EX-13.1 2 dex131.htm PAGES 16 TO 71 OF THE REGISTRANT'S 2005 ANNUAL REPORT TO SHAREHOLDERS Pages 16 to 71 of the Registrant's 2005 Annual Report to Shareholders

Exhibit 13.1

 

Reports of Management

 

Statement of Management’s Responsibility

Cisco’s management has always assumed full accountability for maintaining compliance with our established financial accounting policies and for reporting our results with objectivity and the highest degree of integrity. It is critical for investors and other users of the Consolidated Financial Statements to have confidence that the financial information that we provide is timely, complete, relevant, and accurate. Management is responsible for the fair presentation of Cisco’s Consolidated Financial Statements, prepared in accordance with generally accepted accounting principles (GAAP), and has full responsibility for their integrity and accuracy.

Management, with oversight by Cisco’s Board of Directors, has established and maintains a strong ethical climate so that our affairs are conducted to the highest standards of personal and corporate conduct. Management also has established an effective system of internal control over financial reporting. Cisco’s policies and practices reflect corporate governance initiatives that are compliant with the listing requirements of NASDAQ and the corporate governance requirements of the Sarbanes-Oxley Act of 2002.

We are committed to enhancing shareholder value and fully understand and embrace our fiduciary oversight responsibilities. We are dedicated to ensuring that our high standards of financial accounting and reporting as well as our underlying system of internal controls are maintained. Our culture demands integrity and we have the highest confidence in our processes, our internal controls, and our people, who are objective in their responsibilities and who operate under the highest level of ethical standards.

 

Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting for Cisco. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management (with the participation of the principal executive officer and principal financial officer) conducted an evaluation of the effectiveness of Cisco’s internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that Cisco’s internal control over financial reporting was effective as of July 30, 2005. Management’s assessment of the effectiveness of Cisco’s internal control over financial reporting as of July 30, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.

 

LOGO  

LOGO

 

John T. Chambers   Dennis D. Powell
President and Chief Executive Officer   Senior Vice President and Chief Financial
September 16, 2005   September 16, 2005

 

16  Cisco Systems, Inc.


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of Cisco Systems, Inc.:

 

We have completed an integrated audit of Cisco Systems, Inc.’s 2005 consolidated financial statements and of its internal control over financial reporting as of July 30, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated Financial Statements

 

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of shareholders’ equity and of cash flows appearing on pages 40 to 43 present fairly, in all material respects, the financial position of Cisco Systems, Inc. and its subsidiaries at July 30, 2005 and July 31, 2004, and the results of their operations and their cash flows for each of the three years in the period ended July 30, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

As discussed in Notes 2 and 3 to the consolidated financial statements, effective January 24, 2004, the Company adopted Financial Accounting Standards Board Interpretation No. 46(R), “Consolidation of Variable Interest Entities.”

 

Internal Control Over Financial Reporting

 

Also, in our opinion, management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of July 30, 2005 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 30, 2005, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

LOGO

 

San Jose, California

September 16, 2005

 

2005 Annual Report  17


SELECTED FINANCIAL DATA

Five Years Ended July 30, 2005 (in millions, except per-share amounts)

 

The following selected financial data should be read in conjunction with the Consolidated Financial Statements and related notes which appear on pages 40 to 70 of this Annual Report:

 

     July 30,
2005


   July 31,
2004


    July 26,
2003


   July 27,
2002


   July 28,
2001


 

Net sales

   $ 24,801    $ 22,045     $ 18,878    $ 18,915    $ 22,293  

Net income (loss)

   $ 5,741    $ 4,401 (2)   $ 3,578    $ 1,893    $ (1,014 )(3)

Net income (loss) per share—basic

   $ 0.88    $ 0.64     $ 0.50    $ 0.26    $ (0.14 )

Net income (loss) per share—diluted(1)

   $ 0.87    $ 0.62     $ 0.50    $ 0.25    $ (0.14 )

Shares used in per-share calculation—basic

     6,487      6,840       7,124      7,301      7,196  

Shares used in per-share calculation—diluted(1)

     6,612      7,057       7,223      7,447      7,196  

Cash and cash equivalents and total investments

   $ 16,055    $ 19,267     $ 20,652    $ 21,456    $ 18,517  

Total assets

   $ 33,883    $ 35,594     $ 37,107    $ 37,795    $ 35,238  

Note 1: Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares, as their effect is antidilutive. The weighted-average dilutive potential common shares that were antidilutive for fiscal 2001 amounted to 348 million shares.

 

Note 2: Net income for fiscal 2004 included a noncash charge for the cumulative effect of accounting change relating to a stock-based compensation charge of $567 million, net of tax. See Note 3 to the Consolidated Financial Statements.

 

Note 3: Net loss for fiscal 2001 included restructuring costs and other special charges of $1.2 billion. In addition, net loss for fiscal 2001 included an additional excess inventory charge of $2.2 billion recorded in the third quarter period.

 

18  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” variations of such words, and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, as well as on the inside back cover of this Annual Report to Shareholders and under “Risk Factors,” and elsewhere in our Annual Report on Form 10-K. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.

 

OVERVIEW

 

We sell scalable, standards-based networking products that address a wide range of customers’ business needs, including improving productivity, reducing costs, and gaining a competitive advantage. Our corresponding technology focus is on delivering networking products and systems that simplify customers’ infrastructures, offer integrated services, and are highly secure. Our products and services help customers build their own network infrastructures that support tools and applications that allow them to communicate with key stakeholders, including customers, prospects, business partners, suppliers, and employees. Our product offerings fall into several categories: our core technologies, routing and switching; advanced technologies (currently including enterprise Internet Protocol (IP) communications, home networking, optical networking, security, storage area networking, and wireless technology); and other products, including our access products and network management software. In addition to our product offerings, we provide a broad range of service offerings, including technical support services and advanced services. Our customer base spans virtually all types of public and private agencies and businesses, comprising large enterprise companies, service providers, and commercial customers. We also have consumer customers through our Linksys division.

 

In fiscal 2005, we focused on three long-term financial priorities:

 

    Seek profitable growth opportunities

 

    Achieve profitability targets and improve productivity

 

    Increase shareholder value

 

Our results for fiscal 2005 reflected increases in net sales, net income, and net income per share from fiscal 2004. Net sales were $24.8 billion, compared with $22.0 billion in fiscal 2004. Net income was $5.7 billion, compared with $4.4 billion in fiscal 2004. Diluted earnings per share were $0.87, compared with $0.62 in fiscal 2004. We have continued to achieve a good balance in revenue growth from our geographic segments, customer markets, and product families, as reflected by different geographic segments, customer markets, and product families experiencing the highest comparative quarterly revenue growth on a percentage basis over the course of fiscal 2005 and fiscal 2004.

 

Revenue increased in each of our geographic segments, with the Americas and Europe, Middle East, and Africa (EMEA) theaters together contributing 88.4% of the total increase in fiscal 2005. In addition, during fiscal 2005, sales of our switches, which represent the largest component of our product revenue, increased 12.5%. We also experienced increased sales of our advanced technologies products of 32.1%, reflecting an increase in sales of each of our six advanced technologies product categories. Our router revenue increased by 1.7%. Our gross margins declined from last fiscal year. Product gross margin declined primarily due to higher sales of certain lower-margin products related to switching and home networking and to the effects of pricing and discounts, which were partially offset by higher shipment volumes and lower manufacturing and other costs. We have continued to encounter price-focused competition, including competitors from Asia and, in particular, China. Service gross margin declined as we continued to invest in advanced services and technical support services. Operating expenses as a percentage of net sales have continued to decline year over year.

 

Cash flows from operations were $7.6 billion, compared with $7.0 billion for fiscal 2004. With regard to our balance sheet, at the end of fiscal 2005, cash and cash equivalents and total investments were $16.1 billion and for the fourth quarter of fiscal 2005, days sales outstanding (DSO) were 31 days and annualized inventory turns were 6.6. During the fiscal year, we repurchased $10.2 billion or 540 million shares of our common stock at an average price of $18.95. At the end of fiscal 2005, our cumulative purchases since the inception of the share repurchase program in September 2001 were approximately $27.2 billion, or 1.5 billion shares, at an average price of $18.15.

 

2005 Annual Report  19


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

To position ourselves to take advantage of future growth opportunities, we have continued to rely on innovation and on taking good business risks. Our innovation strategy is a combination of internal development, strategic alliances, and acquisitions designed to provide innovative products to enhance our competitive position. We envision an architectural evolution of networking from simple connectivity of products to intelligent systems. As such, we expect that industry consolidation and the integration of our core and advanced technologies will occur along both technology and business architecture lines. In fiscal 2005, our internal development has resulted in many new product introductions, and we also increased our growth opportunities through new key strategic alliances. We have also completed 17 acquisitions to further extend our talent and technology opportunities. Further, we added, and intend to continue to add, both engineering and sales resources as we focus on developing the next wave of advanced technologies, growing the commercial market segment, capitalizing on our emerging market opportunities, and increasing our market share gains.

 

As we evaluate our growth prospects and manage our operations for the future, we continue to believe that a leading indicator of our growth will be the gross domestic product, or GDP, of the countries into which we sell our products. Beginning in fiscal 2006, we have reorganized our geographic segments to align our focus on long-term growth, capture emerging market opportunities, and serve our customers better.

 

CRITICAL ACCOUNTING ESTIMATES

 

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The accounting policies described below are significantly affected by critical accounting estimates. Such accounting policies require significant judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies.

 

Revenue Recognition

 

Our networking and communications products are integrated with software that is essential to the functionality of the equipment. We provide unspecified software upgrades and enhancements related to the equipment through our maintenance contracts for most of our products. Accordingly, we account for revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met.

 

Contracts, Internet commerce agreements, and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history. When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. The amount of product and service revenue recognized is affected by our judgments as to whether an arrangement includes multiple elements and, if so, whether vendor-specific objective evidence of fair value exists. Changes to the elements in an arrangement and our ability to establish vendor-specific objective evidence for those elements could affect the timing of the revenue recognition. Our total deferred revenue for products was $1.4 billion and $1.5 billion as of July 30, 2005 and July 31, 2004, respectively. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which is typically from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our total deferred revenue for services was $3.6 billion and $3.0 billion as of July 30, 2005 and July 31, 2004, respectively.

 

We make sales to distributors and retail partners and recognize revenue based on a sell-through method using information provided by them. Our distributors and retail partners participate in various cooperative marketing and other programs, and we maintain estimated accruals and allowances for these programs. If actual credits received by our distributors and retail partners for these programs were to deviate significantly from our estimates, which are based on historical experience, our revenue could be adversely affected.

 

Allowance for Doubtful Accounts and Sales Returns

 

Our accounts receivable balance, net of allowance for doubtful accounts, was $2.2 billion as of July 30, 2005, compared with $1.8 billion as of July 31, 2004. The allowance for doubtful accounts as of July 30, 2005 was $162 million or 6.8% of the gross accounts receivable balance, compared with $179 million or 8.9% of the gross accounts receivable balance as of July 31, 2004. The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, the age of the accounts receivable balances, and current economic conditions that may affect a customer’s ability to pay.

 

20  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

We had no provision for doubtful accounts in fiscal 2005. Our provision (credit) for doubtful accounts was $19 million and ($59) million for fiscal 2004 and 2003, respectively. If a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our revenue.

 

A reserve for future sales returns is established based on historical trends in product return rates. The reserve for future sales returns as of July 30, 2005 and July 31, 2004 was $63 million and $74 million, respectively, and was recorded as a reduction of our accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected.

 

Allowance for Inventory

 

Our inventory balance was $1.3 billion as of July 30, 2005, compared with $1.2 billion as of July 31, 2004. Our inventory allowance as of July 30, 2005 was $159 million, compared with $139 million as of July 31, 2004. We provide allowances for inventory based on excess and obsolete inventories determined primarily by future demand forecasts. The allowance is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and is charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

 

Our provision for inventory was $221 million, $205 million, and $70 million for fiscal 2005, 2004, and 2003, respectively. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory allowances, and our gross margin could be adversely affected. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times and the risk of inventory obsolescence.

 

Warranty Costs

 

The liability for product warranties, included in other accrued liabilities, was $259 million as of July 30, 2005, compared with $239 million as of July 31, 2004. See Note 8 to the Consolidated Financial Statements. Our products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products we provide a limited lifetime warranty. We accrue for warranty costs as part of our cost of sales based on associated material costs, technical support labor costs, and associated overhead. Material cost is estimated based primarily upon historical trends in the volume of product returns within the warranty period and the cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities.

 

The provision for product warranties issued during fiscal 2005 and 2004 was $411 million and $333 million, respectively. The increase in the provision for product warranties was due to a higher shipment volume of our products and an increase in warranty claims. If we continue to experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than the expectations on which the accrual has been based, our gross margin could be adversely affected.

 

Investment Impairments

 

Our publicly traded equity securities are reflected in the Consolidated Balance Sheets at a fair value of $941 million as of July 30, 2005, compared with $1.1 billion as of July 31, 2004. See Note 7 to the Consolidated Financial Statements. We recognize an impairment charge when the decline in the fair value of our publicly traded equity securities below their cost basis are judged to be other-than-temporary. The ultimate value realized on these equity securities, to the extent unhedged, is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Our ongoing consideration of these factors could result in additional impairment charges in the future, which could adversely affect our net income. Our impairment charges on investments in publicly held companies were $5 million and $412 million in fiscal 2005 and 2003, respectively. There were no impairment charges on investments in publicly held companies in fiscal 2004.

 

We also have investments in privately held companies, some of which are in the startup or development stages. As of July 30, 2005, our investments in privately held companies were $421 million, compared with $354 million as of July 31, 2004, and were included in other assets. See Note 5 to the Consolidated Financial Statements. We monitor these investments for impairment and make appropriate reductions in carrying values if we determine an impairment charge is required, based primarily on the financial condition and near-term prospects of these companies. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. Our impairment charges on investments in privately held companies were $39 million, $112 million, and $281 million during fiscal 2005, 2004, and 2003, respectively.

 

2005 Annual Report  21


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Goodwill Impairments

 

Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques in the high-technology communications equipment industry. Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. We perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances for each reporting unit. The goodwill recorded in the Consolidated Balance Sheets as of July 30, 2005 and July 31, 2004 was $5.3 billion and $4.2 billion, respectively. In response to changes in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. There was no impairment of goodwill in fiscal 2005, 2004, and 2003.

 

Income Taxes

 

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes and interest will be due. These reserves are established when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are likely to be challenged and may not be sustained on review by tax authorities. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

 

Our effective tax rates differ from the statutory rate primarily due to acquisition-related costs, research and experimentation tax credits, state taxes, and the tax impact of foreign operations. The effective tax rate was 28.6%, 28.9%, and 28.6% for fiscal 2005, 2004, and 2003, respectively. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

 

Loss Contingencies

 

We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.

