-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, A88Vi93bZ8vy0y3FG7Qn3fEhyIgsh1031fkzI7OMSoGPHzJzDCf+991qnDCbqS0F sKCKPrkfPMJ0gLpehj+nxA== 0000891618-99-002711.txt : 19990616 0000891618-99-002711.hdr.sgml : 19990616 ACCESSION NUMBER: 0000891618-99-002711 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990501 FILED AS OF DATE: 19990615 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CISCO SYSTEMS INC CENTRAL INDEX KEY: 0000858877 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 770059951 STATE OF INCORPORATION: CA FISCAL YEAR END: 0731 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-18225 FILM NUMBER: 99646944 BUSINESS ADDRESS: STREET 1: 170 WEST TASMAN DRIVE CITY: SAN JOSE STATE: CA ZIP: 95134-1706 BUSINESS PHONE: 4085264000 MAIL ADDRESS: STREET 1: 225 WEST TASMAN DRIVE CITY: SAN JOSE STATE: CA ZIP: 95134-1706 10-Q 1 FORM 10-Q FOR PERIOD ENDED 5/1/99 1 FORM 10-Q (Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended MAY 1, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ____________ Commission file number 0-18225 CISCO SYSTEMS, INC. (Exact name of registrant as specified in its charter) California 77-0059951 (State or other jurisdiction of (I.R.S. Employer Incorporation or organization) Identification Number) 170 West Tasman Drive San Jose, California 95134 (Address of principal executive office and zip code) (408) 526-4000 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days. YES [X] NO [ ] As of June 9, 1999, 1,611,543,199 shares of the Registrant's common stock were outstanding. 1 2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED MAY 1, 1999 INDEX
Page ---- Facing sheet 1 Index 2 Part I. Financial information Item 1. Financial Statements and Supplementary Data a) Consolidated statements of operations for the three and nine months ended May 1, 1999 and April 25, 1998 3 b) Consolidated balance sheets at May 1, 1999 and July 25, 1998 4 c) Consolidated statements of cash flows for the nine months ended May 1, 1999 and April 25, 1998 5 d) Notes to consolidated financial statements 6 Item 2. Management's discussion and analysis of financial condition and results of operations 12 Part II. Other information 34 Signature 35 Exhibit Exhibit 27, Financial data schedule 36
2 3 PART I. ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except per-share amounts)
Three Months Ended Nine Months Ended ---------------------- ---------------------- May 1, April 25, May 1, April 25, 1999 1998 1999 1998 ------ --------- ------ --------- (Unaudited) Net sales $3,147 $2,184 $8,562 $6,069 Cost of sales 1,102 750 2,981 2,099 ------ ------ ------ ------ Gross margin 2,045 1,434 5,581 3,970 Operating expenses: Research and development 418 263 1,102 726 Sales and marketing 647 412 1,731 1,109 General and administrative 105 67 279 181 Purchased research and development -- 419 390 546 ------ ------ ------ ------ Total operating expenses 1,170 1,161 3,502 2,562 ------ ------ ------ ------ Operating income 875 273 2,079 1,408 Realized gain on sale of investment -- -- -- 5 Interest and other income, net 90 52 235 133 ------ ------ ------ ------ Income before provision for income taxes 965 325 2,314 1,546 Provision for income taxes 319 260 862 687 ------ ------ ------ ------ Net income $ 646 $ 65 $1,452 $ 859 ====== ====== ====== ====== Net income per share--basic $ .40 $ .04 $ .92 $ .56 ====== ====== ====== ====== Net income per share--diluted $ .38 $ .04 $ .86 $ .54 ====== ====== ====== ====== Shares used in per-share calculation--basic 1,601 1,541 1,585 1,526 ====== ====== ====== ====== Shares used in per-share calculation--diluted 1,696 1,614 1,679 1,598 ====== ====== ====== ======
See notes to consolidated financial statements. 3 4 CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (In millions, except par value)
May 1, July 25, 1999 1998 ------ -------- (Unaudited) ASSETS Current assets: Cash and equivalents $ 690 $ 535 Short-term investments 1,161 1,157 Accounts receivable, net of allowance for doubtful accounts of $30 at May 1, 1999 and $40 at July 25, 1998 1,275 1,298 Inventories, net 621 362 Deferred income taxes 490 345 Prepaid expenses and other current assets 89 65 ------- ------ Total current assets 4,326 3,762 Investments 5,840 3,463 Restricted investments 804 554 Property and equipment, net 701 595 Other assets, net 1,037 543 ------- ------ Total assets $12,708 $8,917 ======= ====== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 348 $ 249 Income taxes payable 522 410 Accrued payroll and related expenses 466 391 Other accrued liabilities 1,076 717 ------- ------ Total current liabilities 2,412 1,767 Minority interest 44 43 Shareholders' equity: Preferred stock, no par value, 5 shares authorized: none issued or outstanding at May 1, 1999 and July 25, 1998 Common stock and additional paid-in capital, $0.001 par value, 2,700 shares authorized: 1,607 shares issued and outstanding at May 1, 1999 and 1,563 at July 25, 1998 4,847 3,220 Retained earnings 5,280 3,828 Accumulated comprehensive income 125 59 ------- ------ Total shareholders' equity 10,252 7,107 ------- ------ Total liabilities and shareholders' equity $12,708 $8,917 ======= ======
See notes to consolidated financial statements. 4 5 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)
Nine Months Ended ------------------------ May 1, April 25, 1999 1998 ------- --------- (Unaudited) Cash flows from operating activities: Net income $ 1,452 $ 859 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 334 229 Deferred income taxes (164) (89) Tax benefits from employee stock plans 679 282 Purchased research and development from acquisitions 298 426 Change in operating assets and liabilities: Accounts receivable 29 (94) Inventories (259) (52) Prepaid expenses and other current assets (22) 31 Income taxes payable 110 107 Accounts payable 96 47 Accrued payroll and related expenses 75 79 Other accrued liabilities 328 159 ------- ------- Net cash provided by operating activities 2,956 1,984 ------- ------- Cash flows from investing activities: Purchases of short-term investments (833) (1,099) Proceeds from sales and maturities of short-term investments 1,179 1,373 Purchases of investments (3,977) (2,015) Proceeds from sales of investments 1,338 821 Purchases of restricted investments (661) (325) Proceeds from sales and maturities of restricted investments 408 202 Acquisition of property and equipment (377) (282) Acquisition of Selsius Systems, net of purchased research and development (19) Increase in lease receivables (175) (106) Other (208) 9 ------- ------- Net cash used in investing activities (3,325) (1,422) ------- ------- Cash flows from financing activities: Issuance of common stock 519 343 Other 5 (4) ------- ------- Net cash provided by financing activities 524 339 ------- ------- Net increase in cash and equivalents 155 901 Cash and equivalents, beginning of period 535 270 ------- ------- Cash and equivalents, end of period $ 690 $ 1,171 ======= =======
