OCTOBER 24, 1998
INDEX
<TABLE>
<CAPTION>
Page
<S> <C> <C>
Facing sheet 1
Index 2
Part I. Financial information
Item 1. Financial Statements and Supplementary Data
a) Consolidated statements of operations for the three months ended
October 24, 1998 and October 25, 1997 3
b) Consolidated balance sheets at October 24, 1998 and July 25, 1998
4
c) Consolidated statements of cash flows for the three months ended
October 24, 1998 and October 25, 1997 5
d) Notes to consolidated financial statements 6
Item 2. Management's discussion and analysis of financial condition and
results of operations 9
Part II. Other information 20
Signature 21
Exhibits Exhibit 27, Financial data schedule 22
</TABLE>
2
<PAGE> 3
ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per-share amounts)
<TABLE>
<CAPTION>
Three Months Ended
--------------------------
October 24, October 25,
1998 1997
----------- -----------
(Unaudited)
<S> <C> <C>
Net sales $2,588 $1,869
Cost of sales 894 652
------ ------
Gross margin 1,694 1,217
Operating expenses:
Research and development 327 224
Sales and marketing 514 334
General and administrative 84 56
Purchased research and development 41 127
------ ------
Total operating expenses 966 741
------ ------
Operating income 728 476
Realized gain on sale of investment -- 5
Interest and other income, net 65 37
------ ------
Income before provision for income taxes 793 518
Provision for income taxes 275 181
------ ------
Net income $ 518 $ 337
====== ======
Net income per share-basic $ .33 $ .22
====== ======
Net income per share-diluted $ .31 $ .21
====== ======
Shares used in per-share calculation-basic 1,569 1,514
====== ======
Shares used in per-share calculation-diluted 1,652 1,585
====== ======
</TABLE>
See notes to consolidated financial statements.
3
<PAGE> 4
CISCO SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(In millions, except par value)
<TABLE>
<CAPTION>
October 24, July 25,
1998 1998
----------- ---------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 961 $ 535
Short-term investments 920 1,157
Accounts receivable, net of allowance for doubtful
accounts of $39 at October 24, 1998 and
$40 at July 25, 1998 1,333 1,298
Inventories, net 375 362
Deferred income taxes 315 345
Prepaid expenses and other current assets 94 65
------ ------
Total current assets 3,998 3,762
Investments 4,009 3,463
Restricted investments 640 554
Property and equipment, net 621 595
Other assets 597 543
------ ------
Total assets $9,865 $8,917
====== ======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 282 $ 249
Income taxes payable 405 410
Accrued payroll and related expense 381 391
Other accrued liabilities 801 717
------ ------
Total current liabilities 1,869 1,767
Minority interest 43 43
Shareholders' equity:
Preferred stock, no par value, 5 shares authorized:
none issued or outstanding at October 24, 1998
and July 25, 1998
Common stock, $0.001 par value, 2,700 shares authorized:
1,573 shares issued and outstanding at
October 24, 1998 and 1,563 at July 25, 1998 3,520 3,220
Retained earnings 4,346 3,828
Accumulated comprehensive income 87 59
------ ------
Total shareholders' equity 7,953 7,107
------ ------
Total liabilities and shareholders' equity $9,865 $8,917
====== ======
</TABLE>
See notes to consolidated financial statements.
4
<PAGE> 5
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
<TABLE>
<CAPTION>
Three Months Ended
---------------------------
October 24, October 25,
1998 1997
----------- -----------
(Unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net income $ 518 $ 337
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 111 67
Deferred income taxes 40 (54)
Tax benefits from employee stock plans 116 69
Purchased research and development
from acquisition 41 19
Change in operating assets and liabilities:
Accounts receivable (35) 23
Inventories (13) 13
Prepaid expenses and other current assets (29) 27
Income taxes payable (5) 153
Accounts payable 33 (5)
Accrued payroll and related expenses (10) 12
Other accrued liabilities 83 46
------- -------
Net cash provided by operating activities 850 707
------- -------
Cash flows from investing activities:
Purchases of short-term investments (131) (484)
Proceeds from sales and maturities of
short-term investments 461 186
Purchases of investments (1,048) (467)
Proceeds from sales of investments 427 218
Purchases of restricted investments (133) (105)
Proceeds from sales and maturities of restricted
investments 54 65
Acquisition of property and equipment (125) (63)
Other (68) (43)
------- -------
Net cash used in investing activities (563) (693)
------- -------
Cash flows from financing activities:
Issuance of common stock 128 97
Other 11 (2)
------- -------
Net cash provided by financing activities 139 95
------- -------
Net increase in cash and equivalents 426 109
Cash and equivalents, beginning of period 535 269
------- -------
Cash and equivalents, end of period $ 961 $ 378
======= =======
</TABLE>
See notes to consolidated financial statements.