 

FINANCIAL DATA FOR FISCAL 2005, 2004, AND 2003

 

Net Sales

 

We manage our business based on four geographic theaters: the Americas; EMEA; Asia Pacific; and Japan. Net sales, which include product and service revenue, for each theater are summarized in the following table (in millions, except percentages):

 

Years Ended


 

July 30,

2005


   

July 31,

2004


   

Variance

in Dollars


 

Variance

in Percent


    July 31,
2004


    July 26,
2003


   

Variance

in Dollars


 

Variance

in Percent


 

Net sales:

                                                       

Americas

  $ 13,929     $ 12,233     $ 1,696   13.9 %   $ 12,233     $ 10,544     $ 1,689   16.0 %

Percentage of net sales

    56.2 %     55.5 %                 55.5 %     55.8 %            

EMEA

    6,866       6,126       740   12.1 %     6,126       5,202       924   17.8 %

Percentage of net sales

    27.7 %     27.8 %                 27.8 %     27.6 %            

Asia Pacific

    2,486       2,230       256   11.5 %     2,230       1,860       370   19.9 %

Percentage of net sales

    10.0 %     10.1 %                 10.1 %     9.9 %            

Japan

    1,520       1,456       64   4.4 %     1,456       1,272       184   14.5 %

Percentage of net sales

    6.1 %     6.6 %                 6.6 %     6.7 %            
   


 


 

       


 


 

     

Total

  $ 24,801     $ 22,045     $ 2,756   12.5 %   $ 22,045     $ 18,878     $ 3,167   16.8 %
   


 


 

       


 


 

     

 

22  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

The following table is a breakdown of net sales between product and service revenue (in millions, except percentages):

 

Years Ended


  July 30,
2005


    July 31,
2004


    Variance
in Dollars


  Variance
in Percent


    July 31,
2004


    July 26,
2003


    Variance
in Dollars


  Variance
in Percent


 

Net sales:

                                                       

Product

  $ 20,853     $ 18,550     $ 2,303   12.4 %   $ 18,550     $ 15,565     $ 2,985   19.2 %

Percentage of net sales

    84.1 %     84.1 %                 84.1 %     82.5 %            

Service

    3,948       3,495       453   13.0 %     3,495       3,313       182   5.5 %

Percentage of net sales

    15.9 %     15.9 %                 15.9 %     17.5 %            
   


 


 

       


 


 

     

Total

  $ 24,801     $ 22,045     $ 2,756   12.5 %   $ 22,045     $ 18,878     $ 3,167   16.8 %
   


 


 

       


 


 

     

 

Net Product Sales by Theater

 

The following table is a breakdown of net product sales by theater (in millions, except percentages):

 

Years Ended


  July 30,
2005


    July 31,
2004


    Variance
in Dollars


  Variance
in Percent


    July 31,
2004


    July 26,
2003


    Variance
in Dollars


  Variance
in Percent


 

Net product sales:

                                                       

Americas

  $ 11,071     $ 9,662     $ 1,409   14.6 %   $ 9,662     $ 8,109     $ 1,553   19.2 %

Percentage of net product sales

    53.1 %     52.1 %                 52.1 %     52.1 %            

EMEA

    6,155       5,504       651   11.8 %     5,504       4,609       895   19.4 %

Percentage of net product sales

    29.5 %     29.7 %                 29.7 %     29.6 %            

Asia Pacific

    2,243       2,039       204   10.0 %     2,039       1,687       352   20.9 %

Percentage of net product sales

    10.8 %     11.0 %                 11.0 %     10.8 %            

Japan

    1,384       1,345       39   2.9 %     1,345       1,160       185   15.9 %

Percentage of net product sales

    6.6 %     7.2 %                 7.2 %     7.5 %            
   


 


 

       


 


 

     

Total

  $ 20,853     $ 18,550     $ 2,303   12.4 %   $ 18,550     $ 15,565     $ 2,985   19.2 %
   


 


 

       


 


 

     

 

Net Product Sales by Groups of Similar Products

 

The following table presents net sales for groups of similar products (in millions, except percentages):

 

Years Ended


  July 30,
2005


    July 31,
2004


    Variance
in Dollars


  Variance
in Percent


    July 31,
2004


    July 26,
2003


    Variance
in Dollars


    Variance
in Percent


 

Net product sales:

                                                         

Routers

  $ 5,498     $ 5,406     $ 92   1.7 %   $ 5,406     $ 4,859     $ 547     11.3 %

Percentage of net product sales

    26.4 %     29.1 %                 29.1 %     31.2 %              

Switches

    10,104       8,980       1,124   12.5 %     8,980       7,721       1,259     16.3 %

Percentage of net product sales

    48.5 %     48.4 %                 48.4 %     49.6 %              

Advanced technologies

    4,408       3,336       1,072   32.1 %     3,336       2,004       1,332     66.5 %

Percentage of net product sales

    21.1 %     18.0 %                 18.0 %     12.9 %              

Other

    843       828       15   1.8 %     828       981       (153 )   (15.6 )%

Percentage of net product sales

    4.0 %     4.5 %                 4.5 %     6.3 %              
   


 


 

       


 


 


     

Total

  $ 20,853     $ 18,550     $ 2,303   12.4 %   $ 18,550     $ 15,565     $ 2,985     19.2 %
   


 


 

       


 


 


     

 

Gross Margin

 

The following table shows the gross margin for each theater (in millions, except percentages):

 

     AMOUNT

   PERCENTAGE

 

Years Ended


   July 30,
2005


   July 31,
2004


   July 26,
2003


  

July 30,

2005


   

July 31,

2004


    July 26,
2003


 

Gross margin:

                                       

Americas

   $ 9,213    $ 8,274    $ 7,340    66.1 %   67.6 %   69.6 %

EMEA

     4,754      4,244      3,659    69.2 %   69.3 %   70.3 %

Asia Pacific

     1,671      1,532      1,313    67.2 %   68.7 %   70.6 %

Japan

     1,033      1,076      921    68.0 %   73.9 %   72.4 %
    

  

  

                  

Total

   $ 16,671    $ 15,126    $ 13,233    67.2 %   68.6 %   70.1 %
    

  

  

                  

 

2005 Annual Report  23


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

The following table shows the gross margin for products and services (in millions, except percentages):

 

     AMOUNT

   PERCENTAGE

 

Years Ended


   July 30,
2005


   July 31,
2004


   July 26,
2003


   July 30,
2005


    July 31,
2004


    July 26,
2003


 

Gross margin:

                                       

Product

   $ 14,095    $ 12,784    $ 10,971    67.6 %   68.9 %   70.5 %

Service

     2,576      2,342      2,262    65.2 %   67.0 %   68.3 %
    

  

  

                  

Total

   $ 16,671    $ 15,126    $ 13,233    67.2 %   68.6 %   70.1 %
    

  

  

                  

 

Research and Development, Sales and Marketing, and General and Administrative Expenses

 

Research and development (R&D), sales and marketing, and general and administrative (G&A) expenses are summarized in the following table (in millions, except percentages):

 

Years Ended


 

July 30,

2005


   

July 31,

2004


    Variance
in Dollars


  Variance
in Percent


    July 31,
2004


    July 26,
2003


    Variance
in Dollars


  Variance
in Percent


 

Research and development

  $ 3,322     $ 3,192     $ 130   4.1 %   $ 3,192     $ 3,135     $ 57   1.8 %

Percentage of net sales

    13.4 %     14.5 %                 14.5 %     16.6 %            

Sales and marketing

    4,721       4,530       191   4.2 %     4,530       4,116       414   10.1 %

Percentage of net sales

    19.0 %     20.6 %                 20.6 %     21.8 %            

General and administrative

    959       867       92   10.6 %     867       702       165   23.5 %

Percentage of net sales

    3.9 %     3.9 %                 3.9 %     3.7 %            
   


 


 

       


 


 

     

Total

  $ 9,002     $ 8,589     $ 413   4.8 %   $ 8,589     $ 7,953     $ 636   8.0 %

Percentage of net sales

    36.3 %     39.0 %                 39.0 %     42.1 %            
   


 


 

       


 


 

     

 

Interest and Other Income (Loss), Net

 

Interest and other income (loss), net, were as follows (in millions):

 

Years Ended


   July 30,
2005


   July 31,
2004


   Variance
in Dollars


    July 31,
2004


   July 26,
2003


    Variance
in Dollars


 

Interest income

   $ 552    $ 512    $ 40     $ 512    $ 660     $ (148 )

Other income (loss), net

     68      188      (120 )     188      (529 )     717  
    

  

  


 

  


 


Total

   $ 620    $ 700    $ (80 )   $ 700    $ 131     $ 569  
    

  

  


 

  


 


 

DISCUSSION OF FISCAL 2005 AND 2004

 

The following discussion of fiscal 2005 compared with fiscal 2004 should be read in conjunction with the section of this report entitled “Financial Data for Fiscal 2005, 2004, and 2003.”

 

Net Sales

 

The increase in net product sales can be attributed to the continued gradual recovery in the global economic environment coupled with increased information technology-related capital spending in our enterprise, service provider, commercial, and consumer markets. The increase in net product sales occurred across all geographic theaters, with the Americas and EMEA theaters contributing 89.4% of the total increase. The majority of the increase in net product sales was related to higher sales of switches, which contributed 48.8% of the total increase, and higher sales of advanced technology products, which contributed 46.5% of the total increase. The increase in service revenue was primarily due to increased technical support service contract initiations and renewals associated with higher product sales that have resulted in a larger installed base of equipment being serviced.

 

Fiscal 2005 had 52 weeks compared with 53 weeks in fiscal 2004, and we believe that this extra week may have had a positive impact on our sales in fiscal 2004. However, we are not able to quantify the effect of the slightly longer year on our revenue.

 

24  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Net Product Sales by Theater

 

Net product sales in the Americas theater consist of net product sales in the United States and Americas International, which includes Canada, Mexico, and Latin America. The increase in net product sales in the Americas theater was due to an increase in net product sales to all of our customer markets in the United States. However, our sales to the U.S. federal government, included within our enterprise market, experienced weakness due to, we believe, a realignment of spending priorities.

 

Net product sales in the EMEA theater increased primarily as a result of continued product deployment by service providers and growth in enterprise markets. Net product sales in the United Kingdom represented the largest increase in the EMEA theater. In Asia Pacific, net product sales increased primarily as a result of infrastructure builds, broadband acceleration, and investments by Asian telecommunications carriers. The growth was primarily in the service provider and enterprise markets in India, Korea, and Australia. However, we experienced weakness in our product sales to China. Net product sales in the Japan theater have continued to reflect ongoing economic and other challenges in the theater.

 

As a result of organizational changes, beginning in fiscal 2006, our reportable segments will be changed to the following theaters: United States and Canada; European Markets; Emerging Markets; Asia Pacific; and Japan. The organizational changes are designed to align our focus on long-term growth, capture emerging market opportunities, and serve our customers better.

 

Net Product Sales by Groups of Similar Products

 

Routers    The increase in net product sales related to routers in fiscal 2005 was primarily due to sales of high-end routers. Our sales of high-end routers, which represent a larger proportion of our total router sales compared with midrange and low-end routers, increased by $122 million over the prior fiscal year. Sales of our midrange and low-end routers decreased by $30 million. In fiscal 2005, we introduced the integrated services router. Sales of integrated services routers represented approximately 20% of our total revenue from midrange and low-end routers in fiscal 2005. For the fourth quarter of fiscal 2005, sales of integrated services routers represented approximately 35% of our total revenue from midrange and low-end routers. Our high-end router sales are primarily to service providers, which tend to make large and sporadic purchases. In addition, our router sales in fiscal 2005 may have been impacted by new product introductions and increased competition from price-focused competitors.

 

Switches    The increase in net product sales related to switches in fiscal 2005 was due to sales of local-area network (LAN) fixed switches and LAN modular switches. Our sales of LAN fixed and modular switches increased by approximately $1.2 billion, compared with last fiscal year. The increase in sales of LAN switches was a result of the continued adoption of new technologies by our customers, resulting in higher sales of our high-end modular switch, the Cisco Catalyst 6500 Series, and fixed switches, including the Cisco Catalyst 3750 Series and Catalyst 3560 Series.

 

Advanced Technologies    We experienced higher sales in fiscal 2005 in all of our advanced technologies compared with fiscal 2004. Home networking product sales increased by approximately $250 million, and were related to the growth of our wireless and wired router businesses. Enterprise IP communications sales increased by approximately $220 million primarily due to sales of IP phones and associated software as our customers transitioned from an analog-based to an IP-based infrastructure. Sales of security products increased by approximately $210 million primarily due to module and line-card sales related to our routers and LAN modular switches as customers continued to emphasize network security. Optical product sales increased by approximately $150 million due to sales of the Cisco ONS 15454E and ONS 15454 platforms. Wireless LAN product sales increased by approximately $135 million. Sales of storage area networking products increased by approximately $105 million. Wireless LAN and storage area networking product sales increased primarily due to new customers and continued deployments with existing customers.

 

2005 Annual Report  25


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Factors That May Impact Net Product Sales    Net product sales may continue to be affected by changes in the geopolitical environment and global economic conditions; competition, including price-focused competitors from Asia, especially China; new product introductions; sales cycles and product implementation cycles; changes in the mix of our customers between service provider and enterprise markets; changes in the mix of direct sales and indirect sales; variations in sales channels; and final acceptance criteria of the product, system, or solution as specified by the customer. In addition, sales to the service provider market have been characterized by large and often sporadic purchases, especially relating to our router sales and sales of certain of our advanced technologies. In addition, service provider customers typically have longer implementation cycles, require a broader range of services including network design services, and often have acceptance provisions that can lead to a delay in revenue recognition. To improve customer satisfaction, we continue to focus on managing our manufacturing lead-time performance, 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. Net product sales may also be adversely affected by fluctuations in demand for our products, especially with respect to Internet businesses and telecommunications service providers, price and product competition in the communications and networking industries, introduction and market acceptance of new technologies and products, adoption of new networking standards, and financial difficulties experienced by our customers. We may, from time to time, experience manufacturing issues that create a delay in our suppliers’ ability to provide specific components, resulting in delayed shipments. To the extent that manufacturing issues and any related component shortages result in delayed shipments in the future, and particularly in periods when we and our suppliers are operating at higher levels of capacity, it is possible that revenue for a quarter could be adversely affected if such matters are not remediated within the same quarter.

 

Our distributors and retail partners participate in various cooperative marketing and other programs. In addition, increasing sales to our distributors and retail partners generally results in greater difficulty in forecasting the mix of our products and, to a certain degree, the timing of orders from our customers. We recognize revenue to our distributors and retail partners based on a sell-through method using information provided by them, and we maintain estimated accruals and allowances for all cooperative marketing and other programs.

 

Net Service Revenue

 

The increase in net service revenue was primarily due to increased technical support service contract initiations and renewals associated with higher product sales that have resulted in a larger installed base of equipment being serviced and revenue from advanced services, which relates to consulting support services of our technologies for specific networking needs.

 

Product Gross Margin

 

Product gross margin percentage decreased by 1.3%. Changes in the mix of products sold decreased product gross margin by approximately 2.5% due to higher sales of certain lower-margin switching products and increased sales of home networking products. Product pricing reductions and sales discounts decreased product gross margin by approximately 2%. In addition, a higher provision for warranty and a higher provision for inventory decreased product gross margin by approximately 0.5%. However, lower overall manufacturing costs related to lower component costs and value engineering and other manufacturing-related costs increased product gross margin by approximately 2%. Value engineering is the process by which the production costs are reduced through component redesign, board configuration, test processes, and transformation processes. Higher shipment volumes also increased product gross margin by approximately 1.5%.

