<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 JANUARY 23, 1999
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 March 2, 1999, 1,597,195,347 shares of the Registrant's common stock were
outstanding.
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CISCO SYSTEMS, INC.
FORM 10-Q FOR THE QUARTER ENDED JANUARY 23, 1999
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 and six months
ended January 23, 1999 and January 24, 1998 3
b) Consolidated balance sheets at January 23, 1999 and July 25, 1998 4
c) Consolidated statements of cash flows for the six months
ended January 23, 1999 and January 24, 1998 5
d) Notes to consolidated financial statements 6
Item 2. Management's discussion and analysis of financial
condition and results of operations 11
Part II. Other information 26
Signature 28
Exhibit Exhibit 27, Financial data schedule 29
</TABLE>
2
<PAGE> 3
PART I.
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 Six Months Ended
-------- -------- --------------------
Jan. 23, Jan. 24, Jan. 23, Jan. 24,
1999 1998 1999 1998
-------------------- --------------------
(Unaudited)
<S> <C> <C> <C> <C>
Net sales $2,827 $2,016 $5,415 $3,885
Cost of sales 985 697 1,879 1,349
------ ------ ------ ------
Gross margin 1,842 1,319 3,536 2,536
Operating expenses:
Research and development 357 239 684 463
Sales and marketing 570 363 1,084 697
General and administrative 90 58 174 114
Purchased research and development 349 -- 390 127
------ ------ ------ ------
Total operating expenses 1,366 660 2,332 1,401
------ ------ ------ ------
Operating income 476 659 1,204 1,135
Realized gain on sale of investment -- -- -- 5
Interest and other income, net 80 44 145 81
------ ------ ------ ------
Income before provision for income taxes 556 703 1,349 1,221
Provision for income taxes 268 246 543 427
------ ------ ------ ------
Net income $ 288 $ 457 $ 806 $ 794
====== ====== ====== ======
Net income per share--basic $ .18 $ .30 $ .51 $ .52
====== ====== ====== ======
Net income per share--diluted $ .17 $ .29 $ .48 $ .50
====== ====== ====== ======
Shares used in per-share
calculation--basic 1,585 1,523 1,578 1,518
====== ====== ====== ======
Shares used in per-share
calculation--diluted 1,679 1,594 1,668 1,589
====== ====== ====== ======
</TABLE>
See notes to consolidated financial statements.
3
<PAGE> 4
CISCO SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(In millions, except par value)
<TABLE>
<CAPTION>
January 23, July 25,
1999 1998
----------- --------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents $ 1,421 $ 535
Short-term investments 886 1,157
Accounts receivable, net of allowance for doubtful
accounts of $37 at January 23, 1999 and
$40 at July 25, 1998 1,477 1,298
Inventories, net 472 362
Deferred income taxes 408 345
Prepaid expenses and other current assets 144 65
------- -------
Total current assets 4,808 3,762
Investments 4,225 3,463
Restricted investments 800 554
Property and equipment, net 679 595
Other assets, net 922 543
------- -------
Total assets $11,434 $ 8,917
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 345 $ 249
Income taxes payable 462 410
Accrued payroll and related expenses 506 391
Other accrued liabilities 921 717
------- -------
Total current liabilities 2,234 1,767
Minority interest 44 43
Shareholders' equity:
Preferred stock, no par value, 5 shares authorized:
none issued or outstanding at January 23, 1999
and July 25, 1998
Common stock and additional paid-in capital,
$0.001 par value,
2,700 shares authorized: 1,593 shares
Issued and outstanding at January 23, 1999
and 1,563 at July 25, 1998 4,361 3,220
Retained earnings 4,634 3,828
Accumulated comprehensive income 161 59
------- -------
Total shareholders' equity 9,156 7,107
------- -------
Total liabilities and shareholders' equity $11,434 $ 8,917
======= =======
</TABLE>
See notes to consolidated financial statements.