5
<PAGE> 6
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
Cisco Systems, Inc. (the "Company") provides networking solutions that connect
computing devices and computer networks, allowing people to access or transfer
information without regard to differences in time, place or type of computer
system. The Company sells its products in approximately 105 countries through a
combination of direct sales and reseller and distribution channels.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Year
The Company's fiscal year is the 52- or 53-week period ending on the last
Saturday in July. Fiscal year 1999 will be a 53-week year while 1998 was a
52-week year.
Basis of Presentation
The accompanying financial data as of October 24, 1998 and July 25, 1998, and
for the three months ended October 24, 1998 and October 25, 1997, have been
prepared by the Company, without audit, pursuant to the rules and regulations of
the Securities and Exchange Commission. 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 25, 1998 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 financial statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the year ended July 25, 1998.
In the opinion of management, all adjustments (which include only normal
recurring adjustments) necessary to present fairly the financial position,
results of operations, and cash flows as of October 24, 1998 and for the three
months ended October 24, 1998 and October 25, 1997, have been made. The results
of operations for the period ended October 24, 1998 are not necessarily
indicative of the operating results for the full year.
6
<PAGE> 7
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Computation of Net Income Per Share
Basic net income per common 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 and dilutive common
equivalent shares outstanding during the period. Dilutive common equivalent
shares consist of stock options.
Share and per share data presented reflect the three-for-two stock splits
effective September 1998 and December 1997.
Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131
"Disclosures about Segments of an Enterprise and Related Information" and in
June 1998, issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." Readers are referred to the "Recent Accounting
Pronouncements" section of the Company's 1998 Annual Report to Shareholders for
further discussion.
3. BUSINESS COMBINATIONS
In September 1998, the Company completed its purchase of American Internet
Corporation ("AIC"), a privately held developer of software solutions for IP
address management and Internet access. Under the terms of the agreement, the
Company exchanged stock worth $56 million for all of the outstanding common
stock of AIC. The Company recorded an expense for purchased research and
development related to the transaction of $41 million. The amounts allocated to
purchased research and development were determined through established valuation
techniques in the high-technology communications industry and were expensed upon
acquisition, because technological feasibility had not been established and no
future alternative uses existed. Research and development costs to bring the
software solutions to technological feasibility are not expected to have a
material impact on the Company's future results of operations or cash flows. A
pro forma summary is not presented as the historical operations of AIC are not
material to the Company's consolidated operations and financial position.
7
<PAGE> 8
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. BALANCE SHEET DETAIL
(In millions)
Inventories: October 24, July 25,
1998 1998
----------- --------
(Unaudited)
Raw materials $ 41 $ 76
Work in process 165 143
Finished goods 135 111
Demonstration systems 34 32
------ ------
$ 375 $ 362
====== ======
5. COMPREHENSIVE INCOME
The Company has adopted Statement of Financial Accounting Standards ("SFAS") No,
130, "Reporting Comprehensive Income", as of the first quarter of fiscal 1999.
SFAS No. 130 establishes new rules for the reporting and display of
comprehensive income and its components, however, it has no impact on the
Company's net income or total shareholders' equity.