 

Product gross margin may continue to be adversely affected in the future by: changes in the mix of products sold, including further periods of increased growth of some of our lower-margin products; introduction of new products, including products with price-performance advantages; our ability to reduce production costs; entry into new markets, including markets with different pricing and cost structures; changes in distribution channels; price competition, including competitors from Asia and especially China; changes in geographic mix; sales discounts; increases in material or labor costs; excess inventory and obsolescence charges; warranty costs; changes in shipment volume; loss of cost savings due to changes in component pricing; impact of value engineering; inventory holding charges; and how well we execute on our strategic and operating plans.

 

26  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Service Gross Margin

 

Service gross margin percentage decreased by 1.8%. The decrease in service gross margin was primarily due to increased investments in the service portion of our business during fiscal 2005. One specific area of investment is advanced services, comprising highly specialized employees. As we add personnel and resources to support growth in this business, our service margins will typically be adversely affected in the near term. We have also added investments in our technical support business.

 

Our service gross margin from technical support services is higher than service gross margin from our advanced services. Service gross margin will typically experience some variability over time due to various factors such as the change in mix between technical support services and advanced services, as well as the timing of technical support service contract initiations and renewals and the timing of our adding personnel and resources to support this business. Our revenue from advanced services may continue to increase to a higher proportion of total service revenue due to our continued focus on providing comprehensive support to our customers’ networking devices, applications, and infrastructures.

 

Research and Development, Sales and Marketing, and General and Administrative Expenses

 

R&D expenses in fiscal 2005 were higher primarily due to higher headcount-related expenses of approximately $75 million and higher discretionary spending of approximately $35 million. We have continued to invest in R&D activities and to purchase or license technology in order to bring a broad range of products to 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 have been expensed as incurred.

 

Sales and marketing expenses in fiscal 2005 increased due to higher sales expenses of $151 million and higher marketing expenses of $40 million. Sales expenses increased primarily due to the effect of foreign currency fluctuations of approximately $100 million, net of hedging; and an increase in headcount-related expenses of approximately $60 million (including an adjustment of approximately $40 million relating to the prior fiscal year which reduced sales commissions). Marketing expenses increased primarily due to various marketing programs globally and other marketing investments.

 

The increase in our general and administrative expenses in fiscal 2005 was primarily attributable to costs incurred associated with various compliance programs and expenses related to investments in internal information technology systems and related program spending.

 

We continued to increase our headcount in fiscal 2005. Our headcount increased by 4,042 employees in fiscal 2005, of which approximately 1,200 of the new employees were attributable to acquisitions we completed in fiscal 2005. We intend to continue to add both engineering and sales resources as we focus on developing the next wave of advanced technologies, growing the commercial market segment, capitalizing on our emerging market opportunities, and increasing our market share gains. If we do not achieve the benefits anticipated from these investments, our operating results may be adversely affected.

 

Amortization of Purchased Intangible Assets

 

Amortization of purchased intangible assets included in operating expenses was $227 million in fiscal 2005, compared with $242 million in fiscal 2004. For additional information regarding purchased intangibles, see Note 3 to the Consolidated Financial Statements.

 

In-Process Research and Development

 

Our methodology for allocating the purchase price, relating to purchase acquisitions, to in-process R&D is determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D expense in fiscal 2005 was $26 million, compared with $3 million in fiscal 2004. See Note 3 to the Consolidated Financial Statements for additional information regarding the acquisitions completed in fiscal 2005 and fiscal 2004 and the in-process R&D recorded for each acquisition. In-process R&D was expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed.

 

The fair value of the existing purchased technology and patents, as well as the technology under development, is determined using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations are typically derived from a weighted-average cost of capital analysis and venture capital surveys, adjusted upward to reflect additional risks inherent in the development lifecycle. 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 expense reductions as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include significant anticipated cost savings.

 

2005 Annual Report  27


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

For purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical viability, rapidly changing customer markets, uncertain standards for new products, and significant competitive threats. The nature of the efforts to develop these technologies into commercially viable products consists primarily of planning, designing, experimenting, and testing activities necessary to determine that the technologies 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 key assumptions underlying the valuation for our purchase acquisitions completed in fiscal 2005 and fiscal 2004, for which in-process R&D was recorded (in millions, except percentages):

 

Acquisition


   In-Process
R&D Expense


   Estimated Cost to
Complete Technology
at Time of Acquisition


   Risk-Adjusted
Discount Rate for
In-Process R&D


 

FISCAL 2005

                    

Actona Technologies, Inc.

   $ 4    $ 1    24.0 %

Airespace, Inc.

     3      1    22.0 %

dynamicsoft, Inc.

     2      1    23.0 %

FineGround Networks, Inc.

     1      1    20.0 %

P-Cube Inc.

     6      2    24.0 %

Perfigo, Inc.

     2      1    22.0 %

Protego Networks, Inc.

     3      1    22.0 %

Sipura Technology, Inc.

     1      1    23.0 %

Topspin Communications, Inc.

     4      2    21.0 %
    

  

      

Total

   $ 26    $ 11       
    

  

      

FISCAL 2004

                    

Latitude Communications, Inc.

   $ 1    $ 1    16.5 %

Riverhead Networks, Inc.

     2      1    23.0 %
    

  

      

Total

   $ 3    $ 2       
    

  

      

 

The key assumptions primarily consist of an expected completion date for the in-process projects; estimated costs to complete the projects; revenue and expense projections, assuming the products have entered the market; and discount rates based on the risks associated with the development lifecycle of the in-process technology acquired. 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 may result in impairment charges. Actual results from the purchase acquisitions to date did not have a material adverse impact on our business and operating results.

 

Interest Income

 

The increase in interest income was primarily due to higher average interest rates on our portfolio of cash and cash equivalents and fixed income securities, partially offset by a decrease in the portfolio balance.

 

Other Income (Loss), Net

 

The components of other income (loss), net, are as follows (in millions):

 

Years Ended


   July 30, 2005

    July 31, 2004

 

Net gains on investments in fixed income and publicly traded equity securities

   $ 88     $ 206  

Impairment charges on publicly traded equity securities

     (5 )     —    

Net gains on investments in privately held companies

     51       61  

Impairment charges on investments in privately held companies

     (39 )     (112 )
    


 


Net gains (losses) and impairment charges on investments

     95       155  

Other

     (27 )     33  
    


 


Total

   $ 68     $ 188  
    


 


 

28  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Provision for Income Taxes

 

The effective tax rate was 28.6% for fiscal 2005 and 28.9% for fiscal 2004. The effective tax rate differs from the statutory rate primarily due to acquisition-related costs, research and experimentation tax credits, state taxes, and the tax impact of foreign operations.

 

During the fourth quarter of fiscal 2005, the Internal Revenue Service completed its examination of our federal income tax returns for the fiscal years ended July 25, 1998 through July 28, 2001. Based on the results of the examination, we have decreased previously recorded tax reserves by approximately $110 million and decreased income tax expense by a corresponding amount. This decrease to the provision for income taxes was offset by increases to the provision for income taxes of $57 million related to a fourth quarter fiscal 2005 intercompany restructuring of certain of our foreign operations and $70 million related to the effects of new U.S. tax regulations effective in fiscal 2005 that require intercompany reimbursement of certain stock-based compensation expenses.

 

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

 

On October 22, 2004, the American Jobs Creation Act of 2004 (the “Jobs Creation Act”) was signed into law. The Jobs Creation Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. In the first quarter of fiscal 2006, we distributed cash from our foreign subsidiaries and will report an extraordinary dividend (as defined in the Jobs Creation Act) of $1.2 billion and a related tax liability of approximately $63 million in our fiscal 2006 federal income tax return. This amount was previously provided for in the provision for income taxes and is included in income taxes payable.

 

In July 2005, the Financial Accounting Standards Board (FASB) issued an Exposure Draft of a proposed Interpretation “Accounting for Uncertain Tax Positions—an interpretation of FASB Statement No. 109.” Under the proposed Interpretation, a company would recognize in its financial statements its best estimate of the benefit of a tax position, only if the tax position is considered probable of being sustained on audit based solely on the technical merits of the tax position. In evaluating whether the probable recognition threshold has been met, the proposed Interpretation would require the presumption that the tax position will be evaluated during an audit by taxing authorities. The proposed Interpretation would be effective as of the end of the first fiscal year ending after December 15, 2005, with a cumulative effect of a change in accounting principle to be recorded upon the initial adoption. The proposed Interpretation would apply to all tax positions and only benefits from tax positions that meet the probable recognition threshold at or after the effective date would be recognized. We are currently analyzing the proposed Interpretation and have not determined its potential impact on our Consolidated Financial Statements. While we cannot predict with certainty the rules in the final Interpretation, there is risk that the final Interpretation could result in a cumulative effect charge to earnings upon adoption, increases in future effective tax rates, and/or increases in future interperiod effective tax rate volatility.

 

Cumulative Effect of Accounting Change, Net of Tax

 

In April 2001, we entered into a commitment to provide convertible debt funding of approximately $84 million to Andiamo Systems, Inc. (“Andiamo”), a privately held storage switch developer. This debt was convertible into approximately 44% of the equity of Andiamo. In connection with this investment, we obtained a call option that provided us the right to purchase Andiamo. The purchase price under the call option was based on a valuation of Andiamo using a negotiated formula. On August 19, 2002, we entered into a definitive agreement to acquire Andiamo, which represented the exercise of our rights under the call option. We also entered into a commitment to provide nonconvertible debt funding to Andiamo of approximately $100 million through the close of the acquisition. Substantially all of the convertible debt funding of $84 million and nonconvertible debt funding of $100 million was expensed as R&D costs.

 

We adopted FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46(R)”), effective January 24, 2004. We evaluated our debt investment in Andiamo and determined that Andiamo was a variable interest entity under FIN 46(R). We concluded that we were the primary beneficiary as defined by FIN 46(R) and, therefore, accounted for Andiamo as if we had consolidated Andiamo since our initial investment in April 2001. The consolidation of Andiamo from the date of our initial investment required accounting for the call option as a repurchase right. Under FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” and related interpretations, variable accounting was required for substantially all Andiamo employee stock and options because the ending purchase price was primarily derived from a revenue-based formula.

 

Effective January 24, 2004, the last day of the second quarter of fiscal 2004, we recorded a noncash cumulative stock compensation charge of $567 million, net of tax (representing the amount of variable compensation from April 2001 through January 2004). This charge was reported as a separate line item in the Consolidated Statements of Operations as a cumulative effect of accounting change, net of tax. The charge was based on the value of the Andiamo employee stock and options and their vesting from the adoption of FIN 46(R) pursuant to the formula-based valuation.

 

2005 Annual Report  29


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

On February 19, 2004, we completed the acquisition of Andiamo, exchanging approximately 23 million shares of our common stock for Andiamo shares not owned by us and assuming approximately 6 million stock options, for a total estimated value of $750 million, primarily derived from the revenue-based formula, which after stock price-related adjustments resulted in a total amount recorded of $722 million as summarized in the table below.

 

Subsequent to the adoption of FIN 46(R), changes to the value of Andiamo and the continued vesting of the employee stock and options resulted in an adjustment to the noncash stock compensation charge. We recorded a noncash variable stock compensation adjustment of $58 million in the third quarter of fiscal 2004 to the cumulative stock compensation charge recorded in the second quarter of fiscal 2004 to account for the additional vesting of the Andiamo employee stock and options and changes in the formula-based valuation from January 24, 2004 until February 19, 2004. This noncash adjustment was reported as R&D expense of $52 million and sales and marketing expense of $6 million in the Consolidated Statements of Operations, as stock-based compensation related to acquisitions and investments in the Consolidated Statements of Cash Flows, and as an increase to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity. In addition, upon completion of the acquisition, deferred stock-based compensation of $90 million was recorded to reflect the unvested portion of the formula-based valuation of the Andiamo employee stock and options. See Note 3 to the Consolidated Financial Statements. The amount of deferred stock-based compensation was fixed at the date of acquisition and is being amortized over the vesting period of the Andiamo employee stock and options of approximately two years.

 

A summary of the accounting of the initial consolidation under FIN 46(R) and the subsequent purchase of Andiamo, after stock price-related adjustments, is as follows (in millions):

 

     Amount

Cumulative effect of accounting change, net of tax benefit of $5

   $ 567

Variable stock-based compensation

     58

Deferred stock-based compensation

     90

Net assets

     7
    

Total

   $ 722
    

 

DISCUSSION OF FISCAL 2004 AND 2003

 

The following discussion of fiscal 2004 compared with fiscal 2003 should be read in conjunction with the section of this report entitled “Financial Data for Fiscal 2005, 2004, and 2003.”

 

Net Sales

 

The increase in net product sales was due to the impact of a gradual recovery in the global economic environment coupled with increased information technology-related capital spending in our enterprise, service provider, commercial, and consumer markets. The increase in net product sales occurred across all geographic theaters with the Americas and EMEA theaters contributing approximately 82.0% of the total increase. The majority of the increase in net product sales was related to higher sales of advanced technology products, which contributed approximately 47.9% of the total increase, and higher sales of switches, which contributed approximately 38.9% of the total increase. The increase in service revenue was primarily due to increased technical support service contract initiations and renewals associated with product sales.

 

Fiscal 2004 had 53 weeks, compared with 52 weeks in fiscal 2003, and we believe that this extra week may have had a positive impact on our sales in fiscal 2004. However, we are not able to quantify the effect of the slightly longer year on our revenue.

 

Net Product Sales by Theater

 

Net product sales in the Americas theater increased due to sales of home networking products increasing by approximately $513 million as a result of our acquisition of the Linksys business in the fourth quarter of fiscal 2003. The remainder of the increase in net product sales in the Americas theater was primarily due to an increase in net product sales to enterprise customers and the U.S. federal government. The increase in net product sales to enterprise customers was due to the impact of a gradual recovery in the economic environment coupled with increased information technology-related capital spending. Net product sales to the U.S. federal government increased by approximately 20% due to higher spending in the defense sector.

 

Net product sales in the EMEA theater increased primarily as a result of continued product deployment by service providers and growth in enterprise markets, especially in the public sector. The increase in net product sales in the EMEA theater occurred primarily in the United Kingdom, Germany, the Netherlands, and Russia.

 

In Asia Pacific, net product sales increased primarily as a result of infrastructure builds, broadband acceleration, and investments by Asian telecommunication carriers. The growth was primarily in the service provider and enterprise markets in China, Korea, and India. Net product sales in the Japan theater increased primarily as a result of growth in the service provider market.

 

30  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Net Product Sales by Groups of Similar Products

 

Routers    The increase in net product sales related to routers was attributable to sales of high-end routers, which increased by $556 million primarily as a result of higher spending by service providers, partially offset by a decline in sales of midrange routers and low-end routers, which decreased by $47 million. The decrease in midrange and low-end routers was primarily due to the increased size of the default memory in our basic configurations, which resulted in fewer customers needing to purchase lower-end routers to augment their memory.