4
<PAGE> 5
CISCO SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
<TABLE>
<CAPTION>
Six Months Ended
-------------------------
January 23, January 24,
1999 1998
----------- -----------
(Unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net income $ 806 $ 794
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 229 138
Deferred income taxes (85) (83)
Tax benefits from employee stock plans 398 142
Purchased research and development from acquisitions 298 19
Change in operating assets and liabilities:
Accounts receivable (173) (86)
Inventories (109) (13)
Prepaid expenses and other current assets (77) 30
Income taxes payable 51 63
Accounts payable 93 32
Accrued payroll and related expenses 114 27
Other accrued liabilities 170 104
------- -------
Net cash provided by operating activities 1,715 1,167
------- -------
Cash flows from investing activities:
Purchases of short-term investments (309) (855)
Proceeds from sales and maturities of short-term
investments 890 914
Purchases of investments (1,895) (1,430)
Proceeds from sales of investments 970 507
Purchases of restricted investments (496) (191)
Proceeds from sales and maturities of restricted
investments 251 116
Acquisition of property and equipment (277) (140)
Acquisition of Selsius Systems, net of
purchased research and development (19) --
Increase in lease receivables (137) (66)
Other (133) (10)
------- -------
Net cash used in investing activities (1,155) (1,155)
------- -------
Cash flows from financing activities:
Issuance of common stock 315 199
Other 11 (4)
------- -------
Net cash provided by financing activities 326 195
------- -------
Net increase in cash and equivalents 886 207
Cash and equivalents, beginning of period 535 270
------- -------
Cash and equivalents, end of period $ 1,421 $ 477
======= =======
</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 is a 53-week year while 1998 was a 52-week
year.
Basis of Presentation
The accompanying financial data as of January 23, 1999 and July 25, 1998, and
for the three and six month periods ended January 23, 1999 and January 24, 1998,
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 January 23, 1999 and for the three
and six month periods ended January 23, 1999 and January 24, 1998, have been
made. The
6
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CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
results of operations for the period ended January 23, 1999 are not necessarily
indicative of the operating results for the full year.
Advertising Costs
The Company expenses all advertising costs as they are incurred.
Software Development Costs
Software development costs which are required to be capitalized pursuant to
Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the
Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed," have not
been material to the Company to date.
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.
The Company adopted Statement of Position (SOP) No. 97-2, "Software Revenue
Recognition" in the first quarter of fiscal year 1999 and its adoption had no
material impact on the Company's results from operations or financial position.
7
<PAGE> 8
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. BUSINESS COMBINATIONS
The Company has made a number of purchase acquisitions. 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 an aggregated basis.
The amounts allocated to purchased research and development were determined
based on appraisals completed by an independent third party using 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 products from the acquired companies to technological
feasibility are not expected to have a material impact on the Company's future
results of operations or cash flows. Amounts allocated to goodwill and other
intangibles are amortized on a straight-line basis over periods not exceeding
five years.
In November, the Company completed its purchase of Summa Four, Inc. ("Summa
Four"), a provider of programmable switch products. The Company's acquired
technology consists of two existing programmable switch products and one
programmable switch currently under development. Also in November, the Company
completed its purchase of Clarity Wireless, Inc.("Clarity"), a developer of
high-bandwidth wireless access technology for the computer networking and
Internet access markets. The Company's acquired technology consists of two
high-bandwidth access products currently under development, patents and patents
pending. Also in November, the Company completed its purchase of Selsius
Systems, Inc.("Selsius"), a developer of voice over data network products. The
Company's acquired technology consists of the core technology in Selsius'
existing public broadcast exchange (PBX) system and technology currently under
development for an enterprise-wide PBX system. Selsius' technology is focused on
developing products that will deliver voice over data network solutions. In
December, the Company acquired PipeLinks, Inc.("Pipelinks"), a developer of
SONET/SDH routers. The
8
<PAGE> 9
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Company's acquired technology consists of two research and development projects
in process which are expected to result in the ability to transport both voice
and IP(Internet Protocol) traffic over the same network.
Total purchased research and development expense was $390 million for the six
months ending January 23, 1999. The purchased research and development expense
that was attributable to stock purchase acquisitions for the six month period
was $298 million and the purchased research and development expense attributable
to the cash purchase transaction, consisting of Selsius only, was $92 million
for the six month period ending January 23, 1999.
