10-Q 1 0001.txt 10-Q 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED APRIL 29, 2000 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 May 26, 2000, 7,023,852,451 shares of the Registrant's common stock were outstanding. ================================================================================ 2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED APRIL 29, 2000 INDEX
Page Facing sheet 1 Index 2 Part I. Financial Information Item 1. Financial Statements a) Consolidated statements of operations for the three and nine months ended April 29, 2000 and May 1, 1999 3 b) Consolidated balance sheets at April 29, 2000 and July 31, 1999 4 c) Consolidated statements of cash flows for the nine months ended April 29, 2000 and May 1, 1999 5 d) Notes to consolidated financial statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20 Item 3. Quantitative and Qualitative Disclosures About Market Risk 41 Part II. Other Information Item 2. Changes in Securities and Use of Proceeds 42 Item 6. Exhibits and Reports on Form 8-K 43 Signature 44
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN MILLIONS, EXCEPT PER-SHARE AMOUNTS)
Three Months Ended Nine Months Ended -------------------- --------------------- April 29, May 1, April 29, May 1, 2000 1999 2000 1999 -------------------- --------------------- (Unaudited) (Unaudited) Net sales $ 4,919 $ 3,171 $13,183 $ 8,614 Cost of sales 1,748 1,112 4,671 2,997 ------- ------- ------- ------- Gross margin 3,171 2,059 8,512 5,617 Operating expenses: Research and development 719 433 1,854 1,144 Sales and marketing 1,023 656 2,760 1,752 General and administrative 146 94 399 253 Amortization of goodwill and purchased intangible assets 51 19 122 42 In-process research and development 488 -- 912 390 ------- ------- ------- ------- Total operating expenses 2,427 1,202 6,047 3,581 ------- ------- ------- ------- Operating income 744 857 2,465 2,036 Interest and other income, net 313 91 566 237 ------- ------- ------- ------- Income before provision for income taxes 1,057 948 3,031 2,273 Provision for income taxes 395 312 1,124 846 ------- ------- ------- ------- Net income $ 662 $ 636 $ 1,907 $ 1,427 ======= ======= ======= ======= Net income per share--basic $ .10 $ .10 $ .28 $ .22 ======= ======= ======= ======= Net income per share--diluted $ .09 $ .09 $ .26 $ .21 ======= ======= ======= ======= Shares used in per-share calculation--basic 6,944 6,624 6,892 6,543 ======= ======= ======= ======= Shares used in per-share calculation--diluted 7,450 7,054 7,366 6,955 ======= ======= ======= =======
See notes to consolidated financial statements 3 4 CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (IN MILLIONS, EXCEPT PAR VALUE)
April 29, July 31, 2000 1999 ------- ------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 3,542 $ 886 Short-term investments 1,111 1,189 Accounts receivable, net of allowance for doubtful accounts of $38 at April 29, 2000 and $27 at July 31, 1999 1,922 1,249 Inventories, net 878 656 Deferred tax assets 905 571 Prepaid expenses and other current assets 722 170 ------- ------- Total current assets 9,080 4,721 Investments 10,419 7,032 Restricted investments 1,170 1,080 Property and equipment, net 1,153 822 Other assets, net 4,263 1,191 ------- ------- Total assets $26,085 $14,846 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 596 $ 372 Income taxes payable 941 630 Accrued payroll and related expenses 974 679 Other accrued liabilities 2,588 1,353 ------- ------- Total current liabilities 5,099 3,034 Deferred tax liabilities 915 -- Minority interest 45 44 Shareholders' equity: Preferred stock, no par value, 5 shares authorized: none issued or outstanding at April 29, 2000 and July 31, 1999 -- -- Common stock and additional paid-in capital, $0.001 par value, 20,000 shares authorized: 7,001 shares issued and outstanding at April 29, 2000 and 6,748 at July 31, 1999 10,701 5,665 Retained earnings 7,624 5,805 Accumulated other comprehensive income 1,701 298 ------- ------- Total shareholders' equity 20,026 11,768 ------- ------- Total liabilities and shareholders' equity $26,085 $14,846 ======= =======
See notes to consolidated financial statements 4 5 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN MILLIONS)
Nine Months Ended ---------------------- April 29, May 1, 2000 1999 ------- ------- (Unaudited) Cash flows from operating activities: Net income $ 1,907 $ 1,427 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 492 335 Deferred income taxes (330) (195) Tax benefits from employee stock option plans 930 679 Adjustments to conform fiscal year ends of pooled acquisitions (18) 1 In-process research and development 912 298 Change in operating assets and liabilities: Accounts receivable (631) 19 Inventories (196) (266) Prepaid expenses and other current assets (23) (26) Income taxes payable 305 110 Accounts payable 149 100 Accrued payroll and related expenses 235 88 Other accrued liabilities 788 329 ------- ------- Net cash provided by operating activities 4,520 2,899 ------- ------- Cash flows from investing activities: Purchases of short-term investments (1,431) (833) Proceeds from sales and maturities of short-term investments 1,428 1,179 Purchases of investments (9,797) (3,977) Proceeds from sales and maturities of investments 8,775 1,338 Purchases of restricted investments (272) (661) Proceeds from sales and maturities of restricted investments 181 408 Acquisition of property and equipment (666) (385) Acquisition of businesses, net of cash acquired and in-process research and development 34 (19) Increase in lease receivables (397) (175) Other (722) (196) ------- ------- Net cash used in investing activities (2,867) (3,321) ------- ------- Cash flows from financing activities: Issuance of common stock 1,005 675 Other (2) 5 ------- ------- Net cash provided by financing activities 1,003 680 ------- ------- Net increase in cash and cash equivalents 2,656 258 Cash and cash equivalents, beginning of period 886 609 ------- ------- Cash and cash equivalents, end of period $ 3,542 $ 867 ======= =======
See notes to consolidated financial statements 5 6 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. DESCRIPTION OF BUSINESS Cisco Systems, Inc. ("Cisco" or the "Company") is the worldwide leader in networking for the Internet. Cisco hardware, software, and service offerings are used to create Internet solutions so that individuals, companies, and countries have seamless access to information - regardless of differences in time and place. Cisco solutions provide competitive advantage to our customers through more efficient and timely exchange of information, which in turn leads to cost savings, process efficiencies, and closer relationships with their customers, prospects, business partners, suppliers, and employees. These solutions form the networking foundation for companies, universities, utilities, and government agencies worldwide. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Fiscal Year The Company's fiscal year is the 52-week or 53-week period ending on the last Saturday in July. Fiscal 2000 is a 52-week year while fiscal 1999 was a 53-week year. Basis of Presentation All historical financial information has been restated to reflect the acquisitions of StratumOne Communications, Inc.("StratumOne") and TransMedia Communications, Inc.("TransMedia") in the first quarter of fiscal 2000 and Cerent Corporation ("Cerent") and WebLine Communications Corporation ("WebLine") in the second quarter of fiscal 2000 which were accounted for as poolings of interests. In addition, the historical financial information has been restated to reflect the acquisition of Fibex Systems which was completed in the fourth quarter of fiscal 1999 and accounted for as a pooling of interests. The accompanying financial data as of April 29, 2000 and for the three and nine months ended April 29, 2000 and May 1, 1999, has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The July 31, 1999 consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by 6 7 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) generally accepted accounting principles. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's Annual Report on Form 10-K/A for the year ended July 31, 1999 and Current Report on Form 8-K/A filed February 3, 2000. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position as of April 29, 2000, results of operations for the three and nine months ended April 29, 2000 and May 1, 1999, and cash flows for the nine months ended April 29, 2000 and May 1, 1999 have been made. The results of operations for the three and nine months ended April 29, 2000 are not necessarily indicative of the operating results for the full fiscal year or any future periods. Payroll Taxes Associated with Stock Option Exercises In September 1999, the FASB issued Emerging Issues Task Force Topic No. D-83 ("EITF D-83"), "Accounting for Payroll Taxes Associated with Stock Option Exercises." EITF D-83 requires that payroll taxes paid on the difference between the exercise price and the fair value of acquired stock in association with an employee's exercise of stock options to be treated as operating expenses. Payroll taxes on stock option exercises were $25 million in the third quarter of fiscal 2000. Computation of Net Income Per Common 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 common 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. Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either 7 8 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) assets or liabilities in the balance sheet and measure those instruments at fair value. Management does not expect the adoption of SFAS 133 to have a material effect on the Company's operations or financial position. The Company is required to adopt SFAS 133 in the first quarter of fiscal 2001. In December 1999, the SEC issued Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial Statements." SAB 101 summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. Management does not expect the adoption of SAB 101 to have a material effect on the Company's operations or financial position. The Company is required to adopt SAB 101 in the first quarter of fiscal 2001. 3. BUSINESS COMBINATIONS Purchase 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 aggregate basis. The amounts allocated to in-process research and development expense were determined through established valuation techniques in the high-technology communications industry and were expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. Research and development costs to bring the 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 financial condition. Amounts allocated to goodwill and purchased intangible assets are amortized on a straight-line basis over periods not exceeding five years. In September 1999, the Company completed its purchase of Monterey Networks, Inc. ("Monterey"), a developer of infrastructure-class, optical cross-connect technology that is used to increase network capacity at the core of an optical network. The Company's acquired technology consists of one product currently under development which will result in a wavelength router that would intelligently route signals over long-haul optical pipes created by Dense Wave Division Multiplexing. Also, in September 1999, the Company completed its purchase of MaxComm Technologies, Inc. 8 9 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) ("MaxComm"), a developer of broadband Internet technology that brings data and multiple voice lines to consumers. The Company's acquired technology consists of one product currently under development which is designed to allow the end user to create an adaptable home Local Area Network ("LAN") utilizing their existing in-home wiring to support up to four separate phone lines with different numbers. In November 1999, the Company completed its purchase of Calista, Inc. ("Calista") and Tasmania Network Systems, Inc. ("Tasmania"). Calista is a developer of Internet technology that allows different business phone systems to work together over an open Internet-based infrastructure. The Company's acquired technology for Calista consists of one product currently under development which is designed to link up telecommuters or branch office phones to a corporate PBX over the Internet or intranet. Tasmania is a developer of network caching software technology. The Company's acquired technology consists of one product currently under development which will improve the performance of cache technology. In December 1999, the Company acquired Internet Engineering Group, L.L.C. ("IEng") and Worldwide Data Systems, Inc. ("Worldwide"). IEng is a developer of high-performance software to enable service providers to build next-generation high speed networks. Worldwide is a leader in consulting and engineering services for the convergence of data and voice networks. In February 2000, the Company completed its purchase of the optical systems business of Pirelli S.p.A. of Milan, Italy ("Pirelli"), an innovator in both optical component technology and optical systems for service providers. The Company's acquired technology consists of products which will allow service providers to transmit multi-channel Dense Wave Division Multiplexing signals over optical fiber. In March 2000, the Company completed its purchase of Aironet Wireless Communications, Inc. ("Aironet"), a developer of standards-based, high-speed wireless LAN products. The Company's acquired technology consists of wireless data solutions, including LAN and bridge products, for intra and inter-building applications. 9 10 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The following is a summary of purchase transactions completed in fiscal 2000 (in millions):
In-process Research & Development Form of Consideration and Other Entity Name Consideration Expense Notes to Acquisition ----------- ------------- ----------- ------------------------------------------- Monterey $ 517 $ 354 Common stock and options assumed; $14 in liabilities assumed; goodwill and other intangibles recorded of $154. $ 73 $ 27 Common stock and options assumed; MaxComm goodwill and other intangibles recorded of $41. Calista $ 57 $ 28 Common stock and options assumed; $3 in liabilities assumed; goodwill and other intangibles recorded of $34. Tasmania $ 26 $ 15 Common stock; goodwill and other intangibles recorded of $13. Pirelli $ 2,018 $ 245 Common stock; $362 in liabilities assumed; goodwill and other intangibles recorded of $1,717. Aironet $ 835 $ 243 Common stock and options assumed; $34 in liabilities assumed; goodwill and other intangibles recorded of $589.
Total in-process research and development expense for the nine months ended April 29, 2000 and May 1, 1999 was $912 million and $390 million, respectively. The in-process research and development expense for the nine months ended April 29, 2000 was attributable to stock consideration. The in-process research and development expense for the nine months ended May 1, 1999 was attributable to $298 million of stock consideration and $92 million of cash consideration. Pooling of Interests Combinations In September 1999, the Company acquired StratumOne, a developer of highly integrated, high-performance semiconductor technology, and TransMedia, a provider of Media Gateway technology that unites the multiple networks of public voice communications. Under the terms of the agreements, approximately 13.3 million and 13.9 million shares of common stock were exchanged and options 10 11 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) were assumed to acquire StratumOne and TransMedia, respectively. Also, in September 1999, the Company acquired COCOM A/S ("COCOM"), a European developer of high-speed Internet access solutions over cable, satellite, and wireless networks based on international standards. Under the terms of the agreements, approximately 1.9 million shares of common stock were exchanged to acquire Cocom. Based on the shares of common stock exchanged and options assumed as of the consummation date, the total fair values of the acquisitions were approximately $435 million, $407 million, and $66 million for StratumOne, Transmedia, and COCOM, respectively. In November 1999, the Company completed the acquisitions of Cerent and WebLine. Cerent is a developer of next-generation optical transport products and WebLine is a provider of customer interaction management software for Internet customer service and e-commerce. Under the terms of the agreements, approximately 199.9 million and 9.5 million shares of common stock were exchanged and options were assumed to acquire Cerent and WebLine, respectively. Based on the shares of common stock exchanged and options assumed as of the consummation date, the total fair values of the acquisitions were approximately $6.9 billion and $325 million for Cerent and WebLine, respectively. In December 1999, the Company acquired V-Bits, Inc. ("V-Bits"), a provider of standards-based digital video processing systems for cable television service providers. Under the terms of the agreement, approximately 2.8 million shares of common stock were exchanged and options were assumed to acquire V-Bits. Based on the shares of common stock exchanged and options assumed as of the consummation date, the total fair value of the acquisition was approximately $128 million. In March 2000, the Company acquired Growth Networks, Inc. ("Growth"), a developer of Internet switching fabrics. Under the terms of the agreement, approximately 5.6 million shares of common stock were exchanged and options were assumed to acquire Growth. Based on the shares of common stock exchanged and options assumed as of the date of consummation, the total fair value of the acquisition was approximately $355 million. Also, in March 2000, the Company acquired Altiga Networks, Inc. ("Altiga") and Compatible Systems Corporation ("Compatible"). Altiga is a developer of integrated Virtual Private Networks ("VPN") solutions for remote access applications. Compatible is a developer of standards-based, reliable and scalable VPN solutions for service provider networks. Under the terms of the agreements, 11 12 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) approximately 6.3 million and 3.8 million shares of common stock were exchanged and options were assumed to acquire Altiga and Compatible, respectively. Based on the shares of common stock exchanged and options assumed as of the date of consummation, the total fair values of the acquisitions were approximately $335 million and $232 million for Altiga and Compatible, respectively. All historical financial information contained herein has been restated to reflect the acquisitions of StratumOne, TransMedia, Cerent, and WebLine. The historical operations of Cocom, V-Bits, Growth, Altiga and Compatible were not material to the Company's consolidated operations or financial position; therefore, prior period financial statements have not been restated for these acquisitions. Acquisitions Pending or Completed After April 29, 2000 In March 2000, the Company announced definitive agreements to acquire Atlantech Technologies ("Atlantech") and JetCell, Inc. ("JetCell") for approximately $180 million and $200 million, respectively, payable in common stock and cash. Atlantech is a provider of network element management software designed to help configure and monitor network hardware. JetCell is a developer of standards-based, in-building wireless telephony solutions for corporate networks. The Atlantech and JetCell acquisitions were completed in May 2000 and accounted for as purchases. Also, in March 2000, the Company announced definitive agreements to acquire InfoGear Technology Corporation ("InfoGear") and SightPath, Inc. ("SightPath"). InfoGear is a provider of Internet appliances and software used to manage information appliances. SightPath is a provider of appliances for creating intelligent Content Delivery Networks. Under the terms of the agreements, approximately 4.7 million and 11.4 million shares of common stock were exchanged and options were assumed to acquire InfoGear and SightPath, respectively. Based upon the shares of common stock exchanged and options assumed as of the date of consummation, the total fair values of the acquisitions were approximately $301 million and $800 million, respectively. The InfoGear and Sightpath acquisitions were completed in June 2000 and May 2000, respectively, and accounted for as poolings of interests. In April 2000, the Company announced definitive agreements to acquire Pentacom, Ltd. ("Pentacom") and a wholly-owned subsidiary of Seagull Semiconductor, Ltd. ("Seagull") for approximately $118 million and $19 million, respectively, payable in common stock. Pentacom is a provider of products implementing Spatial Reuse 12 13 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Protocol which allows Internet Protocol-based metropolitan networks to offer the same protection and restoration benefits as SONET-based networks while doubling bandwith efficiency. Seagull is a developer of silicon technology. The Pentacom and Seagull acquisitions are expected to be completed in the fourth quarter of fiscal 2000 and will be accounted for as purchases. In May 2000, the Company announced a definitive agreement to acquire ArrowPoint Communications, Inc. ("ArrowPoint"). ArrowPoint is a provider of content switches that optimize the delivery of web content. Under the terms of the agreement, approximately 90.0 million shares of common stock will be exchanged and options will be assumed to acquire ArrowPoint. Based on the common stock exchanged and options assumed as of the date of consummation, the total fair value of the acquisition is approximately $5.7 billion. The ArrowPoint acquisition is expected to be completed in the fourth quarter of fiscal 2000 and will be accounted for as a pooling of interests. Also, in May 2000, the Company announced a definitive agreement to acquire Qeyton Systems ("Qeyton") for approximately $800 million, payable in common stock. Qeyton is a developer of Metropolitan Dense Wave Division Multiplexing technology to optimize the performance and cost requirements of service providers' metropolitan networks. The Qeyton acquisition is expected to be completed in the fourth quarter of fiscal 2000 and will be accounted for as a purchase. 13 14 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 4. BALANCE SHEET DETAIL (In millions)
Inventories, net: April 29, July 31, 2000 1999 --------- --------- Raw materials $ 109 $ 143 Work in process 303 198 Finished goods 360 280 Demonstration systems 106 35 ------- ------- Total $ 878 $ 656 ======= =======
Other Assets, net: April 29, July 31, 2000 1999 --------- --------- Intangible assets: Goodwill--gross $ 2,200 $ 157 Purchased intangible assets--gross 1,246 395 Less: Accumulated amortization (232) (92) ------- ------- Intangible assets, net 3,214 460 Other assets 1,049 731 ------- ------- Total $ 4,263 $ 1,191 ======= =======
The following table presents the details of the amortization of goodwill and purchased intangible assets as reported in the consolidated statements of operations (in millions):
Three Months Nine Months Ended Ended ------------------- ------------------ April 29, May 1, April 29, May 1, 2000 1999 2000 1999 --------- ------- --------- ------- Reported as: Cost of sales $ 6 $ 2 $ 18 $ 2 Operating expenses 51 19 122 42 ---- ---- ---- ---- Total amortization expense $ 57 $ 21 $140 $ 44 ==== ==== ==== ====
14 15 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. COMPREHENSIVE INCOME The following table presents the calculation of comprehensive income as required by SFAS No. 130. Comprehensive income has no impact on the Company's net income, balance sheet, or shareholders' equity. The components of comprehensive income, net of tax, are as follows (in millions):
Three Months Nine Months Ended Ended ------------------------ ----------------------- April 29, May 1, April 29, May 1, 2000 1999 2000 1999 ---------- ------- ---------- -------- (Unaudited) (Unaudited) Net income $ 662 $ 636 $ 1,907 $ 1,427 Other comprehensive income (loss): Change in unrealized gain on investments, net (111) (30) 1,408 61 Change in accumulated translation adjustments (9) (6) (5) 5 ------- ------- ------- ------- Total comprehensive income $ 542 $ 600 $ 3,310 $ 1,493 ======= ======= ======= =======
6. INCOME TAXES The Company paid income taxes of $217 million and $221 million for the nine months ended April 29, 2000 and May 1, 1999, respectively. The Company's income taxes currently payable for federal, state, and foreign purposes have been reduced by the tax benefits from stock option transactions. The tax benefits totaled $930 million and $679 million for the nine months ended April 29, 2000 and May 1, 1999, respectively, and were credited directly to shareholders' equity. 7. SHAREHOLDERS' EQUITY AND STOCK SPLIT Cisco's Board of Directors authorized the splitting of the Company's common stock on a two-for-one basis for shareholders of record on February 22, 2000. Shares resulting from the split were distributed by the transfer agent on March 22, 2000. All share and per-share numbers contained herein reflect this stock split. 15 16 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 8. SEGMENT INFORMATION AND MAJOR CUSTOMERS The Company's operations involve the design, development, manufacturing, marketing, and technical support of networking products and services. The Company offers end-to-end networking solutions for its customers. Cisco products include routers, LAN and ATM switches, dialup access servers, and network management software. These products, integrated by the Cisco IOS(R) software, link geographically dispersed LANs, WANs, and IBM networks. The Company conducts business globally and is managed geographically. The Company's management relies on an internal management system that provides sales and standard cost information by geographical theater. Sales are attributed to a theater based on the ordering location of the customer. The Company's management makes financial decisions and allocates resources based on the information it receives from this internal management system. The Company does not allocate engineering, sales and marketing, or general and administrative expenses to geographical segments as management does not use this information to measure the performance of the operating segments. Management does not believe that allocating these expenses is material in evaluating a geographical segment's performance. Information from this internal management system differs from the amounts reported under generally accepted accounting principles due to certain corporate level adjustments. These corporate level adjustments are primarily sales adjustments related to credit memos and returns. Based on the criteria set forth in SFAS No. 131, the Company has four reportable segments: the Americas, Europe, Middle East and Africa ("EMEA"), Asia/Pacific, and Japan. 16 17 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Summarized financial information by segment for the three and nine months ended April 29, 2000 and May 1, 1999, as taken from the internal management system discussed above, is as follows (in millions):
Three Months Ended Nine Months Ended ----------------------- ----------------------- April 29, May 1, April 29, May 1, 2000 1999 2000 1999 -------- -------- -------- -------- Net Sales: U.S./Americas $ 3,370 $ 2,046 $ 8,900 $ 5,718 EMEA 1,203 864 3,305 2,288 Asia/Pacific 505 206 1,139 556 Japan 253 154 592 438 Sales adjustments (412) (99) (753) (386) -------- -------- -------- -------- Total--Net Sales $ 4,919 $ 3,171 $ 13,183 $ 8,614 ======== ======== ======== ======== Standard Margin: U.S./Americas $ 2,439 $ 1,478 $ 6,489 $ 4,143 EMEA 902 639 2,468 1,694 Asia/Pacific 363 146 830 403 Japan 197 120 466 337 Sales adjustments (412) (99) (753) (386) Production overhead (133) (66) (322) (183) Manufacturing variances and other related costs (185) (159) (666) (391) -------- -------- -------- -------- Total--Gross Margin $ 3,171 $ 2,059 $ 8,512 $ 5,617 ======== ======== ======== ========
The standard margins by geographical segment differ from the amounts recognized under generally accepted accounting principles because the Company does not allocate certain sales adjustments, production overhead, and manufacturing variances and other related costs to the segments. The above table reconciles the net sales and standard margins by geographical segment to net sales and gross margins as reported in the consolidated statements of operations by including such adjustments. 17 18 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The following table presents external net sales for groups of similar products and services (in millions):
Three Months Ended Nine Months Ended ------------------------- ----------------------- April 29, May 1, April 29, May 1, 2000 1999 2000 1999 ---------- --------- ---------- -------- Routers $ 1,999 $ 1,295 $ 5,285 $ 3,737 Switches 1,924 1,342 5,191 3,659 Access 632 326 1,614 789 Other 776 307 1,846 815 Sales adjustments (412) (99) (753) (386) -------- -------- -------- -------- Total--Net Sales $ 4,919 $ 3,171 $ 13,183 $ 8,614 ======== ======== ======== ========