 

Switches    The increase in net product sales related to switches was primarily due to sales of LAN modular switches, which increased by $694 million, and LAN fixed switches, which increased by $655 million, partially offset by sales of wide-area network (WAN) switches, which decreased by $90 million. The increase in sales of LAN switches was a result of new technologies being implemented by our customers, which resulted in higher sales of our modular switches, Cisco Catalyst 6500 Series and Catalyst 4500 Series, and fixed-configuration switches, including the Cisco Catalyst 3750 Series, introduced in the fourth quarter of fiscal 2003, and the Cisco Catalyst 3550 Series. The decline in sales of WAN switches was due to the continued technology migration away from Asynchronous Transfer Mode (ATM) to IP.

 

Advanced Technologies    The increase in net product sales related to advanced technologies was primarily due to sales of products in all six of our advanced technology markets. Sales of our home networking products, which increased $605 million, were related to our acquisition of the Linksys business in the fourth quarter of fiscal 2003. An increase of $228 million in sales of security products was primarily due to module and line card sales related to our routers and switches as customers continued to emphasize network security in light of continuing, well-publicized worms, viruses, and other attacks. Sales of enterprise IP communications products increased $144 million primarily due to sales of IP phones and associated software related to the transition from analog to IP-based infrastructure. Our wireless technology product sales increased $157 million due to sales of our access points as we gained new customers and continued deployments with existing customers. Sales of storage area networking products, which increased $113 million, were related to our acquisition of Andiamo in the third quarter of fiscal 2004. See Note 3 to the Consolidated Financial Statements. The increase of $85 million in sales of optical products was due to an increase in the sales of the Cisco ONS 15454 platform.

 

Net Service Revenue

 

The increase in net service revenue was primarily due to increased technical support service contract initiations and renewals associated with higher product sales that have resulted in a larger installed base of equipment being serviced and revenue from advanced services, which relates to consulting support services of our technologies for specific networking needs.

 

Product Gross Margin

 

Product gross margin decreased by 1.6%. Changes in the mix of products sold decreased product gross margin by approximately 3% due to increased sales of home networking products related to our acquisition of the Linksys business and new product introductions within our switching business. Product pricing reductions and sales discounts decreased product gross margin by approximately 1%, and higher provision for inventory decreased product gross margin by 0.6%. However, lower manufacturing costs related to lower component costs and value engineering and other manufacturing-related costs increased product gross margin by approximately 1.5%. Higher shipment volume also increased product gross margin by approximately 1.5%.

 

Service Gross Margin

 

Service gross margin decreased by 1.3% but increased $80 million in absolute dollars. Service gross margin will typically experience some variability over time due to various factors such as the change in mix between technical support services and advanced services, as well as the timing of technical support service contract initiations and renewals.

 

Research and Development, Sales and Marketing, and General and Administrative Expenses

 

R&D expenses increased primarily due to higher discretionary spending of $87 million, primarily related to higher prototype expenses and due to an additional week of headcount-related expense of $28 million. The increase in R&D expenses was partially offset by lower depreciation expense of $61 million. The increase in R&D expenses reflects our continued investment in R&D efforts in routers, switches, advanced technologies, and other product technologies. In May 2004, we announced plans to hire additional engineers.

 

2005 Annual Report  31


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Sales and marketing expenses increased primarily due to increases in sales expenses of $270 million and marketing expenses of $144 million. The increase in sales expenses was primarily due to the effect of foreign currency fluctuations, net of hedging, of approximately $120 million, and an increase in sales commissions of approximately $110 million partially offset by a decrease in sales program expenses of $86 million. The remaining increase was primarily due to higher discretionary spending. The increase in marketing expenses was primarily related to an increase of $66 million in our integrated marketing campaign. The increase in marketing expenses was also attributable to additional expenses of $33 million related to our acquisition of the Linksys business in the fourth quarter of fiscal 2003. In May 2004, we announced plans to increase the size of our sales force.

 

G&A expenses increased primarily due to higher amortization of deferred stock-based compensation of $52 million attributable to our acquisitions, expenses related to investments in internal information technology systems and related program spending of $42 million, and the effect of foreign currency fluctuations, net of hedging, of approximately $30 million.

 

Amortization of Purchased Intangible Assets

 

Amortization of purchased intangible assets included in operating expenses was $242 million in fiscal 2004, compared with $394 million in fiscal 2003. The decrease in the amortization of purchased intangible assets was due to the amortization of certain technology and patent intangibles in the prior year period that were fully amortized as of the end of fiscal 2003. For additional information regarding purchased intangible assets, see Note 3 to the Consolidated Financial Statements.

 

In-Process Research and Development

 

The following table summarizes the key assumptions underlying the valuation for our purchase acquisitions completed in fiscal 2004 and fiscal 2003, for which in-process R&D was recorded (in millions, except percentages):

 

Acquisition


   In-Process
R&D Expense


   Estimated Cost to
Complete Technology
at Time of Acquisition


   Risk-Adjusted
Discount Rate for
In-Process R&D


 

FISCAL 2004

                    

Latitude Communications, Inc.

   $ 1    $ 1    16.5 %

Riverhead Networks, Inc.

     2      1    23.0 %
    

  

      

Total

   $ 3    $ 2       
    

  

      

FISCAL 2003

                    

Okena, Inc.

   $ 3    $ 1    22.0 %

SignalWorks, Inc.

     1      1    24.0 %
    

  

      

Total

   $ 4    $ 2       
    

  

      

 

Interest Income

 

The decrease in interest income was primarily due to lower average interest rates on our portfolio of fixed income securities.

 

Other Income (Loss), Net

 

The components of other income (loss), net, are as follows (in millions):

 

Years Ended


   July 31,
2004


    July 26,
2003


 

Net gains on investments in fixed income and publicly traded equity securities

   $ 206     $ 161  

Impairment charges on publicly traded equity securities

     —         (412 )

Net gains on investments in privately held companies

     61       12  

Impairment charges on investments in privately held companies

     (112 )     (281 )
    


 


Net gains (losses) and impairment charges on investments

     155       (520 )

Other

     33       (9 )
    


 


Total

   $ 188     $ (529 )
    


 


 

The impairment charges on publicly traded equity securities of $412 million, pretax, during fiscal 2003 were due to the decline in the fair value of certain publicly traded equity securities below their cost basis that were judged to be other-than-temporary.

 

32  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Provision for Income Taxes

 

The effective tax rate was 28.9% for fiscal 2004 and 28.6% for fiscal 2003. The effective tax rate differs from the statutory rate primarily due to acquisition-related costs, research and experimentation tax credits, state taxes, and the tax impact of foreign operations.

 

Recent Accounting Pronouncement

 

In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based compensation payments and supersedes the current accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). SFAS 123(R) is effective for all annual periods beginning after June 15, 2005. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to the adoption of SFAS 123(R).

 

We adopted SFAS 123(R) in the first quarter of fiscal 2006 and will continue to evaluate the impact of SFAS 123(R) on our operating results and financial condition. The pro forma information in Note 10 presents the estimated compensation charges under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.” As a result of the provisions of SFAS 123(R) and SAB 107, we expect the compensation charges under SFAS 123(R) to reduce diluted net income per share by approximately $0.12 to $0.14 per share for fiscal 2006. However, our assessment of the estimated compensation charges is affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the volatility of our stock price and employee stock option exercise behaviors. We will recognize compensation cost for stock-based awards issued after July 30, 2005 on a straight-line basis over the requisite service period for the entire award.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The following sections discuss the effects of changes in our balance sheet and cash flows, contractual obligations, certain commitments, and the stock repurchase program on our liquidity and capital resources.

 

Balance Sheet and Cash Flows

 

Cash and Cash Equivalents and Total Investments    The following table summarizes our cash and cash equivalents and total investments (in millions):

 

     July 30,
2005


   July 31,
2004


   Increase
(Decrease)


 

Cash and cash equivalents

   $ 4,742    $ 3,722    $ 1,020  

Fixed income securities

     10,372      14,411      (4,039 )

Publicly traded equity securities

     941      1,134      (193 )
    

  

  


Total

   $ 16,055    $ 19,267    $ (3,212 )
    

  

  


 

The decrease in cash and cash equivalents and total investments was primarily a result of cash used for the repurchase of common stock of $10.2 billion, acquisitions of businesses of $911 million, and capital expenditures of $692 million, partially offset by cash provided by operating activities of $7.6 billion and cash provided by the issuance of common stock of $1.1 billion related to employee stock option exercises and employee stock purchases.

 

We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, shipment linearity, accounts receivable collections, inventory management, expensing stock options, and the timing and amount of tax and other payments. Shipment linearity is a measure of the level of shipments throughout a particular quarter. For additional discussion, see the section entitled “Risk Factors” in our Annual Report on Form 10-K.

 

Accounts Receivable, Net    The following table summarizes our accounts receivable, net (in millions):

 

     July 30,
2005


   July 31,
2004


   Increase
(Decrease)


Accounts receivable, net

   $ 2,216    $ 1,825    $ 391

 

DSO in accounts receivables as of July 30, 2005 and July 31, 2004 were 31 days and 28 days, respectively. The increase in DSO was due to more billings occurring later in the fourth quarter of fiscal 2005 related to our product billings and also to the initiations and renewals of technical support service contracts.

 

Our accounts receivable and DSO are primarily affected by shipment linearity and collections performance. A steady level of shipments and good collections performance will result in reduced DSO compared with a higher level of shipments toward the end of a quarter, which will result in a shorter amount of time to collect the related accounts receivable and increased DSO.

 

2005 Annual Report  33


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Inventories    The following table summarizes our inventories (in millions):

 

     July 30,
2005


   July 31,
2004


   Increase
(Decrease)


 

Raw materials

   $ 82    $ 58    $ 24  

Work in process

     431      416      15  

Finished goods:

                      

Distributor inventory and deferred cost of sales

     385      316      69  

Manufacturing finished goods

     184      206      (22 )
    

  

  


Total finished goods

     569      522      47  
    

  

  


Service-related spares

     180      177      3  

Demonstration systems

     35      34      1  
    

  

  


Total

   $ 1,297    $ 1,207    $ 90  
    

  

  


 

Annualized inventory turns were 6.6 in the fourth quarter of fiscal 2005, compared with 6.4 in the fourth quarter of fiscal 2004. Our finished goods consist of distributor inventory and deferred costs of sales and manufacturing finished goods. Distributor inventory and deferred cost of sales are related to unrecognized revenue on shipments to distributors and retail partners and shipments to enterprise and service provider customers. Manufacturing finished goods consist primarily of build-to-order and build-to-stock products, including home networking products. Service-related spares consist of reusable equipment related to our technical support and warranty activities. All inventories are accounted for at the lower of cost or market.

 

Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times against the risk of inventory obsolescence because of rapidly changing technology and customer requirements. We believe the amount of our inventory is appropriate for our current revenue levels.

 

Deferred Revenue    The breakdown of deferred revenue was as follows (in millions):

 

     July 30,
2005


   July 31,
2004


   Increase
(Decrease)


 

Deferred revenue:

                      

Service

   $ 3,618    $ 3,047    $ 571  

Product

     1,424      1,455      (31 )
    

  

  


Total

   $ 5,042    $ 4,502    $ 540  
    

  

  


Reported as:

                      

Current

   $ 3,854    $ 3,527    $ 327  

Noncurrent

     1,188      975      213  
    

  

  


Total

   $ 5,042    $ 4,502    $ 540  
    

  

  


 

The increase in deferred service revenue reflects the impact of the increase in the volume of technical support contract initiations and renewals, partially offset by the ongoing amortization of deferred service revenue. Deferred service revenue is recognized ratably over the service period, which is typically one to three years.

 

34  Cisco Systems, Inc.


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Contractual Obligations

 

Our cash flows from operations are dependent on a number of factors, including fluctuations in our operating results, shipment linearity, accounts receivable collections, inventory management, expensing stock options, and the timing and amount of tax and other payments. As a result, the impact of contractual obligations on our liquidity and capital resources in future periods should be analyzed in conjunction with such factors. In addition, we plan for and measure our liquidity and capital resources through an annual budgeting process.

 

The following tables summarize our contractual obligations at July 30, 2005 and July 31, 2004 and exclude amounts recorded in our Consolidated Balance Sheets (in millions):

 

     PAYMENTS DUE BY PERIOD

July 30, 2005


   Total

   Less than
1 Year


   1-3
Years


   3-5
Years


   More than
5 Years


Operating leases

   $ 1,260    $ 215    $ 281    $ 184    $ 580

Purchase commitments with contract manufacturers and suppliers

     954      954      —        —        —  

Purchase obligations

     1,398      1,014      338      46      —  
    

  

  

  

  

Total

   $ 3,612    $ 2,183    $ 619    $ 230    $ 580
    

  

  

  

  

 

     PAYMENTS DUE BY PERIOD

July 31, 2004


   Total

   Less than
1 Year


   1-3
Years


   3-5
Years


   More than
5 Years


Operating leases

   $ 1,356    $ 231    $ 306    $ 187    $ 632

Purchase commitments with contract manufacturers and suppliers

     951      951      —        —        —  

Purchase obligations

     1,121      631      343      147      —  
    

  

  

  

  

Total

   $ 3,428    $ 1,813    $ 649    $ 334    $ 632
    

  

  

  

  

 

Operating Leases    We lease office space in several U.S. locations, as well as locations elsewhere in the Americas, EMEA, Asia Pacific, and Japan. Operating lease amounts include future minimum lease payments under all our noncancelable operating leases with an initial term in excess of one year.

 

Purchase Commitments with Contract Manufacturers and Suppliers    We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and to help assure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Consequently, only a portion of our reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. The purchase commitments for inventory are expected to be fulfilled within one year.

 

In addition to the above, we record a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of our future demand forecasts consistent with our allowance for inventory. As of July 30, 2005, the liability for our firm, noncancelable, and unconditional purchase commitments was $107 million, compared with $141 million as of July 31, 2004. These amounts are included in other accrued liabilities in our Consolidated Balance Sheets at July 30, 2005 and July 31, 2004, and are not included in the preceding table.

 

Purchase Obligations    Purchase obligations represent an estimate of all open purchase orders and contractual obligations in the ordinary course of business, other than commitments with contract manufacturers and suppliers, for which we have not received the goods or services. Although open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to the delivery of goods or performance of services.

 

2005 Annual Report  35


MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS—(Continued)

 

Other Commitments

 

We have entered into an agreement to invest approximately $800 million in venture funds managed by SOFTBANK Corp. and its affiliates (“SOFTBANK”) that are required to be funded on demand. The total commitment is to be invested in venture funds and as senior debt with entities as directed by SOFTBANK. Our commitment to fund the senior debt is contingent upon the achievement of certain agreed-upon milestones. As of July 30, 2005, we have invested $414 million in the venture funds and $49 million in the senior debt, of which $47 million has been repaid, and both were recorded as investments in privately held companies in our Consolidated Balance Sheets. We had invested $290 million in the venture funds and $49 million in the senior debt as of July 31, 2004.

 

We provide structured financing to certain qualified customers for the purchase of equipment and other needs through our wholly owned subsidiaries. These loan commitments may be funded over a two- to three-year period, provided that these customers achieve specific business milestones and satisfy certain financial covenants. As of July 30, 2005, our outstanding loan commitments were $17 million and all were eligible for draw-down. As of July 31, 2004, our outstanding loan commitments were $61 million, of which $22 million was eligible for draw-down.