Each of the acquisition transactions is further outlined below:
Summary of purchase transactions (in millions):
<TABLE>
<CAPTION>
Purchased
Research &
Development Form of Consideration and Other
Entity Name Consideration Charge Notes to Acquisition
----------- ------------- ------------- -------------------------------
<S> <C> <C> <C>
Quarter Ended -
October 24, 1998
American Internet Corp. $56 $41 Common stock and options assumed;
goodwill and other intangibles
recorded of $18
Quarter Ended-
January 23, 1999
Summa Four, Inc. $129 $64 Common stock and options assumed, $16
in liabilities assumed; goodwill and
other intangibles recorded of $29
Clarity Wireless, Inc. $153 $94 Common stock and options assumed;
goodwill and other intangibles
recorded of $73
Selsius Systems, Inc. $134 $92 $111 in cash; options assumed;
goodwill and other intangibles
recorded of $41
PipeLinks, Inc. $118 $99 Common stock and options assumed;
goodwill and other intangibles
recorded of $11
</TABLE>
9
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CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. BALANCE SHEET DETAIL
(In millions)
<TABLE>
<CAPTION>
Inventories: January 23, July 25,
1999 1998
----------- ---------
(Unaudited)
<S> <C> <C>
Raw materials $ 74 $ 76
Work in process 197 143
Finished goods 168 111
Demonstration systems 33 32
----- -----
$ 472 $ 362
===== =====
</TABLE>
<TABLE>
<CAPTION>
Intangible Assets: January 23, July 25,
1999 1998
----------- -------
(Unaudited)
<S> <C> <C>
Gross Intangible Assets $ 415 $ 200
Less: Accumulated Amortization (52) (30)
----- -----
$ 363 $ 170
===== =====
</TABLE>
Amortization expense for the three and six month periods ending January 23,
1999 and January 24, 1998 was $12 million, $22 million, $4 million and $8
million, respectively.
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.
10
<PAGE> 11
CISCO SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The components of comprehensive income, net of tax, are as follows (in
millions):
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
------------------- -------------------
Jan. 23, Jan. 24, Jan. 23, Jan. 24,
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net income $ 288 $ 457 $ 806 $ 794
Other comprehensive income (loss):
Change in unrealized gain (loss)
on investments, net 74 (3) 91 (7)
Change in accumulated translation
Adjustments 0 (3) 11 (5)
----- ----- ----- -----
Total comprehensive income $ 362 $ 451 $ 908 $ 782
===== ===== ===== =====
</TABLE>
6. INCOME TAXES
The Company paid income taxes of $184 million in the six months ended January
23, 1999 and $307 million in the six months ended January 24, 1998. 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 $398 million in the first six months of fiscal
1999, and was credited directly to shareholders' equity.
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
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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", "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 $2.83 billion in the second quarter of 1999 from $2.02 billion
in the second quarter of 1998. Net sales for the first half of 1999 were $5.42
billion, compared to $3.89 billion in the first half of 1998. The 40.2% increase
in net sales between the two three-month periods and the 39.4% increase in net
sales between the two six- month periods was primarily a result of increasing
unit sales of LAN switching products such as the Catalyst(R) 5000 family and the
Catalyst(R) 2900 series of switches for smaller enterprise networks, 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, sales of some of the
Company's more established product lines, such as the Cisco 2500 and Cisco 4000
product families, have decreased as a percentage of total revenue. Sales to
international customers increased to 42.8% in the second quarter of 1999 versus
41.7% for the second quarter of 1998. The increase reflects sales growth in
certain international markets, particularly Germany and the United Kingdom, and
to a lesser extent Japan. Sales growth in other markets, including Latin America
and Eastern Europe, have 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 decreased slightly to 65.2% in the second quarter of 1999 from
65.4% in the second quarter of 1998. Gross margins for the first six months of
1999 were 65.3%, which remained consistent with the same period in 1998. The
decrease in the quarterly period
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is due principally to the Company's continued shift in revenue mix towards its
lower-margin products and the recent stabilization in the supply of memory chips
which has resulted in an increase in prices. 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 expects that gross margins will
continue to 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 $118 million in the second
quarter of 1999 over the second quarter of 1998, an increase to 12.6% from 11.9%
of net sales. Research and development expenses increased by $221 million in the
first six months of 1999 over the first six months of 1998, an increase to 12.6%
from 11.9% 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, cable modem
technology, wireless access, 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.
13
<PAGE> 14
Sales and marketing expenses increased by $207 million in the second quarter of
1999 over the second quarter of 1998, and increased $387 million in the first
six months of 1999 over the first six months of 1998. This represents an
increase from 18.0% to 20.2% of net sales for the quarter to quarter period and
from 17.9% to 20.0% for the first six months of each fiscal year. 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 $32 million between the second quarters
of 1999 and 1998, an increase to 3.2% from 2.9% of net sales. These expenses
increased $60 million in the first half of 1999 over the first half of 1998,
representing an increase from 2.9% to 3.2% of net sales. The increase primarily
reflects 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 second quarter
of fiscal 1999 arose from the acquisitions of Summa Four, Clarity, Selsius and
PipeLinks (See also Note 3).