See notes to consolidated financial statements. 5 6 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Cisco Systems, Inc. (the "Company") provides networking solutions that connect computing devices and computer networks, allowing people to access or transfer information without regard to differences in time, place or type of computer system. The Company sells its products in approximately 105 countries through a combination of direct sales and reseller and distribution channels. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Fiscal Year The Company's fiscal year is the 52- or 53-week period ending on the last Saturday in July. Fiscal year 1999 is a 53-week year while 1998 was a 52-week year. Basis of Presentation The accompanying financial data as of May 1, 1999 and July 25, 1998, and for the three and nine month periods ended May 1, 1999 and April 25, 1998, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The July 25, 1998 balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended July 25, 1998. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows as of May 1, 1999 and for the three and nine month periods ended May 1, 1999 and April 25, 1998, have been made. The results of operations for the period ended May 1, 1999 are not necessarily indicative of the operating results for the full year. 6 7 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Advertising Costs The Company expenses all advertising costs as they are incurred. Software Development Costs Software development costs which are required to be capitalized pursuant to Statement of Financial Accounting Standards (SFAS) No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed," have not been material to the Company to date. Computation of Net Income Per Share Basic net income per common share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of stock options. Share and per share data presented reflect the three-for-two stock splits effective September 1998 and December 1997. The data does not give effect to the two-for-one stock split that will be effective June 21, 1999. Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" and in June 1998, issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", implementation of which has recently been delayed. Readers are referred to the "Recent Accounting Pronouncements" section of the Company's 1998 Annual Report to Shareholders for further discussion. The Company adopted Statement of Position (SOP) No. 97-2, "Software Revenue Recognition," in the first quarter of fiscal year 1999 and its adoption had no material impact on the Company's results from operations or financial position. 7 8 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. BUSINESS COMBINATIONS 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 aggregated basis. The amounts allocated to purchased research and development were determined based on appraisals completed by an independent third party using established valuation techniques in the high-technology communications industry and were expensed upon acquisition, because technological feasibility had not been established and no future alternative uses existed. Research and development costs to bring the products from the acquired companies to technological feasibility are not expected to have a material impact on the Company's future results of operations or cash flows. Amounts allocated to goodwill and other intangibles are amortized on a straight-line basis over periods not exceeding five years. In November, the Company completed its purchase of Summa Four, Inc. ("Summa Four"), a provider of programmable switch products. The Company's acquired technology consists of two existing programmable switch products and one programmable switch currently under development. Also in November, the Company completed its purchase of Clarity Wireless, Inc.("Clarity"), a developer of high-bandwidth wireless access technology for the computer networking and Internet access markets. The Company's acquired technology consists of two high-bandwidth access projects currently under development, patents and patents pending. Also in November, the Company completed its purchase of Selsius Systems, Inc.("Selsius"), a developer of voice over data network products. The Company's acquired technology consists of the core technology in Selsius' existing public broadcast exchange (PBX) system and technology currently under development for an enterprise-wide PBX system. Selsius' technology is focused on developing products that will deliver voice over data network solutions. In December, the Company acquired PipeLinks, Inc.("PipeLinks"), a developer of SONET/SDH routers. The Company's acquired technology consists of 8 9 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS two research and development projects in process which are expected to result in the ability to transport both voice and IP(Internet Protocol) traffic over the same network. Total purchased research and development expense was $390 million for the nine months ending May 1, 1999. The purchased research and development expense that was attributable to stock purchase acquisitions for the nine month period was $298 million and the purchased research and development expense attributable to the cash purchase transaction, consisting of Selsius only, was $92 million for the nine month period ended May 1, 1999. Each of the completed purchase acquisition transactions is further outlined below: Summary of purchase transactions (in millions):
Purchased Research & Form of Consideration and Other Notes to Entity Name Consideration Development Charge Acquisition ----------- ------------- ------------------ ---------------------------------------- Quarter Ended - October 24, 1998 - ----------------------- American Internet Corp. $ 56 $41 Common stock and options assumed; goodwill and other intangibles recorded of $18 Quarter Ended - January 23, 1999 - ---------------------- Summa Four, Inc. $129 $64 Common stock and options assumed, $16 in liabilities assumed; goodwill and other intangibles recorded of $29 Clarity Wireless, Inc. $153 $94 Common stock and options assumed; goodwill and other intangibles recorded of $73 Selsius Systems, Inc. $134 $92 $111 in cash; options assumed; goodwill and other intangibles recorded of $41 PipeLinks, Inc. $118 $99 Common stock and options assumed; goodwill and other intangibles recorded of $11
9 10 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In April 1999, the Company announced a definitive agreement to acquire Amteva Technologies, Inc., a leading developer of middleware, which provides a unified means for enabling voicemail, fax and e-mail messages over an IP-based network. Under the terms of the agreement, shares of the Company's common stock and cash with an aggregate value of approximately $170 million will be exchanged for all outstanding shares and options of Amteva. This acquisition is expected to be completed in the fourth quarter. Pooling of Interests Combinations In April 1999, the Company announced a definitive agreement to acquire Fibex Systems("Fibex"), a developer in Integrated Access Digital Loop Carrier (IADLC) products, devices that combine traditional voice services with data services using Asynchronous Transfer Mode ("ATM") as the underlying architecture. Also in April, the Company announced a definitive agreement to acquire Sentient Networks, Inc.("Sentient"), a developer of high density ATM Circuit Emulation Service (CES) Gateway, which is capable of transporting circuit-based private line services across packet-based ATM networks. Under terms of the agreement, shares of the Company's common stock with an aggregate value of approximately $320 million and $125 million will be exchanged for all outstanding shares and options of Fibex and Sentient, respectively. Also in April, the Company announced a definitive agreement to acquire GeoTel Communications Corp.("GeoTel"), a provider of software solutions for distributed voice call centers for enterprise and service provider customers. Under terms of the agreement, shares of the Company's common stock with an aggregate value of approximately $2 billion will be exchanged for all outstanding shares and options of GeoTel. These acquisitions are expected to be completed in the fourth quarter, subject to regulatory clearance and shareholder approval of the acquired companies. 10 11 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. BALANCE SHEET DETAIL (In millions)
Inventories: May 1, July 25, 1999 1998 ----- -------- (Unaudited) Raw materials $ 118 $ 76 Work in process 232 143 Finished goods 230 111 Demonstration systems 41 32 ----- ----- $ 621 $ 362 ===== =====
Intangible Assets: May 1, July 25, 1999 1998 ----- -------- (Unaudited) Gross intangible assets $ 415 $ 200 Less: accumulated amortization (71) (30) ===== ===== $ 344 $ 170 ===== =====