 

As of July 30, 2005 and July 31, 2004, we had a commitment of approximately $25 million and $59 million, respectively, to purchase the remaining minority interest of Cisco Systems, K.K. (Japan), and we expect to make the final payment in fiscal 2006.

 

We also have certain other funding commitments related to our privately held investments that are based on the achievement of certain agreed-upon milestones. The funding commitments were $56 million as of July 30, 2005, compared with $67 million as of July 31, 2004.

 

Off-Balance Sheet Arrangements

 

We consider our investments in unconsolidated variable interest entities to be off-balance sheet arrangements. In the ordinary course of business, we have investments in privately held companies and provide structured financing to certain customers through our wholly owned subsidiaries, which may be considered to be variable interest entities. We have evaluated our investments in these privately held companies and structured financings and have determined that there were no significant unconsolidated variable interest entities as of July 30, 2005.

 

Certain events can require a reassessment of our investments in privately held companies or structured financings to determine if they are variable interest entities and if we would be regarded as the primary beneficiary. As a result of such events, we may be required to make additional disclosures or consolidate these entities. Because we may not control these entities, we may not have the ability to influence these events.

 

Stock Repurchase Program

 

In September 2001, our Board of Directors authorized a stock repurchase program. As of July 30, 2005, our Board of Directors has authorized the repurchase of up to $35 billion of common stock under this program. During fiscal 2005, we repurchased and retired 540 million shares of our common stock at an average price of $18.95 per share for an aggregate purchase price of $10.2 billion. As of July 30, 2005, we have repurchased and retired 1.5 billion shares of our common stock at an average price of $18.15 per share for an aggregate purchase price of $27.2 billion since inception of the stock repurchase program, and the remaining authorized amount under the stock repurchase program was $7.8 billion with no termination date.

 

The purchase price for the shares of our common stock repurchased was reflected as a reduction to shareholders’ equity. In accordance with Accounting Principles Board Opinion No. 6, “Status of Accounting Research Bulletins,” we are required to allocate the purchase price of the repurchased shares as a reduction to retained earnings and common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock option plans are recorded as an increase to common stock and additional paid-in capital. As a result of future repurchases, we may be required to report an accumulated deficit included in shareholders’ equity in our Consolidated Balance Sheets.

 

Liquidity and Capital Resource Requirements

 

Based on past performance and current expectations, we believe our cash and cash equivalents, short-term investments, and cash generated from operations will satisfy our working capital needs, capital expenditures, investment requirements, stock repurchases, contractual obligations, commitments (see Note 8 to the Consolidated Financial Statements), future customer financings, and other liquidity requirements associated with our operations through at least the next 12 months. We believe that the most strategic uses of our cash resources include repurchase of shares, strategic investments to gain access to new technologies, acquisitions, financing activities, and working capital. There are no transactions, arrangements, and other relationships with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

 

36  Cisco Systems, Inc.


QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

INVESTMENTS

 

We maintain an investment portfolio of various holdings, types, and maturities. See Note 7 to the Consolidated Financial Statements. These securities are generally classified as available-for-sale and consequently are recorded in the Consolidated Balance Sheets at fair value with unrealized gains or losses, to the extent unhedged, reported as a separate component of accumulated other comprehensive income, net of tax.

 

Fixed Income Securities

 

At any time, a sharp rise in interest rates could have a material adverse effect on the fair value of our investment portfolio. Conversely, declines in interest rates could have a material effect on interest income for our investment portfolio. Our investments are not leveraged as of July 30, 2005, and are held for purposes other than trading. The modeling technique used measures the change in fair value arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (“BPS”), 100 BPS, and 150 BPS. The following tables present the hypothetical changes in fair value in investment securities held at July 30, 2005 and July 31, 2004 that are sensitive to changes in interest rates (in millions):

 

    VALUATION OF SECURITIES
GIVEN AN INTEREST RATE
DECREASE OF X BASIS POINTS


  FAIR VALUE
AS OF
JULY 30,
2005


  VALUATION OF SECURITIES
GIVEN AN INTEREST RATE
INCREASE OF X BASIS POINTS


    (150 BPS)

  (100 BPS)

  (50 BPS)

      50 BPS  

    100 BPS  

    150 BPS  

U.S. government notes and bonds

  $ 3,540   $ 3,503   $ 3,467   $ 3,430   $ 3,393   $ 3,357   $ 3,320

Corporate and municipal notes and bonds and asset-backed securities

    7,101     7,048     6,995     6,942     6,890     6,837     6,784
   

 

 

 

 

 

 

Total

  $ 10,641   $ 10,551   $ 10,462   $ 10,372   $ 10,283   $ 10,194   $ 10,104
   

 

 

 

 

 

 

    VALUATION OF SECURITIES
GIVEN AN INTEREST RATE
DECREASE OF X BASIS POINTS


  FAIR VALUE
AS OF
JULY 31,
2004


  VALUATION OF SECURITIES
GIVEN AN INTEREST RATE
INCREASE OF X BASIS POINTS


    (150 BPS)

  (100 BPS)

  (50 BPS)

    50 BPS

  100 BPS

  150 BPS

U.S. government notes and bonds

  $ 4,517   $ 4,477   $ 4,437   $ 4,397   $ 4,357   $ 4,317   $ 4,277

Corporate and municipal notes and bonds and asset-backed securities

    10,214     10,147     10,080     10,014     9,946     9,879     9,812
   

 

 

 

 

 

 

Total

  $ 14,731   $ 14,624   $ 14,517   $ 14,411   $ 14,303   $ 14,196   $ 14,089
   

 

 

 

 

 

 

 

Publicly Traded Equity Securities

 

The values of our equity investments in several publicly traded companies are subject to market price volatility. The following tables present the hypothetical changes in fair value of publicly traded equity securities, excluding hedged equity securities, held at July 30, 2005 and July 31, 2004 that are sensitive to changes in market price (in millions):

 

     VALUATION OF SECURITIES
GIVEN AN X% DECREASE IN
EACH STOCK’S PRICE


   FAIR VALUE
AS OF
JULY 30,
2005


   VALUATION OF SECURITIES
GIVEN AN X% INCREASE IN
EACH STOCK’S PRICE


         (35%)    

       (25%)    

       (15%)    

          15%    

       25%    

       35%    

Publicly traded equity securities

   $ 498    $ 575    $ 651    $ 766    $ 881    $ 958    $ 1,034
     VALUATION OF SECURITIES
GIVEN AN X% DECREASE IN
EACH STOCK’S PRICE


   FAIR VALUE
AS OF
JULY 31,
2004


   VALUATION OF SECURITIES
GIVEN AN X% INCREASE IN
EACH STOCK’S PRICE


         (35%)    

       (25%)    

       (15%)    

          15%    

       25%    

       35%    

Publicly traded equity securities

   $ 737    $ 851    $ 964    $ 1,134    $ 1,304    $ 1,418    $ 1,531

 

2005 Annual Report  37


QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK —(Continued)

 

Our equity portfolio consists of securities with characteristics that most closely match the Standard & Poor’s 500 Index or NASDAQ Composite Index. These equity securities are held for purposes other than trading. The modeling technique used measures the change in fair value arising from selected hypothetical changes in each stock’s price. Stock price fluctuations of plus or minus 15%, 25%, and 35% were selected based on the probability of their occurrence. Our impairment charges on certain publicly traded equity securities were $5 million and $412 million during fiscal 2005 and 2003, respectively. There were no impairment charges on publicly traded equity securities in fiscal 2004. The impairment charges were related to the decline in the fair value of certain publicly traded equity securities below their cost basis that were judged to be other-than-temporary.

 

Investments In Privately Held Companies

 

We have invested in privately held companies, some of which are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire initial investment in these companies. These investments are primarily carried at cost, which as of July 30, 2005 was $421 million, compared with $354 million at July 31, 2004, and are recorded in other assets in the Consolidated Balance Sheets. Our impairment charges on investments in privately held companies were $39 million, $112 million, and $281 million during fiscal 2005, 2004, and 2003, respectively.

 

Our evaluation of equity investments in private and public companies is based on the fundamentals of the businesses, including, among other factors, the nature of their technologies and potential for financial return to us.

 

DERIVATIVE INSTRUMENTS

 

Foreign Currency Derivatives

 

We enter into foreign exchange forward contracts to reduce the short-term effect of foreign currency fluctuations on receivables, investments, and payables, primarily denominated in Australian, Canadian, Japanese, and several European currencies, including the euro and British pound. Our market risks associated with our foreign currency receivables, investments, and payables relate primarily to variances from our forecasted foreign currency transactions and balances.

 

Approximately 75% of our operating expenses are U.S.-dollar denominated. In order to reduce variability in operating expenses caused by the remaining non-U.S.-dollar denominated operating expenses, we periodically hedge certain foreign currency forecasted transactions with currency options with maturities up to 18 months. These hedging programs are not designed to provide foreign currency protection over longer time horizons. In designing a specific hedging approach, we consider several factors, including offsetting exposures, significance of exposures, costs associated with entering into a particular hedge instrument, and potential effectiveness of the hedge. The gains and losses on foreign exchange contracts mitigate the variability in operating expenses associated with currency movements. Primarily because of our limited currency exposure to date, the effect of foreign currency fluctuations has not been material to our Consolidated Financial Statements. In fiscal 2005, the effect of foreign currency fluctuations, net of hedging, increased total research and development, sales and marketing, and general and administrative expenses by approximately 2% compared with fiscal 2004 and by approximately 2.5% in fiscal 2004 compared with fiscal 2003. The impact of foreign currency fluctuations on sales has not been material because our sales are primarily denominated in U.S. dollars.

 

Foreign exchange forward and option contracts as of July 30, 2005 are summarized as follows (in millions):

 

     Notional Amount

   Fair Value

 

Forward contracts:

               

Purchased

   $ 1,011    $ (5 )

Sold

   $ 450    $ 9  

Option contracts:

               

Purchased

   $ 1,028    $ 10  

Sold

   $ 1,002    $ (7 )

 

Our foreign exchange forward contracts related to current assets and liabilities generally range from one to three months in original maturity. Additionally, we have entered into foreign exchange forward contracts related to long-term customer financings with maturities of up to two years. The foreign exchange forward contracts related to investments generally have maturities of less than one year. Currency option contracts generally have maturities of less than 18 months. We do not enter into foreign exchange forward and option contracts for trading purposes. We do not expect gains or losses on these derivative instruments to have a material impact on our financial results. See Note 8 to the Consolidated Financial Statements.

 

38  Cisco Systems, Inc.


QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK —(Continued)

 

Interest Rate Derivatives

 

Our primary objective for holding fixed income and debt securities is to increase our investment return while preserving principal and managing risk. To realize these objectives, we may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. As of July 30, 2005, we had entered into $1 billion of interest rate swaps designated as fair value hedges. Under the interest rate swap contracts, we make fixed-rate interest payments and receive interest payments based on the London InterBank Offered Rate (LIBOR). The effect of these swaps is to convert fixed-rate returns to LIBOR-based returns on a portion of our fixed income portfolio. The gains and losses related to changes in the value of the interest rate swaps are included in other income (loss), net, in the Consolidated Statements of Operations and offset the changes in fair value of the underlying hedged investment. As of July 30, 2005, the fair value of the interest rate swaps was $15 million. There were no interest rate derivatives as of July 31, 2004.

 

Equity Derivatives

 

We maintain a portfolio of publicly traded equity securities which are subject to price risk. We may hold equity securities for strategic purposes or to provide diversification for our overall investment portfolio. In order to manage our exposure to changes in the value of certain equity securities, we may, from time to time, enter into equity derivative contracts. As of July 30, 2005, we had entered into forward sale and option agreements on certain publicly traded equity securities designated as fair value hedges. The gains and losses due to changes in the value of the hedging instruments are included in other income (loss), net, in the Consolidated Statements of Operations and offset the change in the fair value of the underlying hedged investment. As of July 30, 2005 the notional and fair value amounts of the derivatives were $198 million and $19 million, respectively. There were no equity derivatives as of July 31, 2004.

 

2005 Annual Report  39


CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per-share amounts)

 

Years Ended


   July 30, 2005

   July 31, 2004

    July 26, 2003

 

NET SALES:

                       

Product

   $ 20,853    $ 18,550     $ 15,565  

Service

     3,948      3,495       3,313  
    

  


 


Total net sales

     24,801      22,045       18,878  
    

  


 


COST OF SALES:

                       

Product

     6,758      5,766       4,594  

Service

     1,372      1,153       1,051  
    

  


 


Total cost of sales

     8,130      6,919       5,645  
    

  


 


GROSS MARGIN

     16,671      15,126       13,233  

OPERATING EXPENSES:

                       

Research and development

     3,322      3,192       3,135  

Sales and marketing

     4,721      4,530       4,116  

General and administrative

     959      867       702  

Amortization of purchased intangible assets

     227      242       394  

In-process research and development

     26      3       4  
    

  


 


Total operating expenses

     9,255      8,834       8,351  
    

  


 


OPERATING INCOME

     7,416      6,292       4,882  

Interest income

     552      512       660  

Other income (loss), net

     68      188       (529 )
    

  


 


Interest and other income (loss), net

     620      700       131  
    

  


 


INCOME BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE

     8,036      6,992       5,013  

Provision for income taxes

     2,295      2,024       1,435  
    

  


 


INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE

     5,741      4,968       3,578  

Cumulative effect of accounting change, net of tax

     —        (567 )     —    
    

  


 


NET INCOME

   $ 5,741    $ 4,401     $ 3,578  
    

  


 


Income per share before cumulative effect of accounting change—basic

   $ 0.88    $ 0.73     $ 0.50  
    

  


 


Income per share before cumulative effect of accounting change—diluted

   $ 0.87    $ 0.70     $ 0.50  
    

  


 


Net income per share—basic

   $ 0.88    $ 0.64     $ 0.50  
    

  


 


Net income per share—diluted

   $ 0.87    $ 0.62     $ 0.50  
    

  


 


Shares used in per-share calculation—basic

     6,487      6,840       7,124  
    

  


 


Shares used in per-share calculation—diluted

     6,612      7,057       7,223  
    

  


 


 

See Notes to Consolidated Financial Statements.

 

40  Cisco Systems, Inc.


CONSOLIDATED BALANCE SHEETS

(in millions, except par value)

 

     July 30, 2005

   July 31, 2004

ASSETS

             

Current assets:

             

Cash and cash equivalents

   $ 4,742    $ 3,722

Short-term investments

     2,227      4,947

Accounts receivable, net of allowance for doubtful accounts of $162 at July 30, 2005 and $179 at July 31, 2004

     2,216      1,825

Inventories

     1,297      1,207

Deferred tax assets

     1,582      1,827

Prepaid expenses and other current assets

     967      815
    

  

Total current assets

     13,031      14,343

Investments

     9,086      10,598

Property and equipment, net

     3,320      3,290

Goodwill

     5,295      4,198

Purchased intangible assets, net

     549      325

Other assets

     2,602      2,840
    

  

TOTAL ASSETS

   $ 33,883    $ 35,594
    

  

LIABILITIES AND SHAREHOLDERS’ EQUITY

             

Current liabilities:

             

Accounts payable

   $ 735    $ 657

Income taxes payable

     1,511      963

Accrued compensation

     1,317      1,466

Deferred revenue

     3,854      3,527

Other accrued liabilities

     2,094      2,090
    

  

Total current liabilities

     9,511      8,703

Deferred revenue

     1,188      975
    

  

Total liabilities

     10,699      9,678
    

  

Commitments and contingencies (Note 8)

             

Minority interest

     10      90

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; 6,331 and 6,735 shares issued and outstanding at July 30, 2005 and July 31, 2004, respectively

     22,394      22,450

Retained earnings

     506      3,164

Accumulated other comprehensive income

     274      212
    

  

Total shareholders’ equity

     23,174      25,826
    

  

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 33,883    $ 35,594
    

  

 

See Notes to Consolidated Financial Statements.