The fair value of the existing products and patents for these acquisitions
ranged from a low of approximately $20 million for Summa Four and Selsius, up to
$53 million for Clarity. The fair value of the existing products and patents as
well as the technology currently under development was determined by 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, adjusted upward to reflect
additional risks inherent in the development life cycle. These risk factors have
increased the overall discount rate between 4% and 7.5% for acquisitions in the
current year. The Company expects that the pricing model for products related to
these acquisitions will be considered standard within the high-technology
communications industry. However, the Company does not expect to achieve a
material amount of expense reductions or synergies as a result of
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<PAGE> 15
integrating the acquired in-process technology. Therefore, the valuation
assumptions do not include significant anticipated cost savings. The Company
expects that products incorporating the acquired technology from these
acquisitions will be completed and begin to generate cash flows over the next 6
to 9 months. However, development of these technologies remains a significant
risk to the Company due to the remaining effort 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 the acquired technology into commercially viable products
consists principally of planning, designing and testing activities necessary to
determine that the product 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 the
Company's business and operating results.
Regarding the Company's purchase acquisitions completed in fiscal 1998,
actual results to date have been consistent, in all material respects, with the
assumptions that the Company provided to the independent appraisers for use in
determining the value of purchased in-process research and development. 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 once the products have entered the market. Products from these 1998
acquisitions have been introduced to the market in the last 3 - 6 months.
Shipment volumes are not material to the Company's overall position at the
present time, therefore, it is difficult to determine the accuracy of overall
revenue projections early in the technology or product lifecycle. Failure to
achieve the expected levels of revenues and net income from these products will
negatively impact the return on investment expected at the time that the
acquisition was completed and potentially result in impairment of any other
assets related to the development activities.
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<PAGE> 16
The following table summarizes the significant assumptions underlying the
valuations in 1998 and 1999 (in millions, except percentages):
<TABLE>
<CAPTION>
Acquisition Assumptions
Approximate ------------------------------------------
Costs Incurred Estimated Cost
to Date on to Complete
Acquired Technology at
In-Process Time of Risk Adjusted Discount
Entity Name Technology Acquisition Rate on In-Process R&D
----------- -------------- -------------- ----------------------
<S> <C> <C> <C>
1998 Purchase Acquisitions
DAGAZ Technologies $10 $10 35%
Lightspeed International, $15 $13 26%
Inc.
WheelGroup Corp. $6 $8 24%
NetSpeed International, $16 $12 32%
Inc.
CLASS Data Systems $2 $3 24%
1999 Purchase Acquisitions
American Internet Corp. $* $1 24.9%
Summa Four, Inc. $* $5 25.5%
Clarity Wireless, Inc. $* $42 32%
Selsius Systems, Inc. $* $15 31%
PipeLinks, Inc. $* $5 31%
</TABLE>
* - Costs incurred negligible to date
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
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<PAGE> 17
Accounting Pronouncements" section of the Company's 1998 Annual Report to
Shareholders for further discussion.
The Company adopted Statement of Position (SOP) No. 97-2, "Software Revenue
Recognition," in the first quarter of fiscal year 1999 and its adoption had no
material impact on the Company's results from operations or financial position.
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.
The increasing use of the Euro as a common currency for members of the European
Union 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 will continue to evaluate the impact of the Euro on its
foreign exchange exposure as well as on its internal systems.
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.
17
<PAGE> 18
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 accumulated
comprehensive income, 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 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
18
<PAGE> 19
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; potential difficulties in completing projects
associated with purchased in process research and development; 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
regulation in any country where the Company operates, on such technology as,
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.
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.
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. The
Company has not entered into a material amount of labor intensive service
contracts which require significant production or customization, however, the
Company expects that demand for these types of service contracts
19
<PAGE> 20
will increase in the future. 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 recent 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 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
20
<PAGE> 21
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 Latin America 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 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 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 the periods subsequent to 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
several new products with additional 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
21
<PAGE> 22
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 January 23, 1999 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 is continuing 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.
22
<PAGE> 23
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 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 its 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
23
<PAGE> 24
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 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.