Amortization expense for the three- and nine-month periods ended May 1, 1999 and April 25, 1998 was $19 million, $41 million, $4 million and $12 million, respectively. 5. COMPREHENSIVE INCOME The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income", as of the first quarter of fiscal 1999. SFAS No. 130 establishes new rules for the reporting and display of comprehensive income and its components, however, it has no impact on the Company's net income or total shareholders' equity. 11 12 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The components of comprehensive income, net of tax, are as follows (in millions):
Three Months Ended Nine Months Ended ------------------- -------------------- May 1, Apr. 25, May 1, Apr. 25, 1999 1998 1999 1998 ------ -------- ------ -------- Net income $ 646 $65 $1,452 $ 859 Other comprehensive income (loss): Change in unrealized gain(loss) on investments, net (30) 20 62 13 Change in accumulated translation adjustments (6) 0 5 (5) ----- --- ------ ----- Total comprehensive income $ 610 $85 $1,519 $ 867 ===== === ====== =====
6. INCOME TAXES The Company paid income taxes of $221 million in the nine months ended May 1, 1999 and $389 million in the nine months ended April 25, 1998. The Company's income taxes currently payable for federal, state and foreign purposes have been reduced by the tax benefits of disqualifying dispositions of stock options. This benefit totaled $679 million in the first nine months of fiscal 1999, and was credited directly to shareholders' equity. 7. SHAREHOLDERS' EQUITY AND STOCK SPLIT All references to share and per-share data for all periods presented have been adjusted to give effect to the three-for-two stock splits effective September 1998 and December 1997. In May 1999, the Company's Board of Directors approved a two-for-one split of the Company's common stock that was applicable to shareholders of record on May 24, 1999 and is expected to be effective on June 21, 1999. Share and per-share data have not been adjusted to give effect to this latest stock split. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, statements containing the words "believes", "anticipates", "estimates", "expects", and words of similar import, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. 12 13 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 SEC. Net sales grew to $3.15 billion in the third quarter of 1999 from $2.18 billion in the third quarter of 1998. Net sales for the first nine months of 1999 were $8.56 billion, compared to $6.07 billion in the first nine months of 1998. The 44.1% increase in net sales between the two three-month periods and the 41.1% increase in net sales between the two nine-month periods was primarily a result of increasing unit sales of LAN switching products such as the Catalyst(R) 5000 family and the Catalyst(R) 2900 series of switches for smaller enterprise networks, access servers such as the Cisco 2600 and 3600 families, growth in the sales of add-on boards that provide increased functionality, and increased maintenance service contract sales. The sales growth rate for lower-priced access and switching products targeted toward small and medium-sized businesses has increased faster than that of the Company's high-end core router products. However, these products typically carry lower average selling prices. Additionally, sales of some of the Company's more established product lines, such as the Cisco 2500 and Cisco 4000 product families, have decreased as a percentage of total revenue. Sales to international customers increased to 42.5% in the third quarter of 1999 versus 41.8% for the third quarter of 1998. The increase reflects sales growth in certain international markets, particularly Germany and the United Kingdom. Sales growth in other markets, including Japan and certain countries in Latin America and Eastern Europe, have been negatively impacted by certain factors including weaker economic conditions, delayed government spending, a stronger dollar versus the local currencies, and slower adoption of networking technologies. Gross margins decreased slightly to 65.0% in the third quarter of 1999 from 65.6% in the third quarter of 1998. Gross margins for the first nine months of 1999 were 65.2%, which also decreased slightly compared to the same period in 1998. The decrease in the quarterly period is due principally to the Company's continued shift in revenue mix towards its lower-margin products and the 13 14 continued pricing pressure seen from competitors in certain product areas. The prices of component parts have fluctuated in the recent past, and the Company expects that this trend may continue. An increase in the price of component parts may have a material adverse impact on gross margins. The Company expects that gross margins will continue to decrease in the future, because it believes that the market for lower-margin remote access and switching products for small to medium-sized businesses will continue to increase at a faster rate than the market for the Company's higher-margin router and high-performance switching products. Additionally, as the Company focuses on new market opportunities, it faces increasing competitive pressure from large telecommunications equipment suppliers and well funded start-up companies, which may materially adversely affect gross margins. The Company is attempting to mitigate this trend through various means, such as increasing the functionality of its products, continued value engineering, controlling royalty costs, and improving manufacturing efficiencies. There can be no assurance that any efforts made by the Company in these and other areas will successfully offset decreasing margins. Research and development expenses increased by $155 million in the third quarter of 1999 over the third quarter of 1998, an increase to 13.3% from 12.0% of net sales. Research and development expenses increased by $376 million in the first nine months of 1999 over the first nine months of 1998, an increase to 12.9% from 12.0% of net sales. The increase reflects the Company's ongoing research and development efforts in a wide variety of areas such as voice, video, and data integration, Digital Subscriber Line (DSL) technologies, cable modem technology, wireless access, dial access, enterprise switching, security, network management, and high-end routing technologies, among others. A significant portion of the increase was due to the addition of new personnel, partly through acquisitions, as well as higher expenditures on prototypes and depreciation on additional lab equipment. For the near future, research and development expenses are expected to increase at a rate similar to or slightly greater than the sales growth rate, as the Company invests in technology to address potential market opportunities. The Company also continues to purchase technology in order to bring a broad range of products to the market in a timely fashion. If the Company believes that it is unable to enter a particular market in a timely manner, with internally developed products, it may license technology from other businesses or acquire other businesses as an alternative to internal research and development. All of the Company's research and development costs are expensed as incurred. 