 

2005 Annual Report  41


CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

 

Years Ended


   July 30, 2005

    July 31, 2004

    July 26, 2003

 

Cash flows from operating activities:

                        

Net income

   $ 5,741     $ 4,401     $ 3,578  

Adjustments to reconcile net income to net cash provided by operating activities:

                        

Cumulative effect of accounting change, net of tax

     —         567       —    

Depreciation and amortization

     1,009       1,199       1,463  

Stock-based compensation related to acquisitions and investments

     165       244       128  

Provision for doubtful accounts

     —         19       (59 )

Provision for inventory

     221       205       70  

Deferred income taxes

     55       552       (14 )

Tax benefits from employee stock option plans

     35       537       132  

In-process research and development

     26       3       4  

Net (gains) losses and impairment charges on investments

     (95 )     (155 )     520  

Change in operating assets and liabilities, net of effects of acquisitions:

                        

Accounts receivable

     (373 )     (488 )     (125 )

Inventories

     (305 )     (538 )     (17 )

Prepaid expenses and other current assets

     (58 )     (42 )     (61 )

Lease receivables, net

     (163 )     (159 )     79  

Accounts payable

     62       54       35  

Income taxes payable

     947       260       (125 )

Accrued compensation

     (154 )     (7 )     104  

Deferred revenue

     541       688       (84 )

Other accrued liabilities

     (86 )     (378 )     (309 )
    


 


 


Net cash provided by operating activities

     7,568       6,962       5,319  
    


 


 


Cash flows from investing activities:

                        

Purchases of short-term investments

     (5,483 )     (12,206 )     (9,396 )

Proceeds from sales and maturities of short-term investments

     10,465       13,570       10,319  

Purchases of investments

     (14,831 )     (20,848 )     (18,063 )

Proceeds from sales and maturities of investments

     14,165       20,757       12,497  

Acquisition of property and equipment

     (692 )     (613 )     (717 )

Acquisition of businesses, net of cash and cash equivalents

     (911 )     (104 )     33  

Change in investments in privately held companies

     (171 )     (13 )     (223 )

Purchase of minority interest of Cisco Systems, K.K. (Japan)

     (34 )     (71 )     (59 )

Other

     106       153       94  
    


 


 


Net cash provided by (used in) investing activities

     2,614       625       (5,515 )
    


 


 


Cash flows from financing activities:

                        

Issuance of common stock

     1,087       1,257       578  

Repurchase of common stock

     (10,235 )     (9,080 )     (5,984 )

Other

     (14 )     33       43  
    


 


 


Net cash used in financing activities

     (9,162 )     (7,790 )     (5,363 )
    


 


 


Net increase (decrease) in cash and cash equivalents

     1,020       (203 )     (5,559 )

Cash and cash equivalents, beginning of fiscal year

     3,722       3,925       9,484  
    


 


 


Cash and cash equivalents, end of fiscal year

   $ 4,742     $ 3,722     $ 3,925  
    


 


 


 

See Notes to Consolidated Financial Statements.

 

42  Cisco Systems, Inc.


CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in millions)

 

     Shares of
Common
Stock


   

Common Stock
and

Additional
Paid-In Capital


    Retained
Earnings


    Accumulated
Other
Comprehensive
Income (Loss)


    Total
Shareholders’
Equity


 

BALANCE AT JULY 27, 2002

   7,303     $ 20,950     $ 7,733     $ (27 )   $ 28,656  

Net income

   —         —         3,578       —         3,578  

Change in unrealized gains and losses on investments, net of tax

   —         —         —         352       352  

Other

   —         —         —         29       29  
                                  


Comprehensive income

                                   3,959  
                                  


Issuance of common stock

   68       578       —         —         578  

Repurchase of common stock

   (424 )     (1,232 )     (4,752 )     —         (5,984 )

Tax benefits from employee stock option plans

   —         132       —         —         132  

Purchase acquisitions

   51       557       —         —         557  

Stock-based compensation related to acquisitions and investments

   —         131       —         —         131  
    

 


 


 


 


BALANCE AT JULY 26, 2003

   6,998     $ 21,116     $ 6,559     $ 354     $ 28,029  

Net income

   —         —         4,401       —         4,401  

Change in unrealized gains and losses on investments, net of tax

   —         —         —         (161 )     (161 )

Other

   —         —         —         19       19  
                                  


Comprehensive income

                                   4,259  
                                  


Issuance of common stock

   122       1,257       —         —         1,257  

Repurchase of common stock

   (408 )     (1,284 )     (7,796 )     —         (9,080 )

Tax benefits from employee stock option plans

   —         537       —         —         537  

Purchase acquisitions

   —         6       —         —         6  

Stock-based compensation related to acquisitions and investments

   —         244       —         —         244  

Cumulative effect of accounting change, net of tax

   —         567       —         —         567  

Acquisition of Andiamo Systems, Inc.

   23       7       —         —         7  
    

 


 


 


 


BALANCE AT JULY 31, 2004

   6,735     $ 22,450     $ 3,164     $ 212     $ 25,826  

Net income

   —         —         5,741       —         5,741  

Change in unrealized gains and losses on investments, net of tax

   —         —         —         52       52  

Other

   —         —         —         10       10  
                                  


Comprehensive income

                                   5,803  
                                  


Issuance of common stock

   112       1,087       —         —         1,087  

Repurchase of common stock

   (540 )     (1,836 )     (8,399 )     —         (10,235 )

Tax benefits from employee stock option plans

   —         35       —         —         35  

Acquisitions

   24       504       —         —         504  

Stock-based compensation related to acquisitions and investments

   —         154       —         —         154  
    

 


 


 


 


BALANCE AT JULY 30, 2005

   6,331     $ 22,394     $ 506     $ 274     $ 23,174  
    

 


 


 


 


 

Supplemental Information

 

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of July 30, 2005, the Company’s Board of Directors has authorized the repurchase of up to $35 billion of common stock under this program. For additional information regarding stock repurchases, see Note 9 to the Consolidated Financial Statements. The purchase price of shares of common stock repurchased was reflected as a reduction to retained earnings and common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock option plans are recorded as an increase to common stock and additional paid-in capital. The stock repurchases since the inception of this program are summarized in the table below (in millions):

 

     Shares of
Common
Stock


  

Common Stock
and

Additional
Paid-In Capital


   Retained
Earnings


   Accumulated
Other
Comprehensive
Income (Loss)


   Total
Shareholders’
Equity


Repurchases of common stock

   1,496    $ 4,702    $ 22,451    $ —      $ 27,153

 

See Notes to Consolidated Financial Statements.

 

2005 Annual Report  43


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. DESCRIPTION OF BUSINESS

 

Cisco Systems, Inc. (the “Company” or “Cisco”) manufactures and sells networking and communications products and provides services associated with that equipment and its use. The Company’s products are installed at corporations, public institutions, telecommunication companies, and commercial businesses and are also found in personal residences. Cisco provides a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world.

 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Fiscal Year    The Company’s fiscal year is the 52 or 53 weeks ending on the last Saturday in July. Fiscal 2005 and 2003 were 52-week fiscal years, and fiscal 2004 was a 53-week fiscal year.

 

Principles of Consolidation    The Consolidated Financial Statements include the accounts of Cisco Systems, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.

 

Cash and Cash Equivalents    The Company considers all highly liquid investments purchased with an original or remaining maturity of less than three months at the date of purchase to be cash equivalents. Cash and cash equivalents are maintained with various financial institutions.

 

Investments    The Company’s investments comprise U.S. government notes and bonds; corporate notes, bonds, and asset-backed securities; municipal notes and bonds; and publicly traded equity securities. Investments with remaining maturities of less than one year are considered to be short-term. These investments are held in the custody of several major financial institutions. The specific identification method is used to determine the cost basis of fixed income securities disposed of. The weighted-average method is used to determine the cost basis of publicly traded equity securities disposed of. At July 30, 2005 and July 31, 2004, the Company’s investments were classified as available-for-sale. These investments are recorded in the Consolidated Balance Sheets at fair value. Unrealized gains and losses on these investments, to the extent the investments are unhedged, are included as a separate component of accumulated other comprehensive income, net of tax.

 

The Company recognizes an impairment charge when a decline in the fair value of its investments below the cost basis are judged to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the Company’s cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

 

The Company also has investments in privately held companies. These investments are included in other assets in the Consolidated Balance Sheets and are primarily carried at cost. The Company monitors these investments for impairment and makes appropriate reductions in carrying values if the Company determines that an impairment charge is required based primarily on the financial condition and near-term prospects of these companies.

 

Inventories    Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. The Company provides inventory allowances based on excess and obsolete inventories determined primarily by future demand forecasts. The allowance is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and charged to the provision for inventory, which is a component of cost of sales. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

 

Fair Value of Financial Instruments    The fair value of certain of the Company’s financial instruments, including cash and cash equivalents, accrued compensation, and other accrued liabilities, approximate cost because of their short maturities. The fair value of investments is determined using quoted market prices for those securities or similar financial instruments.

 

Concentrations of Risk    Cash and cash equivalents are maintained with several financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with financial institutions of reputable credit and therefore bear minimal credit risk.

 

The Company performs ongoing credit evaluations of its customers and, with the exception of certain financing transactions, does not require collateral from its customers. The Company’s customers are primarily in the service provider and enterprise markets. The Company receives certain of its components from sole suppliers. Additionally, the Company relies on a limited number of contract manufacturers and suppliers to provide manufacturing services for its products. The inability of a contract manufacturer or supplier to fulfill supply requirements of the Company could materially impact future operating results.

 

44  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Revenue Recognition    The Company’s networking and communications products are integrated with software that is essential to the functionality of the equipment. Additionally, the Company provides unspecified software upgrades and enhancements related to the equipment through its maintenance contracts for most of its products. Accordingly, the Company accounts for revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations.

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which is typically from one to three years. Advanced services revenue is recognized upon delivery or completion of performance.

 

When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. Fair value for each element is established based on the sales price charged when the same element is sold separately.

 

The Company uses distributors that stock inventory and typically sell to systems integrators, service providers, and other resellers. In addition, certain products are sold through retail partners. The Company refers to these sales through distributors and retail partners as its two-tier system of sales to the end customer. Revenue from distributors and retail partners is recognized based on a sell-through method using information provided by them. Distributors and retail partners participate in various cooperative marketing and other programs, and the Company maintains estimated accruals and allowances for these programs. The Company accrues for warranty costs, sales returns, and other allowances based on its historical experience.

 

Allowance for Doubtful Accounts    The allowance for doubtful accounts is based on the Company’s assessment of the collectibility of customer accounts. The Company regularly reviews the allowance by considering factors such as historical experience, credit quality, the age of the accounts receivable balances, and current economic conditions that may affect a customer’s ability to pay.

 

Lease Receivables    The Company provides a variety of lease financing services to its customers to build, maintain, and upgrade their networks. Lease receivables primarily represent the principal balance remaining in sales-type and direct-financing leases under these programs, net of allowances. These leases typically have two- to three-year terms and are usually collateralized by a security interest in the underlying assets.

 

Advertising Costs    The Company expenses all advertising costs as incurred, and the amounts were not material for all periods presented.

 

Software Development Costs    Software development costs required to be capitalized pursuant to Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” have not been material to date. Software development costs for internal use required to be capitalized pursuant to Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” have also not been material to date.

 

Depreciation and Amortization    Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. Estimated useful lives of 25 years are used for buildings. Estimated useful lives of 30 to 36 months are used for computer equipment and related software and five years for furniture and fixtures. Estimated useful lives of up to five years are used for production, engineering, and other equipment. Depreciation of operating lease assets is computed based on the respective lease terms, which generally range up to three years. Depreciation and amortization of leasehold improvements are computed using the shorter of the remaining lease terms or five years.

 

Goodwill and Purchased Intangible Assets    Goodwill is tested for impairment on an annual basis and between annual tests in certain circumstances, and written down when impaired. Based on the impairment tests performed, there was no impairment of goodwill in fiscal 2005, 2004, or 2003. Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. Purchased intangible assets are carried at cost, less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally two to five years.

 

Income Taxes    Income tax expense is based on pretax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts. Valuation allowances are recorded to reduce deferred tax assets to the amount that will more likely than not be realized.

 

2005 Annual Report  45


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 shares and dilutive potential common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is antidilutive. Dilutive potential common shares consist primarily of employee stock options and restricted common stock.

 

Foreign Currency Translation    Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment, where that local currency is the functional currency, are translated to U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments directly recorded to a separate component of accumulated other comprehensive income. Income and expense accounts are translated at average exchange rates during the year. Translation adjustments are recorded in other income (loss), net, where the U.S. dollar is the functional currency.

 

Derivative Instruments    The Company recognizes derivative instruments as either assets or liabilities in the Consolidated Balance Sheets and measures 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.

 

For a derivative instrument 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 instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated 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 derivative instruments that are not designated as accounting hedges, changes in fair value are recognized in earnings in the period of change.

 

The fair value of derivative instruments as of July 30, 2005 was $41 million and the amount was not material as of July 31, 2004. The changes in fair value during fiscal 2005 and 2004 were not material. During fiscal 2005 and 2004, there were no significant gains or losses recognized in earnings for hedge ineffectiveness. The Company did not discontinue any hedges because it was probable that the original forecasted transactions would not occur.

 

Consolidation of Variable Interest Entities    Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), was issued in January 2003. FIN 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46(R)”), was issued in December 2003. The Company adopted FIN 46(R) effective January 24, 2004, and recorded a noncash cumulative stock compensation charge of $567 million, net of tax, relating to the consolidation of Andiamo Systems, Inc. (“Andiamo”). For additional information regarding Andiamo, see Note 3 to these Consolidated Financial Statements. For additional information regarding variable interest entities, see Note 8 to these Consolidated Financial Statements.

 

Minority Interest    The Company consolidated its investment in a venture fund managed by SOFTBANK Corp. and its affiliates (“SOFTBANK”). As of July 30, 2005, minority interest of $7 million represents SOFTBANK’s share of the venture fund. The remaining minority interest of $3 million represents the preferred stockholders’ proportionate share of the equity of Cisco Systems, K.K. (Japan). At July 30, 2005, the Company owned all issued and outstanding common stock, amounting to 99.0% of the aggregate voting rights of Cisco Systems, K.K. (Japan). Each share of preferred stock is convertible into one share of common stock of Cisco Systems, K.K. (Japan) at any time at the option of the holder.

