10-Q 1 f67903e10-q.txt FORM 10-Q 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED OCTOBER 28, 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 November 24, 2000, 7,197,149,590 shares of the registrant's common stock were outstanding. ================================================================================ 2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED OCTOBER 28, 2000 INDEX
Page Part I. Financial Information Item 1. Financial Statements a) Consolidated Statements of Operations for the three months ended October 28, 2000 and October 30, 1999 3 b) Consolidated Balance Sheets at October 28, 2000 and July 29, 2000 4 c) Consolidated Statements of Cash Flows for the three months ended October 28, 2000 and October 30, 1999 5 d) Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 31 Part II. Other Information Item 2. Changes in Securities and Use of Proceeds 32 Item 6. Exhibits and Reports on Form 8-K 33 Signature 34
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 --------------------------- October 28, October 30, 2000 1999 ----------- ----------- (Unaudited) (Unaudited) NET SALES $6,519 $3,918 Cost of sales 2,378 1,388 ------ ------ GROSS MARGIN 4,141 2,530 Operating expenses: Research and development 942 541 Sales and marketing 1,362 818 General and administrative 195 112 Amortization of goodwill and other acquisition-related charges 231 24 In-process research and development 509 381 ------ ------ Total operating expenses 3,239 1,876 ------ ------ OPERATING INCOME 902 654 Net gains realized on minority investments 190 -- Interest and other income, net 230 102 ------ ------ INCOME BEFORE PROVISION FOR INCOME TAXES 1,322 756 Provision for income taxes 524 341 ------ ------ NET INCOME $ 798 $ 415 ====== ====== Net income per share--basic $ 0.11 $ 0.06 ====== ====== Net income per share--diluted $ 0.11 $ 0.06 ====== ====== Shares used in per-share calculation--basic 7,093 6,833 ====== ====== Shares used in per-share calculation--diluted 7,580 7,288 ====== ======
See Notes to Consolidated Financial Statements. 3 4 CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (IN MILLIONS, EXCEPT PAR VALUE)
October 28, July 29, 2000 2000 ----------- -------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 5,538 $ 4,234 Short-term investments 853 1,291 Accounts receivable, net of allowance for doubtful accounts of $57 at October 28, 2000 and $43 at July 29, 2000 2,887 2,299 Inventories, net 1,956 1,232 Deferred tax assets 642 1,091 Lease receivables 459 588 Prepaid expenses and other current assets 724 375 ------- ------- Total current assets 13,059 11,110 Investments 11,808 13,688 Restricted investments 1,386 1,286 Property and equipment, net 1,769 1,426 Goodwill and purchased intangible assets, net 4,427 4,087 Lease receivables 550 527 Other assets 1,153 746 ------- ------- TOTAL ASSETS $34,152 $32,870 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 999 $ 739 Income taxes payable 256 233 Accrued compensation 1,083 1,317 Deferred revenue 1,697 1,386 Other accrued liabilities 1,767 1,521 ------- ------- Total current liabilities 5,802 5,196 Deferred tax liabilities 664 1,132 Minority interest 45 45 Shareholders' equity: Preferred stock, no par value: 5 shares authorized; none issued and outstanding -- -- Common stock and additional paid-in capital, $0.001 par value: 20,000 shares authorized; 7,190 and 7,138 shares issued and outstanding at October 28, 2000 and July 29, 2000, respectively 16,103 14,609 Retained earnings 9,156 8,358 Accumulated other comprehensive income 2,382 3,530 ------- ------- Total shareholders' equity 27,641 26,497 ------- ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $34,152 $32,870 ======= =======
See Notes to Consolidated Financial Statements. 4 5 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN MILLIONS)
Three Months Ended ----------------------------- October 28, October 30, 2000 1999 ----------- ----------- (Unaudited) (Unaudited) Cash flows from operating activities: Net income $ 798 $ 415 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 434 144 Provision for losses 275 75 Deferred income taxes (292) (33) Tax benefits from employee stock option plans 985 390 Adjustment to conform fiscal year ends of pooled acquisitions -- (18) In-process research and development 476 381 Gains on minority investments (81) -- Change in operating assets and liabilities: Accounts receivable (601) (180) Inventories (867) (74) Prepaid expenses and other current assets (349) 2 Accounts payable 259 113 Income taxes payable 23 (159) Accrued compensation (234) (103) Deferred revenue 311 42 Other accrued liabilities 226 137 ------- ------- Net cash provided by operating activities 1,363 1,132 ------- ------- Cash flows from investing activities: Purchases of short-term investments (1,524) (297) Sales and maturities of short-term investments 2,143 825 Purchases of investments (4,134) (3,104) Sales and maturities of investments 4,116 2,262 Purchases of restricted investments (51) (70) Sales and maturities of restricted investments 10 69 Acquisition of property and equipment (524) (201) Acquisition of businesses, net of cash and cash equivalents 31 -- Net investment in lease receivables 106 (119) Minority investments (317) (120) Other (234) (286) ------- ------- Net cash used in investing activities (378) (1,041) ------- ------- Cash flows from financing activities: Issuance of common stock 338 301 Other (19) 6 ------- ------- Net cash provided by financing activities 319 307 ------- ------- Net increase in cash and cash equivalents 1,304 398 Cash and cash equivalents, beginning of period 4,234 913 ------- ------- Cash and cash equivalents, end of period $ 5,538 $ 1,311 ======= =======