14 15 Sales and marketing expenses increased by $235 million in the third quarter of 1999 over the third quarter of 1998, and increased $622 million in the first nine months of 1999 over the first nine months of 1998. This represents an increase from 18.9% to 20.6% of net sales for the quarter to quarter period and from 18.3% to 20.2% for the first nine months of each fiscal year. The increase is due principally to an increase in the size of the Company's direct sales force and its commissions, additional marketing and advertising costs associated with the introduction of new products and the expansion of distribution channels. The increase also reflects the Company's efforts to invest in certain key areas such as expansion of its end-to-end strategy and service provider coverage in order to position itself to take advantage of future market opportunities. General and administrative expenses rose $38 million between the third quarters of 1999 and 1998, an increase to 3.3% from 3.1% of net sales. These expenses increased $98 million in the first nine months of 1999 over the first nine months of 1998, representing an increase from 3.0% to 3.3% of net sales. The increase primarily reflects increased levels of amortization for acquisition- related intangible assets. It is management's intent to keep general and administrative costs relatively constant as a percentage of net sales; however, this is dependent upon the level of acquisition activity and amortization of the resulting intangible assets, among other factors. The amount expensed to purchased research and development in the first nine months of fiscal 1999 arose from the completed acquisitions of American Internet, Summa Four, Clarity, Selsius and PipeLinks (See also Note 3). The fair value of the existing products and patents as well as the technology currently under development was determined by using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations were typically derived from a weighted average cost of capital analysis, adjusted upward to reflect additional risks inherent in the development life cycle. These risk factors have increased the overall discount rate between 4% and 7.5% for acquisitions in the current year. The Company expects that the pricing model for products related to these acquisitions will be considered standard within the high-technology communications industry. However, the Company does not expect to achieve a material amount of expense reductions or synergies as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include significant anticipated cost 15 16 savings. The Company expects that products incorporating the acquired technology from these acquisitions will be completed and begin to generate cash flows over the 6 to 9 months after integration. However, development of these technologies remains a significant risk to the Company due to the remaining effort to achieve technical viability, rapidly changing customer markets, uncertain standards for new products and significant competitive threats from numerous companies. The nature of the efforts to develop the acquired technology into commercially viable products consists principally of planning, designing and testing activities necessary to determine that the product can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share, or a lost opportunity to capitalize on emerging markets, and could have a material adverse impact on the Company's business and operating results. Regarding the Company's purchase acquisitions completed in fiscal 1998, actual results to date have been consistent, in all material respects, with the assumptions of the Company at the time of the acquisitions as they relate to the value of purchased in-process research and development. The assumptions primarily consist of an expected completion date for the in-process projects, estimated costs to complete the projects and revenue and expense projections once the products have entered the market. Products from these 1998 acquisitions have been introduced to the market in the last 6 - 9 months. Shipment volumes of products from acquired technologies are not material to the Company's overall position at the present time, therefore, it is difficult to determine the accuracy of overall revenue projections early in the technology or product lifecycle. Failure to achieve the expected levels of revenues and net income from these products will negatively impact the return on investment expected at the time that the acquisition was completed and potentially result in impairment of any other assets related to the development activities. 16 17 The following table summarizes the significant assumptions underlying the valuations in 1998 and 1999 and the development costs incurred by the Company in the periods after the respective acquisition date (in millions, except percentages):
Approximate Development Acquisition Assumptions Costs --------------------------------------------- Incurred to Estimated Cost Date After to Complete Acquisition Technology at Risk Adjusted on Acquired Time of Discount Rate In-Process Entity Name Acquisition In-Process R&D Technology ----------- -------------- -------------------- ------------ 1998 Purchase Acquisitions - -------------------------- DAGAZ Technologies $10 35% $10 Lightspeed International, Inc. $13 26% $15 WheelGroup Corp. $ 8 24% $ 6 NetSpeed International, Inc. $12 32% $16 CLASS Data Systems $ 3 24% $ 2 1999 Purchase Acquisitions - -------------------------- American Internet Corp. $ 1 24.9% $ 1 Summa Four, Inc. $ 5 25.5% $ 4 Clarity Wireless, Inc. $42 32% $ 6 Selsius Systems, Inc. $15 31% $ 3 PipeLinks, Inc. $ 5 31% $ 6
Recent Accounting Pronouncements In June 1997, the Financial Accounting Standards Board issued SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" and in June 1998, issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", implementation of which has recently been delayed. Readers are referred to the 17 18 "Recent Accounting Pronouncements" section of the Company's 1998 Annual Report to Shareholders for further discussion. The Company adopted Statement of Position (SOP) No. 97-2, "Software Revenue Recognition," in the first quarter of fiscal year 1999 and its adoption had no material impact on the Company's results from operations or financial position. Liquidity and Capital Resources Cash and equivalents, short-term investments, and investments were $7.7 billion at May 1, 1999 an increase of $2.5 billion from July 25, 1998. The increase is primarily a result of cash generated by operations and financing activities, primarily the exercise of employee stock options. These cash flows were partially offset by cash outflows from operating activities including tax payments of approximately $221 million, and cash outflows from investing activities including capital expenditures of approximately $377 million. Accounts receivable decreased 1.8% from July 25, 1998 to May 1, 1999. Days sales outstanding in receivables improved to 40 days at May 1, 1999 from 49 days at July 25, 1998. Inventories increased 71.5% between July 25, 1998 and May 1, 1999, which reflects the Company's new product introductions and continued growth in the Company's two-tiered distribution system. Inventory management remains an area of focus as the Company balances the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements. Accounts payable increased by 39.8% at May 1, 1999 over July 25, 1998 primarily due to increasing levels of raw material purchases. Other accrued liabilities increased by 50.1% primarily due to higher deferred revenue on service contracts. At May 1, 1999, the Company had a line of credit totaling $500 million, which expires July 2002. There have been no borrowings under this facility. The Company has entered into certain lease arrangements in San Jose, California, and Research Triangle Park, North Carolina, where it has established its headquarters operations and certain research and development and customer support activities. In connection with these transactions, the Company pledged $804 million of its investments as collateral for certain obligations of the leases. The Company anticipates that it will occupy more leased property in the future that will require similar pledged securities; however, the Company does not expect the impact of this activity to be material to liquidity. The Company's management believes that its current cash and equivalents, short-term investments, line of credit, and cash generated from operations will satisfy its expected