 

Use of Estimates    The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Estimates are used for revenue recognition, allowance for doubtful accounts and sales returns, allowance for inventory, warranty costs, investment impairments, goodwill impairments, income taxes, and loss contingencies, among others. The actual results experienced by the Company may differ materially from management’s estimates.

 

Impairment of Long-Lived Assets    Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability of long-lived assets is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

 

46  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Employee Stock Benefit Plans    The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the intrinsic value method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Company’s Consolidated Statements of Operations.

 

Pro forma information regarding option grants made to the Company’s employees and directors and common stock issued pursuant to the Employee Stock Purchase Plan is based on specified valuation techniques that produce estimated compensation charges. The following table reflects the pro forma information (in millions, except per-share amounts):

 

Years Ended


   July 30, 2005

    July 31, 2004

    July 26, 2003

 

Net income—as reported

   $ 5,741     $ 4,401     $ 3,578  

Pro forma stock-based compensation expense

     (1,628 )     (2,025 )     (2,098 )

Pro forma tax benefit

     594       810       839  
    


 


 


Pro forma stock-based compensation expense, net of tax

     (1,034 )     (1,215 )     (1,259 )
    


 


 


Net income—pro forma

   $ 4,707     $ 3,186     $ 2,319  
    


 


 


Basic net income per share—as reported

   $ 0.88     $ 0.64     $ 0.50  
    


 


 


Diluted net income per share—as reported

   $ 0.87     $ 0.62     $ 0.50  
    


 


 


Basic net income per share—pro forma

   $ 0.73     $ 0.47     $ 0.33  
    


 


 


Diluted net income per share—pro forma

   $ 0.71     $ 0.45     $ 0.32  
    


 


 


 

The value of each option grant is estimated as of the date of grant using the Black-Scholes option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models do not provide a reliable measure of the fair value of the Company’s employee stock options. See Note 10 for additional information regarding this pro forma information.

 

Recent Accounting Pronouncement    In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based compensation payments and supersedes the Company’s current accounting under APB 25. SFAS 123(R) is effective for all annual periods beginning after June 15, 2005. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to the adoption of SFAS 123(R).

 

The Company adopted SFAS 123(R) in the first quarter of fiscal 2006 and will continue to evaluate the impact of SFAS 123(R) on its operating results and financial condition. The pro forma information presented above and in Note 10 presents the estimated compensation charges under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.” The Company’s assessment of the estimated compensation charges is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the Company’s stock price volatility and employee stock option exercise behaviors. The Company will recognize the compensation cost for stock-based awards issued after July 30, 2005 on a straight-line basis over the requisite service period for the entire award.

 

Reclassifications    Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation.

 

2005 Annual Report  47


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

3. BUSINESS COMBINATIONS

 

Purchase Acquisitions

 

The Company completed the following purchase acquisitions and asset purchases in fiscal 2005:

 

    Acquisition of Actona Technologies, Inc. to expand the functionality of its branch-office access routers with intelligent network services that are designed to allow users at remote sites to access and transfer files as quickly and easily as users at headquarters sites. The acquired technology is also designed to allow enterprises to centralize file servers and storage and better protect and manage their remote office data.

 

    Acquisition of Airespace, Inc. to add to its portfolio of wireless local-area networking (WLAN) solutions and to add advanced features and capabilities to its existing WLAN product portfolio.

 

    Acquisition of dynamicsoft, Inc. to add Session Initiation Protocol (SIP)-based solutions to its solutions portfolio for the broadband communications market that are designed to allow telecommunications service providers to deliver interactive communications, such as conferencing, voice, and instant messaging, over an IP network.

 

    Acquisition of FineGround Networks, Inc. to integrate technology with Cisco’s to provide customers with advanced application-acceleration access networks for highly secure and optimized delivery of Web-based applications.

 

    Acquisition of Jahi Networks Inc. to add network management appliances aimed at simplifying interfaces for device management, deployment, and configuration of networks.

 

    Purchase of assets of NetSift, Inc. to accelerate the integration of additional packet processing capabilities into future core Cisco platforms, such as modular switching.

 

    Acquisition of NetSolve, Incorporated to add remote network-management services, including real-time monitoring of IP communications networks, network security software, and network devices, to its solutions offered to specialized resellers.

 

    Acquisition of Parc Technologies Limited to add to its planning and optimization tools for Multiprotocol Label Switching (MPLS) traffic engineering. The acquired technology, route server algorithms, is designed to break up network routing problems involving complex prioritization constraints and to help service providers deliver higher-quality services while improving network utilization and reducing capital expenditures.

 

    Acquisition of P–Cube Inc. to provide additional control and management capabilities for advanced IP services, such as identifying subscribers, classifying applications, and accurately billing for content-based services, to service providers.

 

    Acquisition of Perfigo, Inc. to expand the offerings in the Network Admission Control (NAC) program, an industrywide initiative, which is designed to enforce endpoint policy compliance and improve the security of networks. The acquired technology is designed to analyze endpoint devices, such as computers, and scan for vulnerabilities.

 

    Acquisition of the intellectual property and select other assets of, and hiring of a majority of the engineering team from, Procket Networks, Inc. to add to its portfolio of intellectual property and to add a team of silicon and software architects.

 

    Acquisition of Protego Networks, Inc. to add network security monitoring and management products designed with the capability to detect, correlate, and mitigate network threats.

 

    Acquisition of Sipura Technology, Inc. to provide voice over IP (VoIP) technology and expertise for the Linksys division’s line of VoIP networking devices.

 

    Acquisition of Topspin Communications, Inc. to add server fabric switches, a new class of server networking equipment that is designed to help improve resource utilization and reduce equipment and management costs, to its switching product portfolio consisting of network and storage switches.

 

48  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

A summary of the acquisitions and asset purchases is as follows (in millions):

 

Acquisition


   Shares Issued

   Purchase
Consideration


   Assumed
Liabilities


   In-Process
R&D
Expense


   Goodwill

   Purchased
Intangible
Assets


Actona Technologies, Inc.

   —      $ 90    $ 4    $ 4    $ 66    $ 21

Airespace, Inc.

   23      447      11      3      337      95

dynamicsoft, Inc.

   —        69      19      2      39      25

FineGround Networks, Inc.

   —        72      3      1      45      21

Jahi Networks Inc.

   —        14      3      —        12      3

NetSift, Inc.

   —        25      —        —        —        38

NetSolve, Incorporated

   —        146      6      —        78      31

Parc Technologies Limited

   —        14      5      —        6      6

P-Cube Inc.

   —        213      17      6      150      56

Perfigo, Inc.

   —        73      2      2      49      20

Procket Networks, Inc.

   —        92      10      —        76      26

Protego Networks, Inc.

   —        64      5      3      44      22

Sipura Technology, Inc.

   —        19      4      1      1      20

Topspin Communications, Inc.

   —        253      23      4      164      67
    
  

  

  

  

  

Total

   23    $ 1,591    $ 112    $ 26    $ 1,067    $ 451
    
  

  

  

  

  

 

Under the terms of the definitive agreements, the purchase consideration for the acquisitions in fiscal 2005 consisted of cash and shares of Cisco common stock and stock options assumed. The purchase consideration for the Company’s acquisitions is also allocated to tangible assets and deferred stock-based compensation. Deferred stock-based compensation represents the intrinsic value of the unvested portion of any restricted shares exchanged, options assumed, or options canceled and replaced with the Company’s options and is amortized as stock-based compensation related to acquisitions over the remaining respective vesting periods. The balance for deferred stock-based compensation is reflected as a reduction to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity. The following table presents the activity of deferred stock-based compensation (in millions):

 

     July 30, 2005

    July 31, 2004

    July 26, 2003

 

Balance at beginning of fiscal year

   $ 153     $ 262       182  

Acquisitions

     128       94       227  

Amortization

     (140 )     (186 )     (131 )

Canceled unvested options

     (4 )     (17 )     (16 )
    


 


 


Balance at end of fiscal year

   $ 137     $ 153     $ 262  
    


 


 


 

In connection with the asset purchase of NetSift, Inc., the Company may be required to pay certain additional amounts of up to $5 million contingent upon achieving certain agreed-upon technology and other milestones. In addition, in connection with the acquisition of Sipura Technology, Inc., the Company may be required to pay an additional amount of $50 million over a four-year period contingent upon continued employment of certain employees with the Company. In each case, any additional amounts paid will be recorded as compensation expense.

 

The Company’s methodology for allocating the purchase price for purchase acquisitions to in-process research and development (“in-process R&D”) is determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist. Total in-process R&D expense in fiscal 2005, 2004, and 2003 was $26 million, $3 million, and $4 million, respectively.

 

2005 Annual Report  49


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

A summary of the purchase transactions completed in fiscal 2004 and 2003 is as follows (in millions):

 

Acquisition


   Shares
Issued


   Purchase
Consideration


   Assumed
Liabilities


   In-Process
R&D Expense


   Goodwill

   Purchased
Intangible
Assets


FISCAL 2004

                                       

Latitude Communications, Inc.

   —      $ 86    $ 29    $ 1    $ 60    $ 16

Riverhead Networks, Inc.

   —        36      6      2      25      7

Twingo Systems, Inc.

   —        5      1      —        5      1
    
  

  

  

  

  

Total

   —      $ 127    $ 36    $ 3    $ 90    $ 24
    
  

  

  

  

  

FISCAL 2003

                                       

AYR Networks, Inc.

   9    $ 96    $ 1    $ —      $ 59    $ —  

Okena, Inc.

   9      152      8      3      96      45

Psionic Software, Inc.

   1      11      2      —        8      5

SignalWorks, Inc.

   1      16      2      1      9      4

The Linksys Group, Inc.

   29      480      111      —        221      114
    
  

  

  

  

  

Total

   49    $ 755    $ 124    $ 4    $ 393    $ 168
    
  

  

  

  

  

 

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, individually or in the aggregate, were not material to the Company’s results.

 

Purchased Intangible Assets

 

The following table presents details of the purchased intangible assets acquired during fiscal 2005 and 2004 (in millions, except years):

 

    TECHNOLOGY

  CUSTOMER RELATIONSHIPS

  OTHER

   
    Estimated
Useful Life
(in Years)


  Amount

  Estimated
Useful Life
(in Years)


  Amount

  Estimated
Useful Life
(in Years)


  Amount

  Total

FISCAL 2005

                                   

Actona Technologies, Inc.

  4.5   $ 21   —     $ —     —     $ —     $ 21

Airespace, Inc.

  4.5     78   3.5     17   —       —       95

dynamicsoft, Inc.

  4.0     17   2.5     6   2.0     2     25

FineGround Networks, Inc.

  4.5     15   4.5     6   —       —       21

Jahi Networks Inc.

  4.0     3   —       —     —       —       3

NetSift, Inc.

  9.0     38   —       —     —       —       38

NetSolve, Incorporated

  3.5     24   5.5     7   —       —       31

Parc Technologies Limited

  5.5     6   —       —     —       —       6

P-Cube Inc.

  4.5     39   2.5     17   —       —       56

Perfigo, Inc.

  4.0     14   2.5     6   —       —       20

Procket Networks, Inc.

  7.5     22   2.5     3   1.0     1     26

Protego Networks, Inc.

  4.0     17   2.5     5   —       —       22

Sipura Technology, Inc.

  3.5     15   3.5     5   —       —       20

Topspin Communications, Inc.

  4.5     39   6.0     28   —       —       67
       

     

     

 

Total

      $ 348       $ 100       $ 3   $ 451
       

     

     

 

FISCAL 2004

                                   

Latitude Communications, Inc.

  4.5   $ 4   4.0   $ 11   7.0   $ 1   $ 16

Riverhead Networks, Inc.

  4.5     5   3.5     2   —       —       7

Twingo Systems, Inc.

  3.5     1   —       —     —       —       1
       

     

     

 

Total

      $ 10       $ 13       $ 1   $ 24
       

     

     

 

 

50  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables present details of the Company’s total purchased intangible assets (in millions):

 

July 30, 2005


   Gross

   Accumulated
Amortization


    Net

Technology

   $ 880    $ (501 )   $ 379

Customer relationships

     188      (53 )     135

Trade names

     64      (35 )     29

Other

     66      (60 )     6
    

  


 

Total

   $ 1,198    $ (649 )   $ 549
    

  


 

July 31, 2004


               

Technology

   $ 627    $ (452 )   $ 175

Technology licenses

     252      (239 )     13

Customer relationships

     88      (20 )     68

Trade names

     90      (43 )     47

Other

     131      (109 )     22
    

  


 

Total

   $ 1,188    $ (863 )   $ 325
    

  


 

 

The following table presents details of the amortization expense of purchased intangible assets as reported in the Consolidated Statements of Operations (in millions):

 

Years Ended


   July 30, 2005

   July 31, 2004

   July 26, 2003

Reported as:

                    

Cost of sales

   $ —      $ 13    $ 15

Operating expenses

     227      242      394
    

  

  

Total

   $ 227    $ 255    $ 409
    

  

  

 

The estimated future amortization expense of purchased intangible assets as of July 30, 2005, is as follows (in millions):

 

Fiscal Year


   Amount

2006

   $ 187

2007

     141

2008

     106

2009

     65

2010

     24

Thereafter

     26
    

Total

   $ 549
    

 

2005 Annual Report  51


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Goodwill

 

The following tables present the changes in goodwill allocated to the Company’s reportable segments during fiscal 2005 and 2004 (in millions):

 

     Balance at
July 31, 2004


   Acquired

   Balance at
July 30, 2005


Americas

   $ 2,716    $ 607    $ 3,323

EMEA

     678      300      978

Asia Pacific

     171      95      266

Japan

     633      95      728
    

  

  

Total

   $ 4,198    $ 1,097    $ 5,295
    

  

  

     Balance at
July 26, 2003


   Acquired

   Balance at
July 31, 2004


Americas

   $ 2,642    $ 74    $ 2,716

EMEA

     668      10      678

Asia Pacific

     167      4      171

Japan

     566      67      633
    

  

  

Total

   $ 4,043    $ 155    $ 4,198
    

  

  

 

In fiscal 2005, the Company purchased a portion of the minority interest of Cisco Systems, K.K. (Japan). As a result, the Company increased its ownership from 97.6% to 99.0% of the voting rights of Cisco Systems, K.K. (Japan) and recorded goodwill of $30 million, which was included in the preceding table.

 

Acquisition of Variable Interest Entities

 

In April 2001, the Company entered into a commitment to provide convertible debt funding of approximately $84 million to Andiamo, a privately held storage switch developer. This debt was convertible into approximately 44% of the equity of Andiamo. In connection with this investment, the Company obtained a call option that provided the Company the right to purchase Andiamo. The purchase price under the call option was based on a valuation of Andiamo using a negotiated formula. On August 19, 2002, the Company entered into a definitive agreement to acquire Andiamo, which represented the exercise of its rights under the call option. The Company also entered into a commitment to provide nonconvertible debt funding to Andiamo of approximately $100 million through the close of the acquisition. Substantially all of the convertible debt funding of $84 million and nonconvertible debt funding of $100 million was expensed as R&D costs.