See Notes to Consolidated Financial Statements. 5 6 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. DESCRIPTION OF BUSINESS Cisco Systems, Inc. (together with its subsidiaries, "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 its 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 2001 and 2000 are 52-week fiscal years. Basis of Presentation The accompanying financial data as of October 28, 2000 and for the three months ended October 28, 2000 and October 30, 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 29, 2000 Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended July 29, 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 October 28, 2000, results of operations for the three months ended October 28, 2000 and October 30, 1999, and cash flows for the three months ended October 28, 2000 and October 30, 1999 have been made. The results of operations for the three months ended October 28, 2000 are not necessarily indicative of the operating results for the full fiscal year or any future periods. 6 7 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Computation of Net Income per Share Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common and dilutive common-equivalent shares outstanding during the period. Dilutive common-equivalent shares primarily consist of employee stock options. Derivatives In the first quarter of fiscal 2001, the Company adopted 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. SFAS 133 requires that an entity recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company designates its derivatives based upon criteria established by SFAS 133. For a derivative designated as a fair value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative designated as a cash flow hedge, the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. The Company enters into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on assets and liabilities denominated in currencies other than the functional currency of the reporting entity. These foreign exchange forward contracts are highly inversely correlated to the hedged items and considered effective as hedges of the underlying assets and liabilities but are not designated as hedges under SFAS 133. In addition, the Company periodically hedges anticipated transactions with purchased currency options which are designated as cash flow hedges. There were no other significant derivatives as of October 28, 2000. The adoption of SFAS 133 did not have a material impact on the Company's operations or financial position. Recent Accounting Pronouncement 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. At this time, management does not expect the adoption of SAB 101 to have a material effect on 7 8 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) the Company's operations or financial position. The Company is required to adopt SAB 101 in the fourth quarter of fiscal 2001. 3. BUSINESS COMBINATIONS Purchase Combinations During fiscal 2001, the Company completed 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 ("in-process R&D") were determined through established valuation techniques in the high-technology communications equipment industry and were expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. Amounts allocated to goodwill and purchased intangible assets are amortized on a straight-line basis over periods not exceeding five years. The following is a summary of purchase transactions completed in fiscal 2001 (in millions):
In-Process Form of Consideration Acquired Company Consideration R&D Expense and Other Notes to Acquisition ---------------- ------------- ----------- ----------------------------------------------- IPmobile, Inc. $ 422 $ 181 Cash of $4; common stock and options assumed; goodwill and other intangibles recorded of $157 NuSpeed, Inc. $ 463 $ 164 Cash of $4; common stock and options assumed; goodwill and other intangibles recorded of $214 Other $ 481 $ 164 Cash of $25; common stock and options assumed; $19 in liabilities assumed; goodwill and other intangibles recorded of $194
Other Purchase Combinations Completed as of October 28, 2000 In the first three months ended October 28, 2000, the Company acquired Netiverse, Inc.; HyNEX, Ltd.; and Komodo Technology, Inc. for a total purchase price of $481 million, paid in common stock and cash. Total in-process R&D related to these acquisitions amounted to $164 million. Total in-process R&D expense for the three months ended October 28, 2000 and October 30, 1999 was $509 million and $381 million, respectively. The in-process R&D expense that was attributable to stock consideration for the same periods was $476 million and $381 million, respectively. 8 9 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 4. BALANCE SHEET DETAIL The following tables provide details of selected balance sheet items (in millions):
October 28, July 29, 2000 2000 ----------- -------- Inventories, net: Raw materials $ 631 $ 145 Work in process 621 472 Finished goods 618 496 Demonstration systems 86 119 ------- ------- Total $ 1,956 $ 1,232 ======= ======= Goodwill and purchased intangible assets, net: Goodwill $ 3,364 $ 2,937 Purchased intangible assets 1,700 1,558 ------- ------- 5,064 4,495 Less, accumulated amortization (637) (408) ------- ------- Total $ 4,427 $ 4,087 ======= =======
The following table presents the details of the amortization of goodwill and purchased intangible assets (in millions):
Three Months Ended ------------------------ October 28, October 30, 2000 1999 ----------- ----------- Reported as: Cost of sales $ 4 $ 6 Operating expenses 225 24 ---- ---- Total $229 $ 30 ==== ====
The amortization of goodwill and other acquisition-related charges as reported in the Consolidated Statements of Operations included $6 million of stock-based compensation arising from purchase acquisitions in the first three months of fiscal 2001. There was no stock-based compensation arising from purchase acquisitions in the first three months of fiscal 2000. 9 10 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. COMPREHENSIVE INCOME The components of comprehensive income, net of tax, are as follows (in millions):
Three Months Ended ---------------------------- October 28, October 30, 2000 1999 ---------- ----------- Net income $ 798 $ 415 Other comprehensive income (loss): Change in net unrealized gains on investments (1,129) 520 Change in accumulated translation adjustments (19) 6 ------- ------- Total $ (350) $ 941 ======= =======
6. INCOME TAXES The Company received net income tax refunds of $219 million for the three months ended October 28, 2000 and paid income taxes of $135 million for the three months ended October 30, 1999. The Company's income taxes currently payable for federal and state purposes have been reduced by the tax benefits of employee stock option transactions. This benefit totaled $985 million and $390 million in the first three months of fiscal 2001 and 2000, respectively, and was credited directly to shareholders' equity. In addition, the Company's valuation allowance against gross deferred tax assets attributable to employee stock option transactions has been increased by $879 million in the first three months of fiscal 2001 and was reflected as a reduction of shareholders' equity. 7. SEGMENT INFORMATION AND MAJOR CUSTOMERS The Company's operations involve the design, development, manufacturing, marketing, and technical support of networking products and services. The Company offers end-to-end networking solutions for its customers. Cisco products include routers, LAN and ATM switches, dial-up access servers, and network-management software. These products, integrated by the Cisco IOS(R) software, link geographically dispersed LANs, 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 geographic theater. Sales are attributed to a theater based on the ordering location of the customer. The Company's management makes financial decisions and allocates resources based on the information it receives from this internal management system. The Company does not allocate research and development, sales and marketing, or general and administrative expenses to its geographic theaters as management does not use this information to measure the performance of the operating segments. Management does not believe that allocating these 10 11 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) expenses is material in evaluating a geographic theater's performance. Information from this internal management system differs from the amounts reported under generally accepted accounting principles due to certain corporate level adjustments not included in the internal management system. These corporate level adjustments are primarily sales adjustments relating to reserves for leases and structured loans, deferred revenue, two-tier distribution, and other timing differences. Based on established criteria, the Company has four reportable segments: the Americas; Europe, Middle East, and Africa ("EMEA"); Asia Pacific; and Japan. Summarized financial information by segment for the three months ended October 28, 2000 and October 30, 1999, as taken from the internal management system discussed above, is as follows (in millions):
Three Months Ended --------------------------- October 28, October 30, 2000 1999 ---------- ----------- Net sales: Americas $ 4,632 $ 2,662 EMEA 1,845 1,020 Asia Pacific 669 283 Japan 484 157 Sales adjustments (1,111) (204) ------- ------- Total $ 6,519 $ 3,918 ======= ======= Gross margin: Americas $ 3,373 $ 1,940 EMEA 1,384 765 Asia Pacific 482 208 Japan 387 125 ------- ------- Standard margin 5,626 3,038 Sales adjustments (1,111) (204) Cost of sales adjustments 293 53 Prodution overhead (154) (83) Manufacturing variances and other related costs (513) (274) ------- ------- Total $ 4,141 $ 2,530 ======= =======
The net sales and standard margins by geographic theater differ from the amounts recognized under generally accepted accounting principles because the Company does not allocate certain sales adjustments, cost of sales adjustments, production overhead, and manufacturing variances and other related costs to the theaters. The above table reconciles the net sales and standard margins by geographic theater 11 12 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) to net sales and gross margin as reported in the Consolidated Statements of Operations by including such adjustments. The following table presents net sales for groups of similar products and services (in millions):
Three Months Ended ---------------------------- October 28, October 30, 2000 1999 ---------- ---------- Routers $ 2,818 $ 1,598 Switches 2,809 1,576 Access 810 475 Other 1,193 473 Sales adjustments (1,111) (204) ------- ------- Total $ 6,519 $ 3,918 ======= =======
Substantially all of the Company's assets at October 28, 2000 and July 29, 2000 were attributable to U.S. operations. No single customer accounted for 10% or more of net sales during the three months ended October 28, 2000 and October 30, 1999. 8. NET INCOME PER SHARE The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):
Three Months Ended -------------------------- October 28, October 30, 2000 1999 ---------- ----------- Net income $ 798 $ 415 ====== ====== Weighted-average shares--basic 7,093 6,833 Effect of dilutive securities 487 455 ------ ------ Weighted-average shares--diluted 7,580 7,288 ====== ====== Net income per share--basic $ 0.11 $ 0.06 ====== ====== Net income per share--diluted $ 0.11 $ 0.06 ====== ======
12 13 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 9. SUBSEQUENT EVENTS Pending Business Combinations The Company announced definitive agreements to acquire PixStream Incorporated; Vovida Networks, Inc.; IPCell Technologies; the broadband subscriber management software business of CAIS Software Solutions; Active Voice Corporation; and Radiata, Inc. for a total purchase price of approximately $1.50 billion, payable in common stock and cash. These acquisitions will be accounted for using the purchase method and are expected to close in the second quarter of fiscal 2001. 13 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, statements containing the words "believes," "anticipates," "estimates," "expects," "projections," and words of similar import, constitute "forward-looking statements." You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us described below and elsewhere in this Quarterly Report, and in other documents we file with the Securities and Exchange Commission. Net sales in the first quarter of fiscal 2001 were $6.52 billion, compared with $3.92 billion in the first quarter of fiscal 2000, an increase of 66.4%. The increase in net sales was primarily a result of increased unit sales of switch, router, and access products; growth in the sales of add-on boards that provide increased functionality; optical transport products; and maintenance, service, and support sales (see Note 7 to the Consolidated Financial Statements). We manage our business on four geographic theaters: the Americas; Europe, the Middle East, and Africa ("EMEA"); Asia Pacific; and Japan. Summarized financial information by theater for the first quarter of fiscal 2001 and 2000 is summarized in the following table (in millions):
Three Months Ended ---------------------------- October 28, October 30, 2000 1999 ----------- ----------- Net sales: Americas $ 4,632 $ 2,662 EMEA 1,845 1,020 Asia Pacific 669 283 Japan 484 157 Sales adjustments (1,111) (204) ------- ------- Total $ 6,519 $ 3,918 ======= =======
Gross margin in the first quarter of fiscal 2001 was 63.5%, compared with 64.6% in the first quarter of fiscal 2000. The following table shows the standard margins for each theater:
Three Months Ended ---------------------------- October 28, October 30, 2000 1999 ----------- ----------- Standard margin: Americas 72.8% 72.9% EMEA 75.0% 75.0% Asia Pacific 72.0% 73.5% Japan 80.0% 79.6%
14 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The net sales and standard margins by geographic theater differ from the amounts recognized under generally accepted accounting principles because we do not allocate certain sales adjustments, cost of sales adjustments, production overhead, and manufacturing variances and other related costs to the theaters. Sales adjustments relate to reserves for leases and structured loans, deferred revenue, two-tier distribution, and other timing differences. Standard margins decreased for two geographic theaters as compared with the first quarter of fiscal 2000. The decrease in the overall gross margin was primarily due to shifts in product mix, introduction of new products, which generally have lower margins when first released, higher production-related costs, the continued pricing pressure seen from competitors in certain product areas, and the above-mentioned sales adjustments, which were not included in the standard margins. We expect gross margin may be adversely affected by increases in material or labor costs, heightened price competition, increasing levels of services, higher inventory balances, introduction of new products for new high-growth markets, and changes in channels of distribution or in the mix of products sold. We believe gross margin may be additionally impacted due to constraints relating to certain component shortages that currently exist in the supply chain. We may also experience a lower gross margin as the product mix for access and optical product volume grows. We have recently introduced several new products, with additional new products scheduled to be released in the future. Increase in demand would result in increased manufacturing capacity, which in turn would result in higher inventory balances. In addition, our vendor base is capacity-constrained and this could result in increased cost pressure on certain components. If product or related warranty costs associated with these new products are greater than we have experienced, gross margin may be adversely affected. Our gross margin 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 a lower gross margin. In addition, increasing third-party and indirect-distribution channels generally results 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 net sales from service provider markets, which may have lower margins or an increase in product costs, which could adversely affect our future operating results. Research and development ("R&D") expenses in the first quarter of fiscal 2001 were $942 million, compared with $541 million in the first quarter of fiscal 2000, an increase of 74.1%. R&D expenses, as a percentage of net sales, increased to 14.5% in the first quarter of fiscal 2001, compared with 13.8% in the first quarter of fiscal 2000. The increase reflected our ongoing R&D efforts in a wide variety of areas such as data, voice, and video 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 15 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS additional lab equipment. We also continued to purchase technology in order to bring a broad range of products to the market in a timely fashion. If we believe that we are unable to enter a particular market in a timely manner with internally developed products, we may license technology from other businesses or acquire businesses as an alternative to internal R&D. All of our R&D costs are expensed as incurred. We currently expect that R&D expenses will continue to increase in absolute dollars as we continue to invest in technology to address potential market opportunities. Sales and marketing expenses in the first quarter of fiscal 2001 were $1.36 billion, compared with $818 million in the first quarter of fiscal 2000, an increase of 66.5%. Sales and marketing expenses, as a percentage of net sales, remained constant at 20.9%. The increase in sales and marketing expense in absolute dollars was 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 increase also reflected our efforts to invest in certain key areas, such as expansion of our end-to-end networking strategy and service provider coverage, in order to be positioned to take advantage of future market opportunities. We currently expect that sales and marketing expenses will continue to increase in absolute dollars. General and administrative ("G&A") expenses in the first quarter of fiscal 2001 were $195 million, compared with $112 million in the first quarter of fiscal 2000, an increase of 74.1%. G&A expenses, as a percentage of net sales, increased to 3.0% in the first quarter of fiscal 2001, compared with 2.9% in the first quarter of fiscal 2000. The increase in G&A expenses was primarily related to the addition of new personnel and investments in infrastructure. We intend to keep G&A expenses relatively constant as a percentage of net sales; however, this depends on the level of acquisition activity and our growth, among other factors. Amortization of goodwill and other acquisition-related charges included in operating expenses was $231 million in the first quarter of fiscal 2001, compared with $24 million in the first quarter of fiscal 2000. Amortization of goodwill and other acquisition-related charges primarily relates to various purchase acquisitions (see Note 3 and Note 4 to the Consolidated Financial Statements). Amortization of goodwill and other acquisition-related charges will continue to increase as we acquire companies and technologies. The amount expensed to in-process research and development ("in-process R&D") arose from the purchase acquisitions (see Note 3 to the Consolidated Financial Statements). The fair values of the existing products and patents, as well as the technology currently under development, were determined using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations were typically derived from a weighted-average cost of capital analysis and venture capital surveys, adjusted upward to reflect additional risks inherent in the development life cycle. These risk factors have increased the overall discount rate for acquisitions in the current year. We consider the pricing model for products related to these acquisitions to be standard within the high-technology communications equipment industry. However, we do not expect to achieve a material amount of 16 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS expense reductions or synergies as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include significant anticipated cost savings. The development of these technologies remains a significant risk due to the remaining 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 technologies into commercially viable products consists principally of planning, designing, and testing activities necessary to determine that the products 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 for our significant purchase acquisitions completed in fiscal 2001 and 2000 (in millions, except percentages):
Acquisition Assumptions ---------------------------------------------- Estimated Cost to Risk-Adjusted Complete Technology at Discount Rate for Acquired Company Time of Acquisition In-Process R&D --------------------------------------- ---------------------- ----------------- FISCAL 2001 ----------- IPmobile, Inc. $15 42.5% NuSpeed, Inc. $ 6 40.0% FISCAL 2000 ----------- Monterey Networks, Inc. $ 4 30.0% The optical systems business of Pirelli S.p.A. $ 5 20.0% Aironet Wireless Communications, Inc. $ 3 23.5% Atlantech Technologies $ 6 37.5% JetCell, Inc. $ 7 30.5% PentaCom, Ltd. $13 30.0% Qeyton Systems $ 6 35.0%
Regarding our purchase acquisitions completed in fiscal 2001 and 2000, actual results to date have been consistent, in all material respects, with our assumptions at the time of the acquisitions. 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. Failure to achieve the expected levels of revenue and net income from these products will negatively impact the return on investment expected at the time that the acquisitions were completed and potentially result in impairment of any other assets related to the development activities. Net gains realized on minority investments were $190 million in the first quarter of fiscal 2001. There were no gains realized on minority investments in the first quarter of fiscal 2000. 17 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Interest and other income, net, was $230 million in the first quarter of fiscal 2001, compared with $102 million in the first quarter of fiscal 2000. The increase was primarily due to interest income related to the general increase in cash and investments generated from our operations. The effective tax rate was 39.6%, which included the impact of nondeductible in-process R&D and acquisition-related costs. Our future effective tax rates could be adversely affected if earnings are lower than anticipated in countries where we have lower effective rates or by unfavorable changes in tax laws and regulations. Liquidity and Capital Resources Cash and cash equivalents, short-term investments, and investments were $19.58 billion at October 28, 2000, a decrease of $914 million from July 29, 2000. The decrease was primarily a result of a net unrealized loss on publicly held investments of $1.75 billion ($1.13 billion net of tax) and cash used in investing activities, including $524 million in capital expenditures and $317 million in minority investments, offset by cash generated by operating and financing activities of $1.68 billion. Accounts receivable increased 25.6% from July 29, 2000 to October 28, 2000. Days sales outstanding in receivables increased to 40 days at October 28, 2000 from 37 days at July 29, 2000. The increase in accounts receivable and days sales outstanding was due, in part, to growth in net sales combined with conditions in a number of markets resulting in longer payment terms. Inventories increased 58.8% from July 29, 2000 to October 28, 2000. Inventory turns decreased to 6.0 times at October 28, 2000 from 7.8 times at July 29, 2000. The increase in inventory levels reflected new product introductions, continued growth in our two-tier distribution system, and increased purchases to secure the supply of certain components. 