Substantially all of the Company's assets at April 29, 2000 and July 31, 1999 were attributable to U.S. operations. No single customer accounted for 10% or more of net sales during the three or nine months ended April 29, 2000 and May 1, 1999. 9. NET INCOME PER COMMON SHARE The following table presents the calculation of basic and diluted earnings per share (in millions, except per-share amounts):
Three Months Ended Nine Months Ended --------------------- --------------------- April 29, May 1, April 29, May 1, 2000 1999 2000 1999 ---------- -------- ---------- -------- Numerator: Net income $ 662 $ 636 $1,907 $1,427 ====== ====== ====== ====== Denominator: Weighted average shares--basic 6,944 6,624 6,892 6,543 Effect of dilutive securities: Employee stock options 506 430 474 412 ------ ------ ------ ------ Weighted average shares--diluted 7,450 7,054 7,366 6,955 ====== ====== ====== ====== Net income per share--basic $ .10 $ .10 $ .28 $ .22 ====== ====== ====== ====== Net income per share--diluted $ .09 $ .09 $ .26 $ .21 ====== ====== ====== ======
18 19 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 10. OTHER In the third quarter of fiscal 2000, the Company invested approximately $1 billion in mandatorily redeemable convertible preferred stock of KPMG Consulting, Inc., a privately held subsidiary of KPMG LLP. KPMG Consulting, Inc. is a provider of Internet integration services. 19 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All historical financial information has been restated to reflect the acquisitions of StratumOne Communications, Inc. and TransMedia Communications, Inc. in the first quarter of fiscal 2000 and Cerent Corporation and WebLine Communications Corporation in the second quarter of fiscal 2000 which were accounted for as poolings of interests. In addition, the historical financial information has been restated to reflect the acquisition of Fibex Systems which was completed in the fourth quarter of fiscal 1999 and accounted for as a pooling of interests. Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, statements containing the words "believes," "anticipates," "estimates," "expects," "projections," and words of similar import, constitute "forward-looking statements." You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described below and elsewhere in this Quarterly Report, and in other documents we file with the Securities and Exchange Commission. Net sales grew to $4.92 billion in the third quarter of fiscal 2000 from $3.17 billion in the third quarter of fiscal 1999. Net sales for the first nine months of fiscal 2000 were $13.18 billion, compared with $8.61 billion for the first nine months of fiscal 1999. The 55.1% increase in net sales between the two three-month periods and the 53.0% increase in net sales between the two nine-month periods were primarily a result of increasing unit sales of LAN switching products such as the Catalyst 3500 and 6000 families, the Cisco 12000 gigabit switch router ("GSR"), modular access routers such as the Cisco 2600 and 3600 families, growth in the sales of add-on boards that provide increased functionality, optical transport products such as the ONS 15400, remote access products such as the AS5300 and AS5800, and increased maintenance service contract sales. Additionally, sales of some of our more established product lines, such as the Catalyst 5000, Cisco 2500 and Cisco 4000 product families have migrated towards newer products such as the Catalyst 6000, Cisco 2600, Cisco 3600 and Cisco 7200 product families. Sales in the third quarter of fiscal 2000 grew 64.7% in the Americas, 39.2% in EMEA, 145.1% in Asia/Pacific and 64.3% in Japan compared to the third quarter of fiscal 1999. Sales in the first nine months of fiscal 2000 grew 55.6% in the Americas, 44.4% in EMEA, 104.9% in Asia/Pacific and 35.2% in Japan compared to the first nine months of fiscal 1999 (See Note 8 to the consolidated financial statements). Market demand and deployment of Internet technologies and business solutions, as well as the overall 20 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS economic health, are primarily driving the strong growth within these regions. Gross margins decreased to 64.5% in the third quarter of fiscal 2000 from 64.9% in the third quarter of fiscal 1999. Gross margins decreased to 64.6% in the first nine months of fiscal 2000 from 65.2% in the first nine months of fiscal 1999. Standard margins for the Americas, EMEA, Asia/Pacific and Japan were 72.4%, 75.0%, 71.9%, and 77.9%, respectively, for the third quarter of fiscal 2000 compared to 72.2%, 74.0%, 70.9%, and 77.9%, respectively, for the third quarter of fiscal 1999. Standard margins for the Americas, EMEA, Asia/Pacific and Japan were 72.9%, 74.7%, 72.9%, and 78.7%, respectively, for the first nine months of fiscal 2000 compared to 72.5%, 74.0%, 72.5%, and 76.9%, respectively, for the first nine months of fiscal 1999 (see Note 8 to the consolidated financial statements). The standard margins by geographical segment differ from the amounts recognized under generally accepted accounting principles because the Company does not allocate certain sales adjustments, production overhead, and manufacturing variances and other related costs to the segments. Standard margins for the Americas, where 68.5% and 67.5% of our revenues were derived in the third quarter and the first nine months of fiscal 2000, respectively, increased by 0.2% and 0.4%, respectively, compared to the same periods in fiscal 1999. Standard margins for EMEA, where 24.5% and 25.1% of our revenues were derived in the third quarter and the first nine months of fiscal 2000, respectively, increased by 1.0% and 0.7%, respectively, compared to the same periods in fiscal 1999. The changes in standard margins for the Americas and EMEA were due to a shift in revenue mix and the timing of when certain sales adjustments are applied to geographical theatres. The decrease in the overall gross margin was primarily due to the continued shift in revenue mix towards our lower-margin products, other production related costs, and the continued pricing pressure seen from competitors in certain product areas. The prices of component parts have fluctuated in the recent past, and we expect that this trend may continue. An increase in the price of component parts may have a material adverse impact on gross margins. We expect that gross margins will continue to decrease in the future because we believe 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 our higher-margin router and high-performance switching products. Additionally, as we focus on new market opportunities, we face increasing competitive pressure from large telecommunications equipment suppliers and well funded start-up companies, which may materially adversely affect gross margins. We are attempting to mitigate this trend through various means, such as increasing the functionality of our products, continued 21 22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS value engineering, controlling royalty costs, and improving manufacturing efficiencies. There can be no assurance that any efforts made by us in these and other areas will successfully offset decreasing margins. Research and development expenses increased by $286 million in the third quarter of fiscal 2000 over the third quarter of fiscal 1999, an increase to 14.6% from 13.7% of net sales. Research and development expenses increased by $710 million in the first nine months of fiscal 2000 over the first nine months of fiscal 1999, an increase to 14.1% from 13.3% of net sales. The increases reflect our 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, optical transport, 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 rate similar to or slightly greater than the sales growth rate, as we invest in technology to address potential market opportunities. We also continue to purchase technology in order to bring a broad range of products to the market in a timely fashion. If we believe that we are unable to enter a particular market in a timely manner with internally developed products, we may license technology or acquire other businesses as an alternative to internal research and development. All of our research and development costs are expensed as incurred. Sales and marketing expenses increased by $367 million in the third quarter of fiscal 2000 over the third quarter of fiscal 1999, an increase to 20.8% from 20.7% of net sales. Sales and marketing expenses increased by $1,008 million in the first nine months of fiscal 2000 over the first nine months of fiscal 1999, an increase to 20.9% from 20.3% of net sales. The increases were principally due to an increase in the size of our direct sales force and related commissions, additional marketing and advertising investments associated with the introduction of new products, the expansion of distribution channels, and general corporate branding. The increases also reflect our efforts to invest in certain key areas such as expansion of our end-to-end strategy and service provider coverage in order to position ourselves to take advantage of future market opportunities. General and administrative expenses increased by $52 million in the third quarter of fiscal 2000 over the third quarter of fiscal 1999, remaining consistent at 3.0% of net sales. General and 22 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS administrative expenses increased by $146 million in the first nine months of fiscal 2000 over the first nine months of fiscal 1999, an increase to 3.0% from 2.9% of net sales. General and administrative expenses for the three and nine months ended April 29, 2000 include acquisition related costs of approximately $25 million. Excluding the acquisition related costs, the increases in general and administrative expenses primarily relate to the addition of new personnel and investments in infrastructure. 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 our growth, among other factors. Amortization of goodwill and purchased intangible assets increased by $32 million in the third quarter of fiscal 2000 over the third quarter of fiscal 1999. Amortization of goodwill and purchased intangible assets increased by $80 million in the first nine months of fiscal 2000 over the first nine months of fiscal 1999. Amortization of goodwill and purchased intangible assets includes the amortization of goodwill and other purchased intangible assets relating to various purchase acquisitions (See Note 4 to the consolidated financial statements). The amounts expensed to in-process research and development in the first nine months of fiscal 2000 arose from the completed acquisitions of Monterey, MaxComm, Calista, Tasmania, Pirelli, and Aironet (See Note 3 and Note 4 to the consolidated financial statements). 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 and venture capital surveys, adjusted upward to reflect additional risks inherent in the development life cycle. These risk factors have increased the overall discount rate between 5% to 20% for acquisitions in the current period. We consider the pricing model for products related to these acquisitions to be standard within the high-technology communications industry. We do not expect to achieve a material amount of expense reductions or synergies as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include anticipated cost savings. We expect that products incorporating the acquired technology from these acquisitions will be completed and begin to generate cash flows over the six to nine months after integration. However, development of these technologies remains a significant risk to us due to the remaining effort to achieve technical viability, 23 24 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 our business and operating results. The following table summarizes the significant assumptions underlying the valuations in fiscal 2000 and 1999 (in millions, except percentages):
Acquisition Assumptions Development -------------------------------- Costs Incurred Estimated Cost to Date After to Complete Risk Adjusted Acquisition on Technology at Discount Acquired Time of Rate for In- In-Process Entity Name Acquisition Process R&D Technology ----------- ----------- ----------- -------------- Fiscal 2000 ----------- Monterey Networks, Inc. $ 4 30% $25 MaxComm Technologies, Inc. $ 2 25% $ 4 Calista, Inc. $ 1 37.5% $ 1 Tasmania Network Systems, Inc. $ 1 45% $ 1 Pirelli S.p.A $ 5 20% $ 2 Aironet Wireless Communications, Inc. $ 3 23.5% $ 2 Fiscal 1999 ----------- American Internet Corp. $ 1 25% $ 1 Summa Four, Inc. $ 5 25% $24 Clarity Wireless, Inc. $42 32% $30 Selsius Systems, Inc. $15 31% $17 PipeLinks, Inc. $ 5 31% $18 Amteva Technologies, Inc. $ 4 35% $ 4
Regarding our purchase acquisitions completed in fiscal 2000 and 1999, actual results to date have been materially consistent with the assumptions at the time of the acquisitions as they relate to the value of in-process research and development. The assumptions primarily consist of an expected completion date for the 24 25 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS in-process projects, estimated costs to complete the projects, and revenue and expense projections once the products have entered the market. Products from these acquisitions have generally been introduced to the market six to nine months after the acquisition. 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. Interest and other income increased by $222 million in the third quarter of fiscal 2000 over the third quarter of fiscal 1999. Interest and other income increased by $329 million for the first nine months of fiscal 2000 over the first nine months of fiscal 1999. The increases were principally due to gains realized on minority investments of $156 million and $187 million in the third quarter and for the first nine months of fiscal 2000, respectively and income related to the general increase in cash and investments which was generated from our positive cash flows. The gains realized on minority investments were not material in fiscal 1999. Liquidity and Capital Resources Cash and cash equivalents, short-term investments, and investments were $15.1 billion at April 29, 2000, an increase of $6.0 billion from July 31, 1999. The increase is primarily a result of unrealized gains on publicly held investments and cash generated by operations and from the exercise of employee stock options. The cash flows from operating activities were partially offset by cash outflows from tax payments of approximately $217 million, and cash outflows from investing activities primarily relating to capital expenditures of approximately $666 million. Accounts receivable increased 53.9% from July 31, 1999 to April 29, 2000. Days sales outstanding in receivables increased to 36 days at April 29, 2000 from 32 days at July 31, 1999. Inventory levels increased 33.8% from July 31, 1999 to April 29, 2000. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements. 25 26 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS At April 29, 2000, we had a line of credit totaling $500 million, which expires July 2002. There have been no borrowings under this facility. We have entered into certain lease arrangements in San Jose, California, and Research Triangle Park, North Carolina, where we have established our headquarter operations and certain research and development and customer support activities. In connection with these transactions, we pledged $1.2 billion of our investments as collateral for certain obligations of the leases. We anticipate that we will occupy more leased property in the future that will require similar pledged securities; however, we do not expect the impact of this activity to be material to liquidity. We believe that our current cash and cash equivalents, short-term investments, line of credit, and cash generated from operations will satisfy our expected working capital and capital expenditure requirements at least through the next twelve months. 26 27 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS Set forth below and elsewhere in this Quarterly Report and in the other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward looking statements contained in this Quarterly Report. YOU SHOULD EXPECT THAT OUR OPERATING RESULTS MAY FLUCTUATE IN FUTURE PERIODS The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. Our operating results have in the past been, and will continue to 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"]), optical transport, wireless, content networking and data, voice, and video capabilities; - Variations in sales channels, product costs, or mix of products sold; - The timing of orders and manufacturing lead times; - The trend towards sales of integrated network solutions; - Employer payroll taxes to be paid on an employee's gain on stock options exercised. Such payroll taxes are recorded as operating expenses and could be material based upon the number of optionees who exercise their options and the price of our common stock; and - Changes in general economic conditions and specific economic conditions in the computer and networking industries. Any of the above factors could have a material adverse impact on our operations and financial results. For example, from time to time, we have made acquisitions that result in-process research and development expenses being charged in an individual quarter. These charges may occur in any particular quarter resulting in variability in our quarterly earnings. Additionally, the dollar amounts of large orders for our products have been increasing and therefore the operating results for a quarter could be materially 27 28 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS adversely affected if a number of large orders are either not received or are delayed, for example, due to cancellations, delays, or deferrals by customers. WE CONTINUE TO INVEST IN NEW AND EXISTING MARKET OPPORTUNITIES We are investing in increased headcount, inventory, manufacturing capacity, and product development through internal efforts and acquisitions, as a result of growth in existing opportunities and new or emerging opportunities in our target markets. Given the expected rate of growth of our segment of the market, we intend to add resources across all functions. With increased levels of spending, an inability to meet shipment requirements in a particular quarter could have a negative impact on our operating results for that period as we will not be able to react quickly enough to scale back expenses. Increased investments across all functions could translate into a faster rate of expense growth compared to revenue growth. SINCE OUR GROWTH RATE MAY SLOW, OPERATING RESULTS FOR A PARTICULAR QUARTER ARE DIFFICULT TO PREDICT We expect that in the future, our net sales may grow at a slower rate than experienced in previous periods and that on a quarter-to-quarter basis, our growth in net sales may be significantly lower than our historical quarterly growth rate. As a consequence, operating results for a particular quarter are extremely difficult to predict. Our ability to meet financial expectations could be hampered if the nonlinear sales pattern seen in past quarters reoccur in future periods. We generally have 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, we continue to attempt to reduce our 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 our quarter-to-quarter net sales and operating results going forward. On the other hand, for certain products, lead times are longer than our goal. If we cannot reduce manufacturing lead times for such products, our customers may cancel orders or not place further orders if shorter lead times are available from other manufacturers, thus creating additional variability. 28 29 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS WE EXPECT GROSS MARGINS TO DECLINE OVER TIME We expect that gross margins may be adversely affected by increases in material or labor costs, heightened price competition, increasing levels of services, and changes in channels of distribution or in the mix of products sold. For example, we believe 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 our higher-margin router and high-performance switching products targeted toward enterprise and service provider customers. We have recently introduced several new products, with additional new products scheduled to be released in the future. If product or related warranty costs associated with these new products are greater than we have experienced historically, gross margins may be adversely affected. Our gross margins may also be impacted by geographic mix, as well as the mix of configurations within each product group. We continue to expand into third-party or indirect distribution channels, which generally results in lower gross margins. In addition, increasing third-party and indirect distribution channels generally result in greater difficulty in forecasting the mix of our product, and to a certain degree, the timing of orders from our customers. Downward pressures on our gross margin may be further impacted by other factors, such as increased percentage of revenues from service provider markets which may have lower margins and/or an increase in product costs, which would adversely affect our future operating results. We also expect that our operating margins may decrease as we continue to hire additional personnel and experience increases in overall operating expenses to support our business. We plan our 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. 29 30 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS WE ARE DEPENDENT UPON ADEQUATE COMPONENT SUPPLY AND MANUFACTURING CAPACITY Our growth and ability to meet customer demands also depend in part on our ability to obtain timely deliveries of parts from our suppliers. We have experienced component shortages in the past that have adversely affected our operations. Although we work closely with our suppliers to avoid these types of shortages, there can be no assurance that we will not encounter these problems in the future. Although we generally use standard parts and components for our products, certain components are presently available only from a single source or limited sources. While our suppliers have performed effectively and been relatively flexible to date, we believe that we will be faced with the following challenges going forward: - New markets that we participate in may grow quickly and thus, consume significant component capacity; and - As we continue to acquire companies and new technologies, we are dependent, at least initially, on unfamiliar supply chains or relatively small supply partners. Manufacturing capacity and component supply constraints could be significant issues for us. A reduction or interruption in supply or a significant increase in the price of one or more components would adversely affect our business, operating results and financial condition and could materially damage customer relationships. WE COMPETE IN THE HIGHLY COMPETITIVE TELECOMMUNICATIONS EQUIPMENT MARKET We compete in the telecommunications equipment market, providing solutions for transporting data, voice, and video traffic across intranets, extranets, and the Internet. The market is characterized by rapid growth, converging technologies, and a conversion to new solutions that offer superior advantages. These market factors represent both an opportunity and a competitive threat to us. We compete with numerous vendors in each product category. We expect that the overall number of competitors providing niche product solutions will increase due to the market's attractive growth. On the other hand, we expect the number of vendors supplying end-to-end telecommunications solutions will decrease due to the rapid pace of acquisitions in the industry. Ultimately we believe only a few large suppliers of 30 31 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS end-to-end telecommunication equipment solutions will become our primary competitors. In addition to the product competition, we compete to attract and retain our current and future key employees. Competition for highly skilled business, technical, marketing and other personnel is intense for high technology companies. Our continued growth and success depends on our ability to retain senior management and other key employees, and the hiring of new qualified employees. Our competitors include, among others, Alcatel, Ericsson, Extreme, Foundry, Juniper, Lucent, Nortel, Siemens AG, and Sycamore. Some of our competitors compete across many of our product lines, while others do not offer as wide a breadth of solutions. Several of our current and potential competitors have greater financial, marketing, and technical resources than us. The principal competitive factors in the markets in which we presently compete and may compete in the future are: - price; - performance; - the ability to provide end-to-end solutions and support; - conformance to standards; - the ability to provide value added features such as security, reliability, and investment protection; and - market presence. We also face competition from customers we license technology to and suppliers from whom we transfer technology. Networking's inherent nature requires interoperability. As such, we must cooperate and at the same time compete with these companies. Our inability to effectively manage these complicated relationships with customers and suppliers could have a material adverse effect on our business, operating results, and financial condition. 31 32 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS WE EXPECT TO MAKE FUTURE ACQUISITIONS WHERE ADVISABLE AND ACQUISITIONS INVOLVE NUMEROUS RISKS The networking business is highly competitive, and as such, our growth is dependent upon market growth, our ability to enhance our existing products and our ability to introduce new products on a timely basis. One of the ways we have addressed and will continue to address the need to develop new products is through acquisitions of other companies. Acquisitions involve numerous risks, including the following: - 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 in-process research and development; - risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions; - initial dependence on unfamiliar supply chains or relatively small supply partners; - insufficient revenues to offset increased expenses associated with acquisitions; and - the potential loss of key employees of the acquired company. Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results or financial condition. We must also maintain our ability to manage any such growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we made could harm our business and operating results. WE ARE EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results. Historically, our primary exposures have related to nondollar-denominated sales in 32 33 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS Japan, Canada, and Australia and nondollar-denominated operating expenses in Europe, Latin America, and Asia where we sell primarily in U.S. dollars. Additionally, we have recently seen our exposures to emerging market currencies, such as the Brazilian real, Korean won, and Russian ruble, among others, increase because of our expanding presence in these markets and the extreme currency volatility. We will continue to monitor our exposure and may hedge against these or any other emerging market currencies as necessary. The increasing use of the euro as a common currency for members of the European Union could impact our foreign exchange exposure. We are currently hedging against fluctuations with the euro and will continue to evaluate the impact of the euro on our future foreign exchange exposure as well as on our internal systems. At the present time, we hedge only those currency exposures associated with certain assets and liabilities denominated in nonfunctional currencies and do not hedge anticipated foreign currency cash flows. The hedging activity undertaken by us is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities. WE ARE EXPOSED TO THE CREDIT RISK OF SOME OF OUR CUSTOMERS AND TO CREDIT EXPOSURES IN WEAKENED MARKETS A significant proportion of our sales are derived through our partners in two-tier distribution channels. These customers are generally given privileges to return inventory, receive credits for changes in selling prices, and participate in cooperative marketing programs. We maintain appropriate accruals 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. We are experiencing increased demands for customer financing and leasing solutions, particularly from competitive local exchange carriers ("CLECs"). CLECs typically finance significant networking infrastructure deployments through alternative forms of financing, including leasing, through us. Although we have programs in place to monitor and mitigate the associated risk, there can be no assurance that such programs will alleviate all of our credit risk. We also continue to monitor increased credit exposures because of the weakened financial conditions in certain geographical regions, and the impact that such conditions may have on the worldwide economy. Although we have not experienced significant losses due to customers failing to meet their obligations to date, such losses, if incurred, could harm our 33 34 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS business and have a material adverse effect on our operating results and financial condition. WE ARE EXPOSED TO FLUCTUATIONS IN THE MARKET VALUES OF OUR PORTFOLIO INVESTMENTS AND IN INTEREST RATES We maintain 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 other 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. For example, as a result of recent market price volatility of our publicly traded equity investments, we experienced a $111 million after-tax unrealized loss on these investments during the third quarter of fiscal 2000. We have also invested in numerous privately held companies, many of which can still be considered in the startup or development stages. These investments are inherently risky as the market for the technologies or products they have under development are typically in the early stages and may never materialize. We could lose our entire initial investment in these companies. We also have certain real estate lease commitments with payments tied to short-term interest rates. At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of our investment portfolio while increasing the costs associated with our lease commitments. Conversely, declines in interest rates could have a material impact on interest earnings for our investment portfolio. We do not currently hedge these interest rate exposures. Readers are referred to pages 28-29 of our fiscal 1999 Annual Report to Shareholders for a more detailed discussion of quantitative and qualitative disclosures about market risk. The following analysis presents the hypothetical change in fair values of public equity investments that are sensitive to changes in the stock market. These equity securities are held for purposes other than trading. The modeling technique used measures the hypothetical change in fair values arising from selected hypothetical changes in each stock's price. Stock price fluctuations of plus or minus 15%, plus or minus 35%, and plus or minus 50% were selected based on the probability of their occurrence. 34 35 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS This table estimates the fair value of the publicly traded corporate equities at a twelve-month time horizon (in millions):
Fair value Valuation of security as of Valuation of security given X% decrease in each April 29, given X% increase in each stock's price 2000 stock's price ------------------------------------- ------- ----------------------------------- (50%) (35%) (15%) 15% 35% 50% ------- ------- ------- ------- ------- ------- Corporate Equities $ 1,622 $ 2,108 $ 2,757 $ 3,243 $ 3,729 $ 4,378 $ 4,865
Our equity portfolio consists of securities with characteristics that most closely match the S&P Index or companies traded on the NASDAQ Exchange. The NASDAQ Composite Index has occurrence of a 15% movement in all of the last three years and a 35% and 50% movement in at least one of the last three years. WE CANNOT PREDICT THE IMPACT OF RECENT ACTIONS AND COMMENTS BY THE SEC AND FASB Recent actions and comments from the SEC have indicated they are reviewing the current valuation methodology of in-process research and development related to business combinations. The SEC is concerned that some companies are writing off more of the value of an acquisition than is appropriate. We believe we are in compliance with all of the rules and related guidance as they currently exist. However, there can be no assurance that the SEC will not seek to reduce the amount of in-process research and development previously expensed by us. This would result in the restatement of our previously filed financial statements and could have a material adverse effect on our results of operations and financial condition for periods subsequent to the acquisitions. Additionally, the Financial Accounting Standards Board ("FASB") has announced that it plans to rescind the pooling of interests method of acquisition accounting. If this occurs, it could alter our acquisition strategy and potentially impair our ability to acquire companies. OUR BUSINESS DEPENDS UPON OUR PROPRIETARY RIGHTS, AND THERE IS A RISK OF INFRINGEMENT Our success is dependent upon our proprietary technology. We generally rely upon patents, copyrights, trademarks, and trade secret laws to establish and maintain our proprietary rights in our technology and products. We have a program to file applications for and obtain patents in the United States and in selected foreign countries where a potential market for our 35 36 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS products exists. We have been issued a number of patents; other patent applications are currently pending. There can be no assurance that any of these patents will not be challenged, invalidated, or circumvented, or that any rights granted thereunder will provide competitive advantages to us. In addition, there can be no assurance that patents will be issued from pending applications, or that claims allowed on any future patents will be sufficiently broad to protect our technology. In addition, the laws of some foreign countries may not permit the protection of our proprietary rights to the same extent as do the laws of the United States. Although we believe the protection afforded by our patents, patent applications, copyrights, and trademarks has value, the rapidly changing technology in the networking industry makes our future success dependent primarily on the innovative skills, technological expertise, and management abilities of our employees rather than on patent, copyright, and trademark protection. Many of our products are designed to include software or other intellectual property licensed from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, we believe that based upon past experience and standard industry practice, such licenses generally could be obtained on commercially reasonable terms. Because of the existence of a large number of patents in the networking field and the rapid rate of issuance of new patents, it is not economically practical to determine in advance whether a product or any of its components infringe on patent rights of others. From time to time, we receive notices from or are sued by third parties regarding patent claims. If infringement is alleged, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all, or that we would prevail in any such challenge. The inability to obtain certain licenses or other rights or to obtain such licenses or rights on favorable terms, or the need to engage in litigation could have a material adverse effect on our business, operating results and financial condition. WE FACE RISKS FROM THE UNCERTAINTIES OF REGULATION OF THE INTERNET There are currently few laws or regulations that apply directly to access or commerce on the Internet. We could be materially adversely affected by regulation in any country where we operate, 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 36 37 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS industry. The adoption of such measures could decrease demand for our products, and at the same time increase our cost of selling our products. Changes in laws or regulations governing the Internet and Internet commerce could have a material adverse effect on our business, operating results and financial condition. THE ENTRANCE INTO NEW OR DEVELOPING MARKETS EXPOSES OUR BUSINESS AND OPERATIONS TO RISKS As we focus on new market opportunities, such as transporting data, voice, and video traffic across the same network, we will increasingly compete with large telecommunications equipment suppliers such as Alcatel, Ericsson, Lucent, Nortel, and Siemens AG, among others, and several well-funded start-up companies. Several of our current and potential competitors have greater financial, marketing, and technical resources than we do. Additionally, as customers in these markets complete infrastructure deployments, they may require greater levels of service, support, and financing than we have experienced in the past. We have not entered into a material amount of labor intensive service contracts which require significant production or customization. However, we expect that demand for these types of service contracts will increase in the future. There can be no assurance that we can provide products, service, support, and financing to effectively compete for these market opportunities. Further, provision of greater levels of services by us may result in less favorable timing of revenue recognition than we have historically experienced. THE LOCATION OF OUR FACILITIES SUBJECTS US TO THE RISK OF EARTHQUAKES AND FLOODS Our corporate headquarters, including most of our research and development operations and our manufacturing facilities, are located in the Silicon Valley area of Northern California, a region known for seismic activity. Additionally, certain of our facilities, which includes one of our manufacturing facilities, are located near rivers that have experienced flooding in the past. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results and financial condition. 37 38 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS WE DEPEND UPON THE DEVELOPMENT OF NEW PRODUCTS AND ARE SUBJECT TO RAPID CHANGES IN TECHNOLOGY AND THE MARKET Our operating results will depend to a significant extent on our ability to reduce the costs to produce existing products. In particular, we broadened our product line by introducing network access products. Sales of these products, which are generally lower priced and carry lower margins than our core products, have increased more rapidly than sales of our core products. The success of these and other new products is dependent on several factors, including proper new product definition, product cost, timely completion and introduction of new products, differentiation of new products from those of our competitors, and market acceptance of these products. The markets for our products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions, and evolving methods of building and operating networks. There can be no assurance that we will successfully identify new product opportunities, develop and bring new products to market in a timely manner, and achieve market acceptance of our products or that products and technologies developed by others will not render our products or technologies obsolete or noncompetitive. WE ARE SUBJECT TO RISKS ASSOCIATED WITH STRATEGIC ALLIANCES We have increased the number of our strategic alliances with large and complex organizations and our ecosystem partners. These arrangements are generally limited to specific projects, the goal of which is generally to facilitate product compatibility and adoption of industry standards. If successful, these relationships will be mutually beneficial and result in industry growth. However, these alliances carry an element of risk because, in most cases, we must compete in some business areas with a company with which we have strategic alliances and, at the same time, cooperate with such company in other business areas. Also, if these companies fail to perform, or if these relationships fail to materialize as expected, we could suffer delays in product development or other operational difficulties. THE INDUSTRY IN WHICH WE COMPETE IS SUBJECT TO CONSOLIDATION There has been a trend toward industry consolidation for several years. We expect this trend toward industry consolidation to continue as companies attempt to strengthen or hold their market positions in an evolving industry. We believe that industry consolidation may provide stronger competitors that are better able to compete as sole-source vendors for customers. This could 38 39 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS lead to more variability in operating results as we compete to be a single vendor solution and could have a material adverse effect on our business, operating results and financial condition. SALES IN THE SERVICE PROVIDER MARKET ARE SUBJECT TO VARIATION Although sales to the service provider market have grown historically, this market is characterized by large, and often sporadic purchases. Sales activity in this industry depends upon the stage of completion of expanding network infrastructures, the availability of funding, and the extent that service providers are affected by regulatory and business conditions in the country of operations. A decline or delay in sales orders from this industry could have a material adverse effect on our business, operating results and financial condition. WE FACE RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATIONS REGULATION AND TARIFFS Changes in domestic and international telecommunications requirements could affect the sales of our products. In particular, we believe it is possible that there may be significant changes in domestic telecommunications regulation in the near future that could slow the expansion of the service providers' network infrastructures and materially adversely affect our business, operating results and financial condition. Future changes in tariffs by regulatory agencies or application of tariff requirements to currently untariffed services could affect the sales of our products for certain classes of customers. Additionally, in the U.S., our products must comply with various Federal Communications Commission requirements and regulations. In countries outside of the U.S., our products must meet various requirements of local telecommunications authorities. Changes in tariffs, or failure by us to obtain timely approval of products could have a material adverse effect on our business, operating results, and financial condition. OUR BUSINESS IS SUBJECT TO RISKS FROM INTERNATIONAL OPERATIONS We conduct business globally. Accordingly, our future results could be materially adversely affected by a variety of uncontrollable and changing factors including, among others, foreign currency exchange rates; regulatory, political, or economic conditions in a specific country or region; trade protection measures and other regulatory requirements; government spending patterns; and natural disasters. Any or all of these 39 40 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS factors could have a material adverse impact on our future international business in these or other countries. OUR BUSINESS SUBSTANTIALLY DEPENDS UPON THE CONTINUED GROWTH OF THE INTERNET AND INTERNET-BASED SYSTEMS We believe that there will be performance problems with Internet communications in the future which could receive a high degree of publicity and visibility. As we are a large supplier of equipment for the Internet infrastructure, customers' perceptions of our products and the marketplace's perception of us as a supplier of networking products may be materially adversely affected, regardless of whether or not these problems are due to the performance of our products. Such an event could also result in a material adverse effect on the market price of our common stock and could materially adversely affect our business, operating results and financial condition. OUR STOCK PRICE MAY BE VOLATILE Our common stock has experienced substantial price volatility, particularly as a result of variations between our actual or anticipated financial results, the published expectations of analysts, and as a result of announcements by our competitors and us. In addition, the stock market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies, in particular, and that have often been unrelated to the operating performance of these companies. These factors, as well as general economic and political conditions, may materially adversely affect the market price of our common stock in the future. OTHER PricewaterhouseCoopers LLP ("PWC"), our independent accountants, has notified us that PWC is engaged in discussions with the Securities and Exchange Commission following an internal review by PWC, pursuant to an administrative settlement with the SEC, of PWC's compliance with auditor independence guidelines. PWC has advised us that we are one of the companies affected by such discussions. We are not involved in the discussions between the SEC and PWC and cannot predict the result of those discussions. 40 41 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information called for by this item is provided under the caption "We Are Exposed To Fluctuations In The Market Values Of Our Portfolio Investments And In Interest Rates" under Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations. 41 42 PART II. OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (c) During the quarter, the Company issued an aggregate of approximately 32.6 million shares of its common stock in exchange for the outstanding capital stock of Compatible Systems Corporation, Growth Networks, Inc. and a subsidiary of Pirelli S.p.A. 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 (either alone or through its representative) with access to all relevant information necessary. The Company has filed Registration Statements on Form S-3 covering the resale of such securities. During the quarter, the Company issued an aggregate of approximately 6.2 million shares of its common stock in exchange for the outstanding capital stock of Altiga Networks, Inc. The shares were issued pursuant to an exemption by reason of Section 3(a)(10) of the Securities Act of 1933. The terms and conditions of such issuances were approved after a hearing upon the fairness of such terms and conditions by a government authority expressly authorized by the law to grant such approval. 42 43 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit 27 Financial Data Schedule (b) Reports on Form 8-K The Company filed six reports on Form 8-K during the quarter ended April 29, 2000. Information regarding the items reported on is as follows: Date Item Reported On ---- ---------------- February 3, 2000 The Company amended the Form 8-K filed on December 15, 1999 to provide additional information relating to SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" and to provide additional disclosure in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section. February 17, 2000 The Company announced the completion of the acquisition of the optical systems business of Pirelli S.p.A of Milan, Italy. March 16, 2000 The Company announced the completion of the acquisition of Aironet Wireless Communications, Inc. March 27, 2000 The Company announced the acquisitions of InfoGear Technology Corporation and JetCell, Inc. March 28, 2000 The Company announced the completion of the acquisitions of Compatible Systems Corporation and Growth Networks, Inc. April 3, 2000 The Company announced the completion of the acquisition of Altiga Networks, Inc. 43 44 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Cisco Systems, Inc. Date: June 13, 2000 By /s/ Larry R. Carter ------------------------------- Larry R. Carter, Senior Vice President, Finance and Administration, Chief Financial Officer, and Secretary 44 45 EXHIBIT INDEX
EXHIBIT DESCRIPTION ------- ----------- EX-3.1 Amendment to the Restated Articles of Incorporation EX-27 Financial Data Schedule
45