working capital and capital expenditure requirements through fiscal 1999. RISK FACTORS CISCO IS EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY As a global concern, Cisco faces exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on Cisco's financial results. Historically, Cisco's primary exposures related to nondollar- denominated sales in Japan, Canada, and Australia and nondollar-denominated operating expenses in Europe, Latin America, and Asia where it sells primarily in U.S. dollars. Additionally, Cisco has recently seen its exposures to emerging market currencies, such as the Brazilian Real and Russian Ruble, among others, increase because of Cisco's expanding presence in these markets and the extreme currency volatility. Cisco currently does not hedge against these or any other emerging market currencies and could suffer unanticipated gains or losses as a result. The increasing use of the Euro as a common currency for members of the European Union could impact Cisco's foreign exchange exposure. Cisco is prepared to hedge against fluctuations in the Euro if this exposure becomes material. Cisco will continue to evaluate the impact of the Euro on its foreign exchange exposure as well as on its internal systems. At the present time, Cisco hedges only those currency exposures associated with certain assets and liabilities denominated in nonfunctional currencies and does not generally hedge anticipated foreign currency cash flows. The hedging activity undertaken by Cisco is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities. The success of this activity depends upon estimations of intercompany balances denominated in various currencies, primarily the Japanese yen, Canadian dollar, Australian dollar and certain European currencies. To the extent that these forecasts are over- or understated during periods of currency volatility, Cisco could experience unanticipated currency gains or losses. 18 19 CISCO IS EXPOSED TO THE CREDIT RISK OF SOME OF ITS CUSTOMERS AND TO CREDIT EXPOSURES IN WEAKENED MARKETS Cisco is experiencing a greater proportion of its sales activity through its partners in two-tier distribution channels. These customers are generally given privileges to return inventory, receive credits for changes in Cisco's selling prices and participate in cooperative marketing programs. Cisco maintains 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. Cisco is experiencing increased demands for customer financing and leasing solutions, particularly to competitive local exchange carriers ("CLEC's"). CLEC's typically finance significant networking infrastructure deployments through alternative forms of financing, including leasing, through Cisco. Although Cisco has programs in place to monitor and mitigate the associated risk, there can no assurance that such programs will alleviate all credit risk to the Company. Cisco also continues to monitor increased credit exposures because of the weakened financial conditions in Asia, and other emerging market regions, and the impact that such conditions may have on the worldwide economy. Although Cisco has not experienced significant losses due to customers failing to meet their obligations to date, such losses, if incurred, could harm our business and financial position. CISCO IS EXPOSED TO FLUCTUATIONS IN THE MARKET VALUES OF ITS PORTFOLIO INVESTMENTS AND IN INTEREST RATES Cisco maintains investment portfolio holdings of various issuers, types and maturities. These securities are generally classified as available for sale, and consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated comprehensive income, net of tax. Part of this portfolio includes minority equity investments in several publicly-traded companies, the values of which are subject to market price volatility. Cisco has also invested in numerous privately-held companies, many of which can still be considered in the start-up or development stage. 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. This could result in Cisco losing up to its entire initial investment. Cisco also has certain real estate lease commitments with payments tied to short-term interest rates. At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of Cisco's investment portfolio 19 20 while increasing the costs associated with its lease commitments. Conversely, declines in interest rates could have a material impact on interest earnings for Cisco's investment portfolio. Cisco does not currently hedge these interest rate exposures. CISCO EXPECTS TO MAKE FUTURE ACQUISITIONS WHERE ADVISABLE AND ACQUISITIONS INVOLVE NUMEROUS RISKS. The networking business is highly competitive, and as such, Cisco's growth is dependent upon market growth and its ability to enhance its existing products and introduce new products on a timely basis. One of the ways Cisco has 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: o difficulties in integration of the operations, technologies, and products of the acquired companies; o the risk of diverting management's attention from normal daily operations of the business; o potential difficulties in completing projects associated with purchased in process research and development; o risks of entering markets in which Cisco has no or limited direct prior experience and where competitors in such markets have stronger market positions; and o 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 Cisco's previous or future acquisitions will be successful and will not adversely affect Cisco's financial condition or results of operations. Cisco must also maintain its ability to manage any such growth effectively. Failure to manage growth effectively and successfully integrate acquisitions made by Cisco could harm Cisco's business and operating results. 20 21 SINCE CISCO'S GROWTH RATE MAY SLOW, OPERATING RESULTS FOR A PARTICULAR QUARTER ARE DIFFICULT TO PREDICT Cisco expects that in the future, its net sales may grow at a slower rate than was experienced in previous periods, and that on a quarter-to-quarter basis, Cisco's growth in net sales may be significantly lower than its historical quarterly growth rate. As a consequence, operating results for a particular quarter are extremely difficult to predict. Cisco's ability to meet financial expectations could be hampered if the nonlinear sales pattern seen in past quarters reoccurs in future periods. Cisco generally has had one quarter of the fiscal year when backlog has been reduced. Although such reductions have not occurred consistently in recent years, they are difficult to predict and may occur in the future. In addition, in response to customer demand, Cisco continues to attempt to reduce its product manufacturing lead times, which may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less predictability in Cisco's quarter-to-quarter net sales and operating results going forward. On the other hand, for certain products, lead times are longer than Cisco's goal. If Cisco cannot reduce manufacturing lead times for such products, Cisco's customers may cancel orders or not place further orders if shorter lead times are available from other manufacturers, thus creating additional variability. As a result of recent unfavorable economic conditions, sales to certain countries in the Pacific Rim, Eastern Europe, and Latin America, have declined as a percentage of Cisco's total revenue. If the economic conditions in these markets, or other markets which recently experienced unfavorable conditions worsen, or if these unfavorable conditions result in a wider regional or global economic slowdown, this decline may have a material adverse impact on Cisco's business, operations and financial condition. Recent actions and comments from the Securities and Exchange Commission have indicated they are reviewing the current valuation methodology of purchased in-process research and development 21 22 related to business combinations. The