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. At October 28, 2000, we had a line of credit totaling $500 million, which expires in July 2002. There have been no borrowings under this agreement. We have entered into certain lease agreements in San Jose, California, where our headquarters operations are established, and in Boxborough, Massachusetts; Littleton, Massachusetts; Salem, New Hampshire; Richardson, Texas; and Research Triangle Park, North Carolina, where we have expanded certain R&D and customer-support activities. In connection with these transactions, we pledged $1.39 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 our liquidity position. 18 19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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, capital expenditure, and investment requirements at least through the next 12 months. 19 20 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; - The timing and amount of employer payroll tax to be paid on employees' gains on stock options exercised; - Overall information technology spending, especially service provider capital spending in the data or IP segment; 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 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, as a further example, the dollar amounts of large orders for our products have been increasing and therefore the operating results for a quarter could be materially adversely affected if a number of large orders are either not received or are delayed, for example, due to cancellations, delays, or deferrals by customers. 20 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS 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. We intend to add resources across all functions. With increased levels of spending, an inability to meet expected revenue levels in a particular quarter could have a material, 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 reoccurs 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. WE EXPECT GROSS MARGIN TO DECLINE OVER TIME We expect gross margin may be adversely affected by increases in material or labor costs, heightened price competition, increasing levels of services, higher inventory balances, introduction of new products for new high-growth markets, and changes in channels of distribution or in the mix of products sold. We believe gross margin may additionally be impacted due to constraints relating to certain component shortages that currently exist in the supply chain. We may also experience a lower gross margin as the product mix for access and optical product volume grows. We recently introduced several new products, with additional new products scheduled to be released in the future. Increase in demand would result in increased manufacturing capacity, which in turn would result in higher inventory balances. In addition, our vendor base is capacity- 21 22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS constrained, and this could result in increased cost pressure on certain components. If product or related warranty costs associated with these new products are greater than we have experienced, gross margin may be adversely affected. Our gross margin 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 a lower gross margin. In addition, increasing third-party and indirect- distribution channels generally results 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 revenue from service provider markets, which may have lower margins or an increase in product costs, which could adversely affect our future operating results. We also expect that our operating margin 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. 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; - As we continue to acquire companies and new technologies, we are dependent, at least initially, on unfamiliar supply chains or relatively small supply partners; and - We face increased competition for certain components, which are currently supply constrained, from existing competitors and companies in other markets. Manufacturing capacity and component supply constraints could be significant issues for us. For example, we have increased our manufacturing capacity significantly and plan to further increase capacity. To mitigate the component supply constraints, we have started to build inventory 22 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS levels and intend to continue to carry a higher level of inventory until lead times improve. 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, perhaps materially, and could materially damage customer relationships. WE COMPETE IN THE HIGHLY COMPETITIVE TELECOMMUNICATIONS EQUIPMENT MARKET We compete in the Internet infrastructure market, providing solutions for transporting data, voice, and video traffic across intranets, extranets, and the Internet. The market is characterized by rapid growth, converging technologies, and a conversion to New World 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 networking solutions will decrease, due to the rapid pace of acquisitions in the industry. We believe our primary competition comes from nimble start-ups and young companies offering innovative niche solutions. Our competitors include Alcatel, Ericsson, Extreme, Foundry, Juniper, Lucent, Nortel, Redback, 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 we do. The principal competitive factors in the markets in which we presently compete and may compete in the future are: - Price and/or ability to provide financing; - Performance; - The ability to provide end-to-end networking 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 inter-operability. 