The components of comprehensive income, net of tax, are as follows (in
millions):
<TABLE>
<CAPTION>
Three Months Ended
-------------------------
October 24, October 25,
1988 1997
----------- -----------
<S> <C> <C>
Net income $ 518 $ 337
Other comprehensive income (loss):
Change in unrealized gain on investments, net 17 (4)
Change in accumulated translation adjustments 11 (2)
----- -----
Total comprehensive income $ 546 $ 331
===== =====
</TABLE>
6. INCOME TAXES
The Company paid income taxes of $125 million for the quarter ended October 24,
1998 and $14 million for the quarter ended October 25, 1997. The Company's
income taxes currently payable for federal, state and foreign purposes have been
reduced by the tax benefits of disqualifying dispositions of stock options. This
benefit totaled $116 million in the first quarter of fiscal 1999, and was
credited directly to shareholders' equity.
8
<PAGE> 9
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. SHAREHOLDERS' EQUITY AND STOCK SPLIT
In August 1998, the Company's Board of Directors approved a three-for-two split
of the Company's common stock that was applicable to shareholders of record on
August 14, 1998 and effective on September 15, 1998. All references to share and
per-share data for all periods presented have been adjusted to give effect to
this three-for-two stock split as well as the three-for-two stock split
effective December 1997.
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", and words of similar import, constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. Readers are referred to the "Financial Risk Management" and "Potential
Volatility in Operating Results" sections of the Company's 1998 Annual Report to
Shareholders, to the "Acquisitions, Investments and Alliances", "Backlog",
"Competition", "Research and Development", "Manufacturing", "Patents,
Intellectual Property and Licensing", "Future Growth Subject to Risks" and
"Other Risk Factors" sections, among others, contained in the Company's 1998
Form 10-K filed on September 25, 1998, and to the "Financial Risk Management"
and "Future Growth Subject to Risks" and "Potential Volatility in Operating
Results" sections contained herein which identify important risk factors that
could cause actual results to differ from those contained in the forward looking
statements.
Net sales grew to $2.59 billion in the first quarter of 1999 from $1.87 billion
in the first quarter of 1998. The 38.5% increase in net sales between the two
periods was primarily a result of increasing unit sales of LAN switching
products such as the Catalyst(R) 5000 family, access servers such as the Cisco
3600 family, growth in the sales of add-on boards that provide increased
functionality, and increased maintenance service contract sales. The sales
growth rate for lower-priced access and switching products targeted toward small
and medium-sized businesses has increased faster than that of the Company's
high-end core router products. However, these products typically carry lower
average selling prices. Additionally, some of the Company's more established
product lines, such as the Cisco 2500 and 4000 product families, have decreased
as a percentage of total revenue. Sales to international customers increased to
41.1% in the first quarter of 1999 versus 39.1% for the first quarter of 1998.
The increase reflects
9
<PAGE> 10
sales growth in certain international markets, particularly Germany, the United
Kingdom and Canada. Sales growth in other markets, such as Japan, has been
negatively impacted by certain factors including weaker economic conditions,
delayed government spending, a stronger dollar versus the local currencies, and
slower adoption of networking technologies.
Gross margins increased slightly to 65.5% in the first quarter of 1999 from
65.1% in the first quarter of 1998. This increase is due principally to the
Company's improvements in value engineering efforts and material cost
reductions, and was partially offset by the continued shift in revenue mix to
the Company's lower-margin products. The prices of component parts have
fluctuated in the recent past, and the Company expects that this trend may
continue. An increase in the price of component parts may have a material
adverse impact on gross margins. The Company continues to expect that gross
margins will decrease in the future, because it believes that the market for
lower-margin remote access and switching products for small to medium-sized
businesses will continue to increase at a faster rate than the market for the
Company's higher-margin router and high-performance switching products.
Additionally, as the Company focuses on new market opportunities, it faces
increasing competitive pressure from large telecommunications equipment
suppliers and well funded start-up companies, which may adversely effect gross
margins. The Company is attempting to mitigate this trend through various means,
such as increasing the functionality of its products, continued value
engineering, controlling royalty costs, and improving manufacturing
efficiencies. There can be no assurance that any efforts made by the Company in
these and other areas will successfully offset decreasing margins.
Research and development expenses increased by $103 million in the first quarter
of 1999 over the first quarter of 1998, an increase to 12.6% from 12.0% of net
sales. The increase reflects the Company's ongoing research and development
efforts in a wide variety of areas such as voice, video, and data integration,
Digital Subscriber Line (DSL) technologies, dial access, enterprise switching,
security, network management, and high-end routing technologies, among others. A
significant portion of the increase was due to the addition of new personnel,
partly through acquisitions, as well as higher expenditures on prototypes and
depreciation on additional lab equipment. For the near future, research and
development expenses are expected to increase at a greater rate than the sales
growth rate, as the Company invests in technology to address potential market
opportunities. The Company also continues to purchase technology in order to
bring a broad range of products to the market in a timely fashion. If the
Company believes that it is unable to enter a particular market in a timely
manner, with internally developed products, it may license technology from other
businesses or acquire other businesses as an alternative to internal research
and development. All of the Company's research and development costs are
expensed as incurred.
10
<PAGE> 11
Sales and marketing expenses increased by $180 million in the first quarter of
1999 over the first quarter of 1998, an increase to 19.9% from 17.9% of net
sales. The increase is due principally to an increase in the size of the
Company's direct sales force and its commissions, additional marketing and
advertising costs associated with the introduction of new products and the
expansion of distribution channels. The increase also reflects the Company's
efforts to invest in certain key areas such as expansion of its end-to-end
strategy and service provider coverage in order to position itself to take
advantage of future market opportunities.
General and administrative expenses rose $28 million between the first quarters
of 1999 and 1998, an increase to 3.2% from 3.0% of net sales. The increase
reflects increased personnel costs necessary to support the Company's business
infrastructure, including those associated with its European Logistics Center,
the further development of its information systems as well as increased levels
of amortization for acquisition-related intangible assets. It is management's
intent to keep general and administrative costs relatively constant as a
percentage of net sales; however, this is dependent upon the level of
acquisition activity and amortization of the resulting intangible assets, among
other factors.
The amount expensed to purchased research and development in the first quarter
of fiscal 1999 arose from the acquisition of AIC (See Note 3).
Recent Accounting Pronouncements
In June 1997, the FASB issued SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information" and in June 1998, issued SFAS No. 133
"Accounting for Derivative Instruments and Hedging Activities." Readers are
referred to the "Recent Accounting Pronouncements" section of the Company's 1998
Annual Report to Shareholders for further discussion.
FINANCIAL RISK MANAGEMENT
As a global concern, the Company faces 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 the Company's
financial results. Historically, the Company's primary exposures related to
nondollar-denominated sales in Japan, Canada, and Australia and
nondollar-denominated operating expenses in Europe, Latin America, and Asia
where the Company sells primarily in U.S. dollars. Additionally, the Company has
recently seen its exposures to emerging market currencies, such as the Korean
Won and Russian Ruble, among others, increase because of the Company's expanding
presence in these markets and the extreme currency volatility. The Company
currently does not hedge against these or any other emerging market currencies
and could suffer unanticipated gains or losses as a result.
11
<PAGE> 12
The introduction of the Euro as a common currency for members of the European
Union is scheduled to take place in January 1999. The use of the Euro could
impact the Company's foreign exchange exposure. The Company is prepared to hedge
against fluctuations in the Euro if this exposure becomes material. The Company
also expects that its internal systems will be affected by the introduction of
the Euro, but expects these systems to be capable of processing Euro denominated
transactions by January 1999, although there can be no assurance in this regard.
At the present time, the Company hedges only those currency exposures associated
with certain assets and liabilities denominated in nonfunctional currencies and
does not generally hedge anticipated foreign currency cash flows. The hedging
activity undertaken by the Company is intended to offset the impact of currency
fluctuations on certain nonfunctional currency assets and liabilities. The
success of this activity depends upon estimations of intercompany balances
denominated in various currencies, primarily the Japanese yen, Canadian dollar,
Australian dollar, and certain European currencies. To the extent that these
forecasts are over- or understated during periods of currency volatility, the
Company could experience unanticipated currency gains or losses.
The Company is experiencing a greater proportion of its sales activity through
its partners in two-tier distribution channels. These customers are generally
given privileges to return inventory, receive credits for changes in the
Company's selling prices and participate in cooperative marketing programs. The
Company maintains appropriate reserves and allowances for such exposures.