Liquidity and Capital Resources
Cash and equivalents, short-term investments, and investments were $6.5 billion
at January 23, 1999 an increase of $1.4 billion from July 25, 1998. The increase
is primarily a result of cash generated by operations and financing activities,
primarily the exercise of employee stock options. These cash flows were
24
<PAGE> 25
partially offset by cash outflows from operating activities including tax
payments of approximately $184 million, and cash outflows from investing
activities including capital expenditures of approximately $277 million.
Accounts receivable increased 13.8% from July 25, 1998 to January 23, 1999,
while sales grew by 18.3% over the same period. Days sales outstanding in
receivables improved to 48 days at January 23, 1999 from 49 days at July 25,
1998. Inventories increased 30.4% between July 25, 1998 and January 23, 1999,
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 38.6% at January 23, 1999 over July 25, 1998
primarily due to increasing levels of raw material purchases. Other accrued
liabilities increased by 28.5% primarily due to higher deferred revenue on
service contracts.
At January 23, 1999, the Company had a line of credit totaling $500 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
$800 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.
25
<PAGE> 26
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the quarter, the Company issued an aggregate of
2,083,039 shares of its Common Stock in exchange for the
outstanding capital stock of Clarity Wireless Incorporated.
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 a Registration Statement on Form S-3
covering the resale of such securities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
The Company held its annual meeting of shareholders on
November 12, 1998. At such meeting the following actions were
voted upon:
<TABLE>
<CAPTION>
Affirmative Negative Votes Broker
Votes Votes Withheld Non-Votes
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
a. Election of Directors
Carol A. Bartz 1,281,794,722 -- 60,466,399 --
John T. Chambers 1,281,960,087 -- 60,301,035 --
Mary Cirillo 1,281,813,286 -- 60,447,835 --
James F. Gibbons 1,281,756,316 -- 60,509,305 --
Edward R. Kozel 1,281,950,448 -- 60,310,674 --
James Morgan 1,281,897,183 -- 60,363,939 --
John P. Morgridge 1,281,916,333 -- 60,344,788 --
Robert L. Puette 1,281,936,169 -- 60,324,952 --
Masayoshi Son 1,281,891,534 -- 60,369,588 --
Donald T. Valentine 1,281,844,510 -- 60,416,611 --
Steven M. West 1,282,021,678 -- 60,239,443 --
b. Approval of Amendment to the
1996 Stock Incentive Plan,
to extend the automatic share
increase provisions for an
additional three-year period. 652,056,816 370,831,534 6,128,676 313,244,095
c. Ratification of
PricewaterhouseCoopers as
the Company's independent
accountants for the fiscal
year ending July 31, 1999. 1,329,482,476 1,530,555 11,247,715 375
</TABLE>
26
<PAGE> 27
ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K
(a) Exhibit
27 Financial data schedule
(b) Reports on Form 8-K
The Company filed two reports on Form 8-K during the fiscal quarter
ended January 23, 1999. One report was filed on November 2, 1999 and
reported on the November acquisition of Clarity Wireless
Incorporated. The second report was filed on November 4, 1999 and
reported on the November acquisition of Summa Four, Inc.
27
<PAGE> 28
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 8, 1999 By /s/ Larry R. Carter
-------------------------------------
Larry R. Carter,
Senior Vice President Finance, and
Chief Financial Officer (Principal
Financial and Accounting Officer)
28
<PAGE> 29
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
No. 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 January 23, 1999, and is qualified
in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> JUL-31-1999
<PERIOD-START> JUL-26-1998
<PERIOD-END> JAN-23-1999
<CASH> 1,421
<SECURITIES> 886
<RECEIVABLES> 1,514
<ALLOWANCES> 37
<INVENTORY> 472
<CURRENT-ASSETS> 4,808
<PP&E> 1,519
<DEPRECIATION> 840
<TOTAL-ASSETS> 11,434
<CURRENT-LIABILITIES> 2,234
<BONDS> 0
0
0
<COMMON> 4,361
<OTHER-SE> 4,795
<TOTAL-LIABILITY-AND-EQUITY> 11,434
<SALES> 5,415
<TOTAL-REVENUES> 5,415
<CGS> 1,879
<TOTAL-COSTS> 4,211
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,349
<INCOME-TAX> 543
<INCOME-CONTINUING> 806
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 806
<EPS-PRIMARY> 0.51<F1>
<EPS-DILUTED> 0.48
<FN>
<F1>For Purposes of This Exhibit Primary means Basic.
</FN>
</TABLE>