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. 23 24 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 integrating the operations, technologies, and products of the acquired companies; - The risk of diverting management's attention from normal daily operations of the business; - Potential difficulties in completing projects associated with in-process research and development; - Risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions; - Initial dependence on unfamiliar supply chains or relatively small supply partners; - Insufficient revenues to offset increased expenses associated with acquisitions; and - The potential loss of key employees of the acquired companies. Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results, or financial condition. We must also manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we made could harm our business and operating results in a material way. 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 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 continued to see our exposures to emerging market currencies, such as the Korean won, increase because of our expanding presence in these markets and their extreme currency volatility. We will continue to monitor our exposure and may hedge against these or any other emerging market currencies as necessary. 24 25 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS 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 periodically will hedge anticipated foreign currency cash flows. The hedging activity undertaken by us is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities. 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, including loan financing and leasing solutions. We expect demands for customer financing to continue. We believe it is a competitive factor in obtaining business, particularly in supplying customers involved in significant infrastructure projects. Our loan financing arrangements may include not only financing the acquisition of our products but also providing additional funds for soft costs associated with network installation and integration of our products and for working capital purposes. Although we have programs in place to monitor and mitigate the associated risk, there can be no assurance that such programs will be effective in reducing our credit risk. We also continue to monitor increased credit exposures from weakened financial conditions in certain geographic regions, and the impact that such conditions may have on the worldwide economy. We have experienced losses due to customers failing to meet their obligations. Although these losses have not been significant, future losses, if incurred, could harm our business and have a material adverse effect on our operating results and financial condition. WE ARE EXPOSED TO FLUCTUATIONS IN THE MARKET VALUES OF OUR PORTFOLIO INVESTMENTS AND IN INTEREST RATES For additional information regarding the sensitivity of and risks associated with the market value of portfolio investments and interest rates, see Item 3 "Quantitative and Qualitative Disclosures About Market Risk" contained in this Quarterly Report. 25 26 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS 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 operating results and financial condition for periods subsequent to the acquisitions. Additionally, 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 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 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. Furthermore, the laws of some foreign countries may not permit the protection of our proprietary rights to the same extent as do the laws of the United States. Although we believe the protection afforded by its 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 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, we believe that, based upon industry practice, any necessary license or rights under such patents may 26 27 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS be obtained on terms that would not have a material adverse effect on our business, operating results, or financial condition. Nevertheless, 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 of the Internet and Internet commerce in any country where we operate on such technology as voice over the Internet, encryption technology, and access charges for Internet service providers. We also could be materially adversely affected by the continuing deregulation of the telecommunications industry. The adoption of regulation of the Internet and Internet commerce could decrease demand for our products, and at the same time increase the cost of selling our products, which could have a material adverse effect on our business, operating results, and financial condition. 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 may 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 27 28 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results, and financial condition. 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 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. 28 29 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS 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 United States, our products must comply with various Federal Communications Commission requirements and regulations. In countries outside of the United States, our products must meet various requirements of local telecommunications authorities. Changes in tariffs or failure by us to obtain timely approval of products could have a material adverse effect on our business, operating results, and financial condition. OUR BUSINESS IS SUBJECT TO RISKS FROM INTERNATIONAL OPERATIONS We conduct business globally. Accordingly, our future results could be materially adversely affected by a variety of uncontrollable and changing factors including, among others, foreign currency exchange rates; regulatory, political, or economic conditions in a specific country or region; trade protection measures and other regulatory requirements; service provider and government spending patterns; and natural disasters. Any or all of these factors could have a material adverse impact on our future international business. 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 29 30 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK FACTORS 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. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options. OTHER PricewaterhouseCoopers LLP ("PwC"), our independent accountants, has notified us that PwC is engaged in discussions with the SEC 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. 30 31 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We maintain an investment portfolio of various holdings, types, and maturities. These securities are generally classified as available for sale and, consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income, 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 $1.13 billion after-tax unrealized loss during the first quarter of fiscal 2001 on these investments. We have also invested in numerous privately held companies, many of which can still be considered in the start-up or development stages. These investments are inherently risky as the market for the technologies or products they have under development are typically in the early stages and may never materialize. We could lose our entire initial investment in these companies. We also have certain real estate lease commitments with payments tied to short-term interest rates. At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of our investment portfolio while increasing the costs associated with our lease commitments. Conversely, declines in interest rates could have a material impact on interest earnings for our investment portfolio. We do not currently hedge these interest rate exposures. Readers are referred to pages 23 to 24 of the fiscal 2000 Annual Report to Shareholders for a more detailed discussion of quantitative and qualitative disclosures about market risk. The following analysis presents the hypothetical changes in fair values of public equity investments that are sensitive to changes in the stock market. 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. The following table estimates the fair value of the publicly traded corporate equities at a 12-month horizon (in millions):
Valuation of Securities Valuation of Securities Given X% Decrease Fair Value Given X% Increase in Each Stock's Price as of in Each Stock's Price ------------------------------- Oct. 28, ------------------------------- (50%) (35%) (15%) 2000 15% 35% 50% ------- ------- ------- ---------- ------- ------- ------- Corporate equities $ 2,308 $ 3,000 $ 3,924 $ 4,616 $ 5,308 $ 6,232 $ 6,924
Our equity portfolio consists of securities with characteristics that most closely match the S&P Index or companies traded on the NASDAQ National Market. The NASDAQ Composite Index has shown a 15% movement in each of the last three years and a 35% and 50% movement in at least one of the last three years. 31 32 PART II. OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (c) During the quarter ended October 28, 2000, the Company issued an aggregate of approximately 16.8 million shares of its common stock in connection with the purchase of the capital stock of HyNEX, Ltd., IPmobile, Inc., Komodo Technology, Inc., Netiverse, Inc., and NuSpeed, Inc. The shares were issued pursuant to exemptions by reason of Section 4(2) of the Securities Act of 1933, as amended. These sales were made without general solicitation or advertising. Each purchaser was an accredited investor or a sophisticated investor with access to all relevant information necessary. The Company has filed Registration Statements on Form S-3 covering the resale of such securities. 32 33 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit 27 Financial Data Schedule (b) Reports on Form 8-K The Company filed seven reports on Form 8-K during the quarter ended October 28, 2000. Information regarding the items reported on is as follows:
Date Item Reported On ---- ---------------- August 4, 2000 The Company reported that the supplementary consolidated financial information reflected the acquisitions of SightPath, Inc., InfoGear Technology Corporation, and ArrowPoint Communications, Inc. as if the acquired entities were wholly owned subsidiaries of the Company since inception. August 15, 2000 The Company reported its fourth quarter results for the period ending July 29, 2000 and announced the departure of Don Listwin, Executive Vice President of Corporate Marketing and Service Provider and Consumer Lines of Business. September 7, 2000 The Company announced the completion of the acquisition of IPmobile, Inc. September 15, 2000 The Company announced the completion of the acquisition of NuSpeed, Inc. September 26, 2000 The Company announced the completion of the acquisition of HyNEX, Ltd. September 28, 2000 The Company announced the completion of the acquisition of Komodo Technology, Inc. September 29, 2000 The Company announced the acquisition of Vovida Networks, Inc. and IPCell Technologies, Inc.
33 34 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Cisco Systems, Inc. Date: December 11, 2000 By /s/ Larry R. Carter -------------------------------------- Larry R. Carter, Senior Vice President, Finance and Administration, Chief Financial Officer and Secretary 34 35 EXHIBIT INDEX
No. Description --- ----------- 27 Financial Data Schedule
35