 

The Company adopted FIN 46(R) effective January 24, 2004. The Company evaluated its debt investment in Andiamo and determined that Andiamo was a variable interest entity under FIN 46(R). The Company concluded that the Company was the primary beneficiary as defined by FIN 46(R) and, therefore, accounted for Andiamo as if the Company had consolidated Andiamo since the Company’s initial investment in April 2001. The consolidation of Andiamo from the date of the Company’s initial investment required accounting for the call option as a repurchase right. Under FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” and related interpretations, variable accounting was required for substantially all Andiamo employee stock and options because the ending purchase price was primarily derived from a revenue-based formula.

 

Effective January 24, 2004, the last day of the second quarter of fiscal 2004, the Company recorded a noncash cumulative stock compensation charge of $567 million, net of tax (representing the amount of variable compensation from April 2001 through January 2004). This charge was reported as a separate line item in the Consolidated Statements of Operations as a cumulative effect of accounting change, net of tax. The charge was based on the value of the Andiamo employee stock and options and their vesting from the adoption of FIN 46(R) pursuant to the formula-based valuation.

 

On February 19, 2004, the Company completed the acquisition of Andiamo, exchanging approximately 23 million shares of the Company’s common stock for Andiamo shares not owned by the Company and assuming approximately 6 million stock options, for a total estimated value of $750 million, primarily derived from the revenue-based formula, which after stock price-related adjustments resulted in a total amount recorded of $722 million, as summarized in the table below.

 

52  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Subsequent to the adoption of FIN 46(R), changes to the value of Andiamo and the continued vesting of the employee stock and options resulted in an adjustment to the noncash stock compensation charge. The Company recorded a noncash variable stock compensation adjustment of $58 million in the third quarter of fiscal 2004 to the cumulative stock compensation charge recorded in the second quarter of fiscal 2004 to account for the additional vesting of the Andiamo employee stock and options and changes in the formula-based valuation from January 24, 2004 until February 19, 2004. This noncash adjustment was reported as operating expense in the Consolidated Statements of Operations, as stock-based compensation related to acquisitions and investments in the Consolidated Statements of Cash Flows, and as an increase to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity. In addition, upon completion of the acquisition, deferred stock-based compensation of $90 million was recorded in the Consolidated Balance Sheets to reflect the unvested portion of the formula-based valuation of the Andiamo employee stock and options. The amount of deferred stock-based compensation was fixed at the date of acquisition and is being amortized over the vesting period of Andiamo employee stock and options of approximately two years.

 

A summary of the accounting of the initial consolidation under FIN 46(R) and the subsequent purchase of Andiamo, after stock price-related adjustments, is as follows (in millions):

 

     Amount

Cumulative effect of accounting change, net of tax benefit of $5

   $ 567

Variable stock-based compensation

     58

Deferred stock-based compensation

     90

Net assets

     7
    

Total

   $ 722
    

 

In fiscal 2005, the Company completed the acquisitions of the following companies which had been consolidated prior to acquisition because the Company was deemed to be the primary beneficiary under FIN 46(R):

 

    Acquisition of BCN Systems, Inc. to contribute to the continued evolution of the Company’s routing platforms and support ongoing efforts to speed the delivery of next-generation data, voice, and video services over a converged network. The acquisition was completed for a purchase price of approximately $45 million to be paid over a five-year period contingent upon continued employment of certain employees with the Company, which may be increased by approximately $122 million depending upon the achievement of certain development and product milestones. The purchase consideration consisted of cash.

 

    Acquisition of M.I. Secure, Corporation to add to the Company’s network security technology. The acquisition was completed for a purchase price of approximately $1 million, which may be increased by approximately $12 million depending upon the achievement of certain development and product milestones. The purchase consideration consisted of cash.

 

    Acquisition of Vihana, Inc., a developer of custom application-specific integrated circuit (ASIC) chips, for a purchase price of approximately $30 million. The purchase consideration consisted of shares of Cisco common stock and stock options assumed. Upon completion of the acquisition, deferred stock-based compensation of $7 million was recorded in the Consolidated Balance Sheets.

 

The purchase consideration and any additional amounts to be paid for each of these acquisitions is recorded by the Company as compensation expense related to acquisitions and investments. During fiscal 2005, the Company recorded approximately $34 million of compensation expense relating to these acquisitions.

 

2005 Annual Report  53


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

4. RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES

 

On April 16, 2001, the Company announced a restructuring program, which included a worldwide workforce reduction, consolidation of excess facilities, and restructuring of certain business functions. The liability for restructuring costs is recorded in other accrued liabilities in the Consolidated Balance Sheets. The following table summarizes the activity related to the remaining liability for restructuring costs and other special charges, comprised primarily of operating lease liabilities, as of July 30, 2005 (in millions):

 

     Amount

 

Balance at July 26, 2003

   $ 295  

Cash payments(1)

     (230 )
    


Balance at July 31, 2004

     65  

Cash payments

     (27 )
    


Balance at July 30, 2005

   $ 38  
    



Note 1: Cash payments include payments of approximately $204 million for lease obligations that were terminated.

 

5. BALANCE SHEET DETAILS

 

The following tables provide details of selected balance sheet items (in millions):

 

     July 30, 2005

    July 31, 2004

 

Inventories:

                

Raw materials

   $ 82     $ 58  

Work in process

     431       416  

Finished goods:

                

Distributor inventory and deferred cost of sales

     385       316  

Manufacturing finished goods

     184       206  
    


 


Total finished goods

     569       522  
    


 


Service-related spares

     180       177  

Demonstration systems

     35       34  
    


 


Total

   $ 1,297     $ 1,207  
    


 


Property and equipment, net:

                

Land, buildings, and leasehold improvements

   $ 3,492     $ 3,429  

Computer equipment and related software

     1,244       1,120  

Production, engineering, and other equipment

     3,095       2,643  

Operating lease assets

     136       94  

Furniture and fixtures

     355       356  
    


 


       8,322       7,642  

Less accumulated depreciation and amortization

     (5,002 )     (4,352 )
    


 


Total

   $ 3,320     $ 3,290  
    


 


 

54  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

5. BALANCE SHEET DETAILS (Continued)

 

The following tables provide details of selected balance sheet items (in millions):

 

     July 30, 2005

   July 31, 2004

Other assets:

             

Deferred tax assets

   $ 1,201    $ 1,130

Investments in privately held companies

     421      354

Income tax receivable

     277      690

Lease receivables, net

     353      231

Other

     350      435
    

  

Total

   $ 2,602    $ 2,840
    

  

Deferred revenue:

             

Service

   $ 3,618    $ 3,047

Product

     1,424      1,455
    

  

Total

   $ 5,042    $ 4,502
    

  

Reported as:

             

Current deferred revenue

   $ 3,854    $ 3,527

Noncurrent deferred revenue

     1,188      975
    

  

Total

   $ 5,042    $ 4,502
    

  

 

6. LEASE RECEIVABLES, NET

 

Lease receivables represent sales-type and direct-financing leases resulting from the sale of the Company’s and complementary third-party products and services. These lease arrangements typically have terms from two to three years and are generally collateralized by a security interest in the underlying assets. The current portion of lease receivables, net, is recorded in prepaid expenses and other current assets, and the noncurrent portion is recorded in other assets in the Consolidated Balance Sheets. The net lease receivables are summarized as follows (in millions):

 

     July 30, 2005

    July 31, 2004

 

Gross lease receivables

   $ 731     $ 616  

Unearned income and other allowances

     (130 )     (170 )
    


 


Total

   $ 601     $ 446  
    


 


Reported as:

                

Current

   $ 248     $ 215  

Noncurrent

     353       231  
    


 


Total

   $ 601     $ 446  
    


 


 

Contractual maturities of the gross lease receivables at July 30, 2005 were $299 million in fiscal 2006, $191 million in fiscal 2007, $122 million in fiscal 2008, $79 million in fiscal 2009, and $40 million in fiscal 2010 and thereafter. Actual cash collections may differ from the contractual maturities due to early customer buyouts, refinancings, or customer defaults.

 

2005 Annual Report  55


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

7. INVESTMENTS

 

The following tables summarize the Company’s investments (in millions):

 

July 30, 2005


   Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


    Fair
Value


Fixed income securities:

                            

U.S. government notes and bonds

   $ 3,453    $ 2    $ (25 )   $ 3,430

Corporate notes, bonds, and asset-backed securities

     6,299      3      (63 )     6,239

Municipal notes and bonds

     705      —        (2 )     703
    

  

  


 

Total fixed income securities

     10,457      5      (90 )     10,372

Publicly traded equity securities

     514      433      (6 )     941
    

  

  


 

Total

   $ 10,971    $ 438    $ (96 )   $ 11,313
    

  

  


 

Reported as:

                            

Short-term investments

                         $ 2,227

Investments

                           9,086
                          

Total

                         $ 11,313
                          

 

July 31, 2004


   Amortized
Cost


   Gross
Unrealized
Gains


   Gross
Unrealized
Losses


    Fair
Value


Fixed income securities:

                            

U.S. government notes and bonds

   $ 4,408    $ 9    $ (20 )   $ 4,397

Corporate notes, bonds, and asset-backed securities

     9,333      14      (42 )     9,305

Municipal notes and bonds

     710      —        (1 )     709
    

  

  


 

Total fixed income securities

     14,451      23      (63 )     14,411

Publicly traded equity securities

     755      387      (8 )     1,134
    

  

  


 

Total

   $ 15,206    $ 410    $ (71 )   $ 15,545
    

  

  


 

Reported as:

                            

Short-term investments

                         $ 4,947

Investments

                           10,598
                          

Total

                         $ 15,545
                          

 

The following table provides gross realized gains and losses related to the Company’s investments (in millions):

 

Years Ended


   July 30, 2005

    July 31, 2004

    July 26, 2003

 

Gross realized gains

   $ 144     $ 208     $ 339  

Gross realized losses

     (61 )     (2 )     (590 )
    


 


 


Total

   $ 83     $ 206     $ (251 )
    


 


 


 

The gross realized losses in fiscal 2005 and 2003 included charges of $5 million and $412 million, respectively, related to the impairment of certain publicly traded equity securities. There were no impairment charges related to publicly traded equity securities in fiscal 2004. The impairment charges were due to a decline in the fair value of the investments below their cost basis that were judged to be other-than-temporary. The specific identification method is used to determine the cost basis of fixed income securities disposed of. The weighted-average method is used to determine the cost basis of publicly traded equity securities disposed of.

 

56  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables provide the breakdown of the investments with unrealized losses at July 30, 2005 and July 31, 2004 (in millions):

 

    

UNREALIZED
LOSSES
LESS THAN

12 MONTHS


    UNREALIZED
LOSSES
12 MONTHS
OR GREATER


    TOTAL

 

July 30, 2005


   Fair
Value


   Gross
Unrealized
Losses


    Fair
Value


   Gross
Unrealized
Losses


    Fair
Value


   Gross
Unrealized
Losses


 

U.S. government notes and bonds

   $ 2,947    $ (21 )   $ 220    $ (4 )   $ 3,167    $ (25 )

Corporate notes, bonds, and asset-backed securities

     4,388      (52 )     531      (11 )     4,919      (63 )

Municipal notes and bonds

     260      (2 )     —        —         260      (2 )

Publicly traded equity securities

     34      (5 )     4      (1 )     38      (6 )
    

  


 

  


 

  


Total

   $ 7,629    $ (80 )   $ 755    $ (16 )   $ 8,384    $ (96 )
    

  


 

  


 

  


 

    

UNREALIZED
LOSSES
LESS THAN

12 MONTHS


   

UNREALIZED
LOSSES

12 MONTHS

OR GREATER


    TOTAL

 

July 31, 2004


   Fair
Value


   Gross
Unrealized
Losses


    Fair
Value


   Gross
Unrealized
Losses


    Fair
Value


   Gross
Unrealized
Losses


 

U.S. government notes and bonds

   $ 2,859    $ (18 )   $ 84    $ (2 )   $ 2,943    $ (20 )

Corporate notes, bonds, and asset-backed securities

     3,883      (38 )     189      (4 )     4,072      (42 )

Municipal notes and bonds

     176      (1 )     —        —         176      (1 )

Publicly traded equity securities

     83      (8 )     —        —         83      (8 )
    

  


 

  


 

  


Total

   $ 7,001    $ (65 )   $ 273    $ (6 )   $ 7,274    $ (71 )
    

  


 

  


 

  


 

The gross unrealized losses related to fixed income securities were primarily due to changes in interest rates. The gross unrealized losses related to publicly traded equity securities were due to changes in market prices. The Company’s management has determined that the gross unrealized losses on its investment securities at July 30, 2005 are temporary in nature. The Company reviews its investments to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Substantially all of the Company’s fixed income securities are rated investment grade or better.

 

2005 Annual Report  57


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes the maturities of the Company’s fixed income securities at July 30, 2005 (in millions):

 

     Amortized
Cost


   Fair
Value


Less than one year

   $ 2,237    $ 2,227

Due in 1-2 years

     2,612      2,585

Due in 2-5 years

     4,634      4,586

Due after 5 years

     974      974
    

  

Total

   $ 10,457    $ 10,372
    

  

 

Actual maturities may differ from the contractual maturities because borrowers have the right to call or prepay certain obligations.

 

8. COMMITMENTS AND CONTINGENCIES

 

Operating Leases

 

The Company leases office space in several U.S. locations, as well as locations elsewhere in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific; and Japan. Rent expense totaled $179 million, $191 million, and $196 million in fiscal 2005, 2004, and 2003, respectively. Future annual minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of July 30, 2005 were as follows (in millions):

 

Fiscal Year


   Amount

2006

   $ 215

2007

     163

2008

     118

2009

     96

2010

     88

Thereafter

     580
    

Total

   $ 1,260
    

 

Purchase Commitments with Contract Manufacturers and Suppliers

 

The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help assure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the Company’s requirements. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Company’s requirements based on its business needs prior to firm orders being placed. Consequently, only a portion of the Company’s reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. As of July 30, 2005, the Company had total purchase commitments for inventory of approximately $954 million, compared with $951 million as of July 31, 2004.

 

In addition to the above, the Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the Company’s allowance for inventory. As of July 30, 2005, the liability for these firm, noncancelable, and unconditional purchase commitments was $107 million, compared with $141 million as of July 31, 2004 and was included in other accrued liabilities.

 

58  Cisco Systems, Inc.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other Commitments

 

The Company has entered into an agreement to invest approximately $800 million in venture funds managed by SOFTBANK that are required to be funded on demand. The total commitment is to be invested in venture funds and as senior debt with entities as directed by SOFTBANK. The Company’s commitment to fund the senior debt is contingent upon the achievement of certain agreed-upon milestones. As of July 30, 2005, the Company had invested $414 million in the venture funds pursuant to the commitment, compared with $290 million as of July 31, 2004. In addition, as of July 30, 2005 and July 31, 2004, the Company had invested $49 million in senior debt pursuant to the commitment, of which $47 million and $19 million has been repaid as of July 30, 2005 and July 31, 2004, respectively.

 

The Company provides structured financing to certain qualified customers for the purchase of equipment and other needs through its wholly owned subsidiaries. These loan commitments may be funded over a two- to three-year period, provided that these customers achieve specific business milestones and satisfy certain financial covenants. As of July 30, 2005, the outstanding loan commitments were $17 million and all were eