-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Qxa/v93tLYWsQazLCjbHx+1Rji2JjOLb8/+fjHRy2qwXcYfFVfCdRM9NHqD/+ain Y5qSeU/m+NuAlVSiAd3O/Q== 0000891618-99-000863.txt : 19990310 0000891618-99-000863.hdr.sgml : 19990310 ACCESSION NUMBER: 0000891618-99-000863 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990123 FILED AS OF DATE: 19990309 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CISCO SYSTEMS INC CENTRAL INDEX KEY: 0000858877 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 770059951 STATE OF INCORPORATION: CA FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-18225 FILM NUMBER: 99560712 BUSINESS ADDRESS: STREET 1: 170 WEST TASMAN DRIVE CITY: SAN JOSE STATE: CA ZIP: 95134-1706 BUSINESS PHONE: 4085264000 MAIL ADDRESS: STREET 1: 225 WEST TASMAN DRIVE CITY: SAN JOSE STATE: CA ZIP: 95134-1706 10-Q 1 FORM 10-Q FOR THE PERIOD ENDED JANUARY 23, 1999 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. 2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED JANUARY 23, 1999 INDEX
Page 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
2 3 PART I. ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except per-share amounts)
Three Months Ended Six Months Ended -------- -------- -------------------- Jan. 23, Jan. 24, Jan. 23, Jan. 24, 1999 1998 1999 1998 -------------------- -------------------- (Unaudited) 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 ====== ====== ====== ======
See notes to consolidated financial statements. 3 4 CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (In millions, except par value)
January 23, July 25, 1999 1998 ----------- -------- (Unaudited) 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 ======= =======
See notes to consolidated financial statements. 4 5 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)
Six Months Ended ------------------------- January 23, January 24, 1999 1998 ----------- ----------- (Unaudited) 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 ======= =======
See notes to consolidated financial statements. 5 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 7 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 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 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):
Purchased Research & Development Form of Consideration and Other Entity Name Consideration Charge Notes to Acquisition ----------- ------------- ------------- ------------------------------- 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
9 10 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. BALANCE SHEET DETAIL (In millions)
Inventories: January 23, July 25, 1999 1998 ----------- --------- (Unaudited) Raw materials $ 74 $ 76 Work in process 197 143 Finished goods 168 111 Demonstration systems 33 32 ----- ----- $ 472 $ 362 ===== =====
Intangible Assets: January 23, July 25, 1999 1998 ----------- ------- (Unaudited) Gross Intangible Assets $ 415 $ 200 Less: Accumulated Amortization (52) (30) ----- ----- $ 363 $ 170 ===== =====
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 11 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The components of comprehensive income, net of tax, are as follows (in millions):
Three Months Ended Six Months Ended ------------------- ------------------- Jan. 23, Jan. 24, Jan. 23, Jan. 24, 1999 1998 1999 1998 -------- -------- -------- -------- 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 ===== ===== ===== =====
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 11 12 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 12 13 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 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 14 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. 15 16 The following table summarizes the significant assumptions underlying the valuations in 1998 and 1999 (in millions, except percentages):
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 ----------- -------------- -------------- ---------------------- 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%
* - 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 16 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 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 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 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 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 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 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 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 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 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:
Affirmative Negative Votes Broker Votes Votes Withheld Non-Votes ------------- ------------- ------------- ------------- 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
26 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 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 29 EXHIBIT INDEX
Exhibit No. Description - ------- ----------- 27 Financial Data Schedule
EX-27 2 FINANCIAL DATA SCHEDULE
5 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. 1,000,000 12-MOS JUL-31-1999 JUL-26-1998 JAN-23-1999 1,421 886 1,514 37 472 4,808 1,519 840 11,434 2,234 0 0 0 4,361 4,795 11,434 5,415 5,415 1,879 4,211 0 0 0 1,349 543 806 0 0 0 806 0.51 0.48 For Purposes of This Exhibit Primary means Basic.
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