However, such partners 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. Additionally, the Company is experiencing
increased demands for customer financing and leasing solutions. The Company also
continues to monitor increased credit exposures because of the weakened
financial conditions in Asia, and other emerging market regions, and the impact
that such conditions may have on the worldwide economy. Although the Company has
not experienced significant losses due to customers failing to meet their
obligations to date, such losses, if incurred, could have a material adverse
impact on the Company's business, operating results, and financial position.
The Company maintains investment portfolio holdings of various issuers, 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 shareholders'
equity, net of tax. Part of this portfolio includes minority equity investments
in several publicly-traded companies, the values of which are subject to market
price volatility. The Company also has certain real estate lease commitments
with payments tied to short-term interest rates. At any time, a sharp rise
12
<PAGE> 13
in interest rates could have a material adverse impact on the fair value of the
Company's investment portfolio while increasing the costs associated with its
lease commitments. Conversely, declines in interest rates could have a material
impact on interest earnings for the Company's investment portfolio. The Company
does not currently hedge these interest rate exposures. Readers are referred to
pages 23-25 of the Company's 1998 Annual Report to Shareholders for further
discussion of the Company's interest rate exposures.
FUTURE GROWTH SUBJECT TO RISKS
The networking business is highly competitive, and as such, the Company's growth
is dependent upon market growth and its ability to enhance its existing products
and introduce new products on a timely basis. One of the ways the Company has
addressed and will continue to address the need to develop new products is
through acquisitions of other companies. Acquisitions involve numerous risks,
including difficulties in integration of the operations, technologies, and
products of the acquired companies; the risk of diverting management's attention
from normal daily operations of the business; risks of entering markets in which
the Company has no or limited direct prior experience and where competitors in
such markets have stronger market positions; and the potential loss of key
employees of the acquired company. The Company must also maintain its ability to
manage any such growth effectively. Failure to manage growth effectively and
successfully integrate acquisitions made by the Company could materially
adversely affect the Company's business and operating results.
There are currently few laws or regulations that apply directly to access or
commerce on the Internet. The Company could be materially adversely affected by
proposed regulation on voice over the Internet, encryption technology and access
charges for Internet service providers, as well as the continuing deregulation
of the telecommunications industry. The adoption of such measures could decrease
demand for the Company's products, and at the same time increase the Company's
cost of selling its products. Changes in laws or regulations governing the
Internet and Internet commerce could have a material adverse effect on the
Company's business, operating results and financial condition.
The markets for the Company's products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions, and
evolving methods of building and operating networks. There can be no assurance
that the Company will successfully identify new product opportunities and
develop and bring new products to market in a timely manner, or that products
and technologies developed by others will not render the Company's products or
technologies obsolete or noncompetitive.
13
<PAGE> 14
As the Company focuses on new market opportunities, such as transporting voice,
video, and data traffic across the same network, it will increasingly compete
with large telecommunications equipment suppliers such as Lucent, Ericsson and
Nortel, among others, and well funded start-up companies. Several of the
Company's current and potential competitors have greater financial, marketing
and technical resources than the Company. Additionally, as customers in these
markets complete infrastructure deployments, they may require greater levels of
service, support and financing than the Company has experienced in the past.
There can be no assurance that the Company can provide products, service,
support and financing to effectively compete for these market opportunities.
Further, provision of greater levels of services by the Company may result in
less favorable revenue recognition treatment than has historically been
experienced. Readers are also referred to the "Competition" section of the
Company's Form 10-K filed on September 25, 1998 for further discussion.
The Company's growth and ability to meet customer demands also depend in part on
its ability to obtain timely deliveries of parts from its suppliers. The Company
has experienced component shortages in the past that have adversely affected its
operations. Although the Company works closely with its suppliers to avoid these
types of shortages, there can be no assurance that the Company will not
encounter these problems in the future.
The Company's corporate headquarters, including most of its research and
development operations and its manufacturing facilities, are located in the
Silicon Valley area of Northern California, a region known for seismic activity.
Additionally, one of the Company's manufacturing facilities is located near a
river that has experienced flooding in the past. A significant natural disaster,
such as an earthquake or a flood, could have a material adverse impact on the
Company's business, financial condition and operating results.
POTENTIAL VOLATILITY IN OPERATING RESULTS
The Company expects that in the future, its net sales may grow at a slower rate
than was experienced in previous periods, and that on a quarter-to-quarter
basis, the Company's growth in net sales may be significantly lower than its
historical quarterly growth rate. As a consequence, operating results for a
particular quarter are extremely difficult to predict. The Company's ability to
meet financial expectations could be hampered if the nonlinear sales pattern
seen in past quarters reoccurs in future periods. The Company generally has had
one quarter of the fiscal year when backlog has been reduced. Although such
reductions have not occurred consistently in recent years, they are difficult to
predict and may occur in the future. In addition, in response to customer
demand, the Company continues to attempt to reduce its product manufacturing
lead times, which may result in corresponding reductions in order backlog. A
decline in backlog levels could result in more variability and less
predictability
14
<PAGE> 15
in the Company's quarter-to-quarter net sales and operating results going
forward. On the other hand, for certain products, lead times are longer than the
Company's goal. If the Company cannot reduce manufacturing lead times for such
products, the Company's customers may cancel orders or not place further orders
if shorter lead times are available from other manufacturers, thus creating
additional variability.
As a result of recent unfavorable economic conditions, sales to certain
countries in Asia and the Pacific Rim have declined as a percentage of the
Company's total revenue. If the economic conditions in these markets, or other
markets which recently experienced unfavorable conditions, such as Latin America
and Eastern Europe, worsen, or if these unfavorable conditions result in a wider
regional or global economic slowdown, this decline may have a material adverse
impact on the Company's business, operations and financial condition.
Recent actions and comments from the Securities and Exchange Commission have
indicated they are reviewing the current valuation methodology of purchased
in-process research and development related to business combinations. The
Commission is concerned that some companies are writing off more of the value of
an acquisition than is appropriate. The Company believes it is in compliance
with all of the rules and related guidance as they currently exist. However,
there can be no assurance that the Commission will not seek to retroactively
apply new guidance and reduce the amount of purchased in-process research and
development previously expensed by the Company. This would result in the
restatement of previously filed financial statements of the Company and could
have a material adverse impact on financial results for periods subsequent to
the acquisitions.
The Company also expects that gross margins may be adversely affected by
increases in material or labor costs, heightened price competition, and changes
in channels of distribution or in the mix of products sold. For example, the
Company believes that gross margins may decline over time, because the markets
for lower-margin access products targeted toward small to medium-sized customers
have continued to grow at a faster rate than the markets for the Company's
higher-margin router and high-performance switching products targeted toward
enterprise and service provider customers. The Company has recently introduced
new products with several new products scheduled to be released in the near
future. If warranty costs associated with these new products are greater than
the Company has experienced historically, gross margins may be adversely
affected. The Company's gross margins may also be impacted by geographic mix, as
well as the mix of configurations within each product group. The Company
continues to expand into third-party or indirect distribution channels, which
generally results in lower gross margins. In addition, increasing third-party
and indirect distribution channels generally results in greater difficulty in
forecasting the mix of the Company's products, and to a certain degree, the
timing of its orders.
The Company also expects that its operating margins may decrease as it continues
to hire additional personnel and increases other operating expenses to support
its business. The Company plans its operating expense levels based primarily on
forecasted revenue levels. Because these expenses are relatively fixed in the
short term, a shortfall in revenue could lead to operating results being below
expectations.
The results of operations for the quarter ended October 24, 1998 are not
necessarily indicative of results to be expected in future periods, and the
Company's operating results may be subject to quarterly fluctuations as a result
of a number of factors. These factors include the integration of people,
operations, and products from acquired businesses and technologies; increased
competition in the networking industry; the overall trend toward industry
consolidation; the introduction and market acceptance of new technologies and
standards, including switch routers, Gigabit Ethernet switching, Tag Switching
(currently also known as multiprotocol label switching (MPLS)) and voice, video
and data capabilities; variations in sales channels, product costs, or mix of
products sold; the timing of orders and manufacturing lead times; and changes in
general economic conditions, any of which could have a material adverse impact
on operations and financial results.
Year 2000
The Company has begun to assess the impact of the Year 2000 issue on its current
and future products, internal information systems and non-information technology
systems (equipment and systems) and has begun, and in many cases completed,
corrective efforts in these areas. The Company is using a four phase approach to
address the issue. The first phase consists of the inventorying of all potential
business disruption problems, including those with products and systems, as well
as potential disruption from suppliers and other third parties. The second phase
consists of the prioritization of all the potential problems to allocate the
appropriate level of resources to the most critical areas. The third phase
addresses the remediation programs to solve or mitigate any identified Year 2000
problems. The fourth phase, if necessary, will be to develop contingency plans
if it appears the Company or its key suppliers will not be Year 2000 compliant,
and such noncompliance is expected to have a material adverse impact on the
Company's operations.
The Company has largely completed the implementation of Year 2000 compliant
internal computer applications for its main financial, manufacturing and order
processing systems. The systems are being tested for compliance; the Company
does not currently expect any significant issues to be identified during this
review. However, the failure of any internal system to achieve Year 2000
readiness could result in material disruption to the Company's operations.
The Company has also conducted extensive work regarding the status of its
currently available, developing and installed base of products. The Company
believes that its current products are largely Year 2000 compliant. There can be
no assurance that certain previous releases of the Company's products which are
no longer under support will prove to be Year 2000 compliant with customers'
systems or within an existing network. Further information about the Company's
products is available on its Year 2000 Internet Website. The Company has
developed programs for customers who have indicated a need to upgrade components
of their systems. However, the inability of any of the Company's products to
properly
15
<PAGE> 16
manage and manipulate data in the year 2000 could result in increased warranty
costs, customer satisfaction issues, potential lawsuits and other material costs
and liabilities.
The Company has completed phases I and II of its review of supplier bases
and, in the third phase of the compliance approach, is in the process of
reviewing the state of readiness of its supplier base. This exercise includes
compliance inquiries and reviews that will continue throughout 1999. Where
issues are identified with a particular supplier, contingency plans will be
developed as discussed below. Even where assurances are received from third
parties there remains a risk that failure of systems and products of other
companies on which the Company relies could have a material adverse effect on
the Company. Further, if these suppliers fail to adequately address the Year
2000 issue for the products they provide to the Company, critical materials,
products and services may not be delivered timely and the Company may not be
able to manufacture sufficient product to meet sales demand.
Based on the work done to date, the Company has not incurred material costs and
does not expect to incur future material costs in the work to address the Year
2000 problem for its systems (as a result of relatively new legacy information
systems) and products.
The Company has taken and will continue to take corrective action to mitigate
any significant Year 2000 problems with its systems and products and believes
that the Year 2000 issue for information systems will not have a material impact
on its operations or financial results. However, there can be no assurance that
the Company will not experience significant business disruptions or loss of
business due to an inability to adequately address the Year 2000 issue. The
Company is concerned that many enterprises will be devoting a substantial
portion of their information systems spending to addressing the Year 2000 issue.
This expense may result in spending being diverted from networking solutions in
the near future. This diversion of information technology spending could have a
material adverse impact on the Company's future sales volume.
Contingency plans will be developed in certain key areas, in particular
surrounding third party manufacturers and other suppliers, to ensure that any
potential business interruptions caused by the Year 2000 issue are mitigated.
Such contingency plans include identification of alternative sources of supply
and test exercises to ensure that such alternatives are able to provide the
Company with an adequate level of support. These plans are expected to be
developed beginning in May 1999.
The foregoing statements are based upon management's best estimates at the
present time, which were derived utilizing numerous assumptions of future
events, including the continued availability of certain resources, third party
modification plans and other factors. There can
16
<PAGE> 17
be no guarantee that these estimates will be achieved and actual results could
differ materially from those anticipated. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to locate and correct all
relevant computer codes, the nature and amount of programming required to
upgrade or replace each of the affected programs, the rate and magnitude of
related labor and consulting costs and the success of the Company's external
customers and suppliers in addressing the Year 2000 issue. The Company's
evaluation is on-going and it expects that new and different information will
become available to it as that evaluation continues. Consequently, there is no
guarantee that all material elements will be Year 2000 ready in time.
17
<PAGE> 18
Liquidity and Capital Resources
Cash and equivalents, short-term investments, and investments were $5.9 billion
at October 24, 1998, an increase of $735 million from July 25, 1998. The
increase is primarily a result of cash generated by operations; and to a lesser
extent, through financing activities, primarily the exercise of employee stock
options. These cash flows were partially offset by cash outflows from operating
activities including tax payments of approximately $125 million, and cash
outflows from investing activities including capital expenditures of
approximately $125 million.
Accounts receivable increased 2.7% from July 25, 1998 to October 24, 1998, while
sales grew by 8.3% over the same period. Days sales outstanding in receivables
improved to 47 days at October 24, 1998 from 49 days at July 25, 1998.
Inventories increased 3.6% between July 25, 1998 and October 24, 1998, which
reflects the Company's new product introductions and continued growth in the
Company's two-tiered distribution system. Inventory management remains an area
of focus as the Company balances 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.
Accounts payable increased by 13.3% at October 24, 1998 over July 25, 1998.
Other accrued liabilities increased by 11.7% primarily due to higher deferred
revenue on service contracts.
At October 24, 1998, the Company had a line of credit totaling $500
18
<PAGE> 19
million, which expires July 2002. There have been no borrowings under this
facility.
The Company has entered into certain lease arrangements in San Jose, California,
and Research Triangle Park, North Carolina, where it has established its
headquarters operations and certain research and development and customer
support activities. In connection with these transactions, the Company pledged
$640 million of its investments as collateral for certain obligations of the
leases. The Company anticipates that it will occupy more leased property in the
future that will require similar pledged securities; however, the Company does
not expect the impact of this activity to be material to liquidity.
The Company's management believes that its current cash and equivalents,
short-term investments, line of credit, and cash generated from operations will
satisfy its expected working capital and capital expenditure requirements
through fiscal 1999.
19
<PAGE> 20
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the quarter, the Company issued an aggregate of 743,761
shares of its Common Stock in exchange for the outstanding
capital stock of American Internet Corporation. The shares
were issued pursuant to an exemption by reason of Section 4(2)
of the Securities Act of 1933. These sales were made without
general solicitation or advertising. Each purchaser was an
accredited investor or a sophisticated investor with access to
all relevant information necessary. The Company has filed
Registration Statements on Form S-3 covering the resale of
such securities.
ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K
(a) Exhibit
27 Financial data schedule
(b) Reports on Form 8-K
The Company filed one report on Form 8-K during the fiscal
quarter ended October 24, 1998. The report was filed on
October 13, 1998 and reported on the September acquisition of
American Internet Corporation.
20
<PAGE> 21
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: December 7, 1998 By /s/ Larry R. Carter
------------------------------------
Larry R. Carter,
Senior Vice President Finance, and Chief
Financial Officer (Principal Financial
and Accounting Officer)
21
<PAGE> 22
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------ -----------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheet and consolidated statement of operations included in
the Company's Form 10-Q for the period ended October 24, 1998, and is qualified
in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> JUL-31-1999
<PERIOD-START> JUL-25-1998
<PERIOD-END> OCT-24-1998
<CASH> 961
<SECURITIES> 5,569
<RECEIVABLES> 1,372
<ALLOWANCES> 39
<INVENTORY> 375
<CURRENT-ASSETS> 3,998
<PP&E> 1,375
<DEPRECIATION> 754
<TOTAL-ASSETS> 9,865
<CURRENT-LIABILITIES> 1,869
<BONDS> 0
0
0
<COMMON> 3,520
<OTHER-SE> 4,433
<TOTAL-LIABILITY-AND-EQUITY> 9,865
<SALES> 2,588
<TOTAL-REVENUES> 2,588
<CGS> 894
<TOTAL-COSTS> 1,860
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 793
<INCOME-TAX> 275
<INCOME-CONTINUING> 518
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 518
<EPS-PRIMARY> 0.33<F1>
<EPS-DILUTED> 0.31
<FN>
<F1>For purposes of this statement, primary means basic.
</FN>
</TABLE>