Commission is concerned that some companies are writing off more of the value of an acquisition than is appropriate. Cisco believes it is in compliance with all of the rules and related guidance as they currently exist. However, there can be no assurance that the Commission will not seek to reduce the amount of purchased in-process research and development previously expensed by Cisco. This would result in the restatement of previously filed financial statements of Cisco and could have a material negative impact on financial results for the periods subsequent to 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 Cisco's acquisition strategy and potentially impair its ability to acquire companies. The FASB has also announced that it is reviewing the current accounting rules associated with stock options. The FASB is concerned that current practice, as outlined in Accounting Principles Board No. 25 (APB25), does not accurately reflect appropriate compensation expense under a variety of scenarios, including the assumption of option plans from acquired companies. The changes proposed could alter Cisco's practices of annual stock option grants and the assumption of stock option plans of acquired companies. Any change in these business practices could make it more difficult to attract and retain qualified personnel. Cisco also expects that gross margins may be adversely affected by increases in material or labor costs, heightened price competition, and changes in channels of distribution or in the mix of products sold. For example, Cisco believes that gross margins may decline over time, because the markets for lower-margin access products targeted toward small to medium-sized customers have continued to grow at a faster rate than the markets for Cisco's higher-margin router and high-performance switching products targeted toward enterprise and service provider customers. Cisco has recently introduced several new products with additional new products scheduled to be released in the near future. If warranty costs associated with these new products are greater than Cisco has experienced historically, gross margins may be adversely affected. Cisco's gross margins may also be impacted by geographic mix, as well as the mix of configurations within each product group. Cisco continues to expand into third-party or indirect distribution channels, which generally results in lower gross margins. In addition, increasing third-party and indirect distribution channels generally results in greater difficulty in forecasting the mix of Cisco's products, and to a certain degree, the timing of its orders. 22 23 Cisco also expects that its operating margins may decrease as it continues to hire additional personnel and increases other operating expenses to support its business. Cisco plans its operating expense levels based primarily on forecasted revenue levels. Because these expenses are relatively fixed in the short term, a shortfall in revenue could lead to operating results being below expectations. YOU SHOULD EXPECT THAT CISCO'S 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. Cisco's 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: o the integration of people, operations, and products from acquired businesses and technologies; o increased competition in the networking industry; o the overall trend toward industry consolidation; o the introduction and market acceptance of new technologies and standards, including switch routers, Gigabit Ethernet switching, Tag Switching (currently also known as multiprotocol label switching (MPLS)) and voice, video and data capabilities; o variations in sales channels, product costs, or mix of products sold; o the timing of orders and manufacturing lead times; and o changes in general economic conditions and specific economic conditions in the computer and networking industries. Any of the factors could have a material adverse impact on Cisco's operations and financial results. For example, Cisco from time to time has made acquisitions that result in purchased research and development expenses being charged in an individual quarter. These charges may occur in any particular quarter resulting in variability in Cisco's quarterly earnings. Additionally, the dollar amounts of large orders for Cisco's 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, due for example, to cancellations, delays or deferrals by customers. THE YEAR 2000 PROBLEM MAY HAVE AN ADVERSE EFFECT ON CISCO'S OPERATIONS AND ABILITY TO OFFER PRODUCTS AND SERVICES WITHOUT INTERRUPTION 23 24 Cisco is continuing to assess the impact of the Year 2000 issue on its current and future products, internal information systems and non-information technology systems (equipment and systems) and has begun, and in many cases completed, corrective efforts in these areas. Cisco is using a four phase approach to address the issue. o The first phase consists of the inventorying of all potential business disruption problems, including those with products and systems, as well as potential disruption from suppliers and other third parties. o The second phase consists of the prioritization of all the potential problems to allocate the appropriate level of resources to the most critical areas. o The third phase addresses the remediation programs to solve or mitigate any identified Year 2000 problems. o The fourth phase, if necessary, will be to develop contingency plans if it appears Cisco or its key suppliers will not be Year 2000 compliant, and such noncompliance is expected to have a material adverse impact on Cisco's operations. Cisco has largely completed the implementation of Year 2000 compliant internal computer applications for its main financial, manufacturing and order processing systems. The systems are being tested for compliance and Cisco does not currently expect any significant issues to be identified during this review. However, the failure of any internal system to achieve Year 2000 readiness could result in material disruption to Cisco's operations. Cisco has also conducted extensive work regarding the status of its currently available, developing and installed base of products. Cisco believes that its current products are largely Year 2000 compliant. There can be no assurance that certain previous releases of Cisco's products which are no longer under support will prove to be Year 2000 compliant with customers' systems or within an existing network. Further information about Cisco's products is available on its Year 2000 Internet web site. Cisco has developed programs for customers who have indicated a need to upgrade components of their systems. However, the inability of any of Cisco's products to properly manage and manipulate data in the year 2000 could result in increased warranty costs, customer satisfaction issues, potential lawsuits and other material costs and liabilities. 24 25 Cisco has completed phases I and II of its review of its supplier bases and, in the third phase of the compliance approach, is in the process of reviewing the state of readiness of its supplier base. This exercise includes compliance inquiries and reviews that will continue throughout 1999. Where issues are identified with a particular supplier, contingency plans will be developed as discussed below. Even where assurances are received from third parties there remains a risk that failure of systems and products of other companies on which Cisco relies could have a material adverse effect on Cisco. Further, if these suppliers fail to adequately address the Year 2000 issue for the products they provide to Cisco, critical materials, products and services may not be delivered timely and Cisco may not be able to manufacture sufficient product to meet sales demand. Based on the work done to date, Cisco has not incurred material costs and does not expect to incur future material costs in the work to address the Year 2000 problem for its systems (as a result of relatively new legacy information systems) and products. Cisco has taken and will continue to take corrective action to mitigate any significant Year 2000 problems with its systems and products and believes that the Year 2000 issue for information systems will not have a material impact on its operations or financial results. However, there can be no assurance that Cisco will not experience significant business disruptions or loss of business due to an inability to adequately address the Year 2000 issue. Cisco is concerned that many enterprises will be devoting a substantial portion of their information systems spending to addressing the Year 2000 issue. This expense may result in spending being diverted from networking solutions in the near future. This diversion of information technology spending could have a material adverse impact on Cisco's future sales volume. Contingency plans are being developed in certain key areas, in particular surrounding third party manufacturers and other suppliers, to ensure that any potential business interruptions caused by the Year 2000 issue are mitigated. Such contingency plans include identification of alternative sources of supply and test exercises to ensure that such alternatives are able to provide Cisco with an adequate level of support. These plans are expected to be developed by the end of June 1999 and will be tested in the six months beginning in July 1999, prior to the year 2000. The foregoing statements are based upon management's best estimates at the present time, which were derived utilizing numerous assumptions of future events, including the continued availability 25 26 of certain resources, third party modification plans and other factors. There can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to: o the availability and cost of personnel trained in this area; o the ability to locate and correct all relevant computer codes; o the nature and amount of programming required to upgrade or replace each of the affected programs; and o the rate and magnitude of related labor and consulting costs and the success of Cisco's external customers and suppliers in addressing the Year 2000 issue. Cisco's evaluation is on-going and it expects that new and different information will become available to it as that evaluation continues. Consequently, there is no guarantee that all material elements will be Year 2000 ready in time. CISCO COMPETES IN THE HIGHLY COMPETITIVE TELECOMMUNICATIONS EQUIPMENT MARKET Cisco competes 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 Cisco. Cisco competes with numerous vendors in each product category. Cisco expects that the overall number of competitors providing niche product solutions will increase due to the market's attractive growth. On the other hand, Cisco expects the number of vendors supplying end-to-end telecommunications solutions will decrease, due to the rapid pace of acquisitions in the industry. Ultimately Cisco believes only a few larger suppliers of end-to-end telecommunication equipment solutions will become its primary competitors. Cisco's competitors include Lucent, Nortel, Ericsson, 3Com, Cabletron, Fore and IBM. Some of Cisco's competitors compete across many of Cisco's product lines, while others do not offer as wide a breadth of solutions. Several of Cisco's current and potential competitors have greater financial, marketing and technical resources than Cisco. The principal competitive factors in the markets in which Cisco presently competes and may compete in the future are: o price; 26 27 o performance; o the ability to provide end-to-end solutions and support; o conformance to standards; o the ability to provide added value features such as security, reliability, and investment protection; and o market presence. Cisco also faces competition from customers it licenses technology to and suppliers from whom it transfers technology. Networking's inherent nature requires interoperability. As such, Cisco must cooperate, and at the same time compete, with these companies. Cisco's inability to effectively manage these complicated relationships with customers and suppliers could have a material adverse effect on Cisco's business, operating results, and financial condition. CISCO'S BUSINESS DEPENDS UPON ITS PROPRIETARY RIGHTS, AND THERE IS A RISK OF INFRINGEMENT Cisco's success is dependent upon its proprietary technology. Cisco generally relies upon patents, copyrights, trademarks and trade secret laws to establish and maintain its proprietary rights in its technology and products. Cisco has a program to file applications for and obtain patents in the United States and in selected foreign countries where a potential market for Cisco's products exists. Cisco has 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 Cisco. 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 Cisco's technology. In addition, the laws of some foreign countries may not permit the protection of Cisco's proprietary rights to the same extent as do the laws of the United States. Although Cisco believes the protection afforded by its patents, patent applications, copyrights and trademarks has value, the rapidly changing technology in the networking industry makes Cisco's future success dependent primarily on the innovative skills, technological expertise and management abilities of its employees rather than on patent, copyright and trademark protection. 27 28 Many of Cisco's 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 its products, Cisco believes 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, Cisco receives notices from or is sued by third parties regarding patent claims. If infringement is alleged, Cisco believes that, based upon industry practice, any necessary license or rights under such patents may be obtained on terms that would not have a material adverse effect on Cisco's business, operating results and financial condition. Nevertheless, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all, or that Cisco 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 Cisco's business, operating results and financial condition. CISCO FACES 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. Cisco could be materially adversely affected by regulation in any country where Cisco operates, on such technology as voice over the Internet, encryption technology and access charges for Internet service providers, as well as the continuing deregulation of the telecommunication industry. The adoption of such measures could decrease demand for Cisco's products, and at the same time increase Cisco's cost of selling its products. Changes in laws or regulations governing the Internet and Internet commerce could have a material adverse effect on Cisco's business, operating results and financial condition. THE ENTRANCE INTO NEW OR DEVELOPING MARKETS EXPOSES OUR BUSINESS AND OPERATIONS TO RISKS. As Cisco focuses on new market opportunities, such as transporting voice, video, and data traffic across the same network, it will increasingly compete with large telecommunications equipment suppliers such as Lucent, Ericsson and Nortel, among others, and several well funded start-up companies. Several of Cisco's current and potential competitors have greater financial, marketing and technical resources than Cisco. Additionally, as customers in these markets complete infrastructure deployments, they may require greater levels of service, support and financing than Cisco has experienced in the past. Cisco has not entered into a material amount of labor intensive service contracts which require significant production or customization. However, Cisco expects that demand for these types of service contracts will increase in the future. There can be no assurance that Cisco can provide products, service, support and financing to effectively compete for these market opportunities. Further, provision of greater levels of services by Cisco may result in less favorable name recognition treatment than has historically been experienced. CISCO IS DEPENDENT UPON THE ABILITY OF SUPPLIERS TO DELIVER PARTS ON TIME Cisco's growth and ability to meet customer demands also depend in part on its ability to obtain timely deliveries of parts from its suppliers. Cisco has experienced component shortages in the past that have adversely affected its operations. Although Cisco works 28 29 closely with its suppliers to avoid these types of shortages, there can be no assurances that Cisco will not encounter these problems in the future. THE LOCATION OF OUR FACILITIES SUBJECTS CISCO TO THE RISK OF EARTHQUAKES AND FLOODS Cisco's corporate headquarters, including most of its research and development operations and its manufacturing facilities, are located in the Silicon Valley area of Northern California, a region known for seismic activity. Additionally, one of Cisco's manufacturing facilities is located near a river that has experienced flooding in the past. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on Cisco's business, financial condition and operating results. CISCO DEPENDS UPON THE DEVELOPMENT OF NEW PRODUCTS AND IS SUBJECT TO RAPID CHANGES IN TECHNOLOGY AND THE MARKET Cisco's operating results will depend to a significant extent on its ability to reduce the costs to produce existing products. In particular, Cisco broadened its product line by introducing network access products. Sales of these products, which are generally lower priced and carry lower margins than Cisco's core products, have increased more rapidly than sales of Cisco's 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 Cisco's competitors and market acceptance of these products. The markets for Cisco's products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions, and evolving methods of building and operating networks. There can be no assurance that Cisco will successfully identify new product opportunities, develop and bring new products to market in a timely manner, and achieve market acceptance of its products or that products and technologies developed by others will not render Cisco's products or technologies obsolete or noncompetitive. CISCO IS SUBJECT TO RISKS ASSOCIATED WITH STRATEGIC ALLIANCES Cisco has a number of strategic alliances with companies including Microsoft, Hewlett-Packard, EDS, Sprint and Motorola, among others. 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 29 30 will be mutually beneficial and result in industry growth. However, these alliances carry an element of risk because, in most cases, Cisco must compete in some business areas with a company with which it has 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, Cisco could suffer delays in product development or other operational difficulties. THE INDUSTRY IN WHICH CISCO COMPETES IS SUBJECT TO CONSOLIDATION There has been a trend toward industry consolidation for several years, which has continued during fiscal 1999. Cisco expects this trend toward industry consolidation to continue as companies attempt to strengthen or hold their market positions in an evolving industry. Cisco believes 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 Cisco competes to be a single vendor solution and could have a material adverse effect on Cisco's business, operating results and financial condition. SALES IN THE SERVICE PROVIDER MARKET ARE SUBJECT TO VARIATION Although sales to the service provider market have continued to grow, 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 Cisco's business, operating results and financial condition. CISCO IS SUBJECT TO RISKS ASSOCIATED WITH THE MANUFACTURE OF PARTS AND COMPONENTS OF ITS PRODUCTS Although Cisco generally uses standard parts and components for its products, certain components are presently available only from a single source or limited sources. A reduction or interruption in supply or a significant increase in the price of one or more components would adversely affect Cisco's business, operating results and financial condition and could damage customer relationships. CISCO FACES RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATION REGULATION AND TARIFFS 30 31 Changes in domestic and international telecommunication requirements could affect Cisco's sales of its products. In particular, Cisco believes it is possible that there may be significant changes in domestic telecommunications regulations in the near future that could slow the expansion of the service providers' network infrastructures and adversely affect Cisco's 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 Cisco's products for certain classes of customers. Additionally, in the U.S. Cisco's products must comply with various Federal Communication Commission requirements and regulations. In countries outside of the U.S., Cisco's products must meet various requirements of local telecommunications authorities. Changes in tariffs, or failure by Cisco to obtain timely approval of products could have a material adverse effect on Cisco's business, operating results and financial condition. CISCO'S BUSINESS IS SUBJECT TO RISKS FROM INTERNATIONAL OPERATIONS Cisco conducts business globally. Accordingly, Cisco's future results could be adversely affected by a variety of uncontrollable and changing factors including 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, among other factors. In fiscal 1998, Cisco experienced slower sales growth in Japan, as well as in certain other parts of Asia. Any or all of these factors could have a material adverse impact on Cisco's future international business in these or other countries. CISCO'S BUSINESS SUBSTANTIALLY DEPENDS UPON THE CONTINUED GROWTH OF THE INTERNET AND INTERNET-BASED SYSTEMS Cisco's management believes that there will be performance problems with Internet communications in the future which could receive a high degree of publicity and visibility. As Cisco is a large supplier of equipment for the Internet infrastructure, customers' perceptions of Cisco's products and the marketplace's perception of Cisco as a supplier of networking products, may be materially adversely affected, regardless of whether or not these problems are due to the performance of Cisco's products. Such an event could also result in a material adverse effect on the market price of Cisco's Common Stock and could materially adversely affect Cisco's business, operating results and financial condition. 31 32 CISCO'S STOCK PRICE MAY BE VOLATILE Cisco's Common Stock has experienced substantial price volatility, particularly as a result of variations between Cisco's actual or anticipated financial results and the published expectations of analysts and as a result of announcements by Cisco and its competitors. 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 adversely affect the market price of Cisco's Common Stock in the future. 32 33 PART II. OTHER INFORMATION ITEM 6. EXHIBIT AND REPORTS ON FORM 8-K (a) Exhibit 27 Financial data schedule (b) Reports on Form 8-K None 34 34 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 11, 1999 By /s/ Larry R. Carter ------------------------------------- Larry R. Carter, Senior Vice President Finance, and Chief Financial Officer (Principal Financial and Accounting Officer) 35 35 INDEX TO EXHIBITS
Exhibit - ------- 27 Financial data schedule
EX-27 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AND CONSOLIDATED STATEMENT OF OPERATIONS INCLUDED IN THE COMPANY'S FORM 10-Q FOR THE PERIOD ENDED MAY 1, 1999, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000,000 12-MOS JUL-31-1999 JUL-26-1998 MAY-01-1999 690 7,805 1,305 30 621 4,326 1,618 917 12,708 2,412 0 0 0 4,847 5,405 12,708 8,562 8,562 2,981 6,483 0 0 0 2,314 862 1,452 0 0 0 1,452 0.92 0.86 For purpose of this statement, primary means basic.
-----END PRIVACY-ENHANCED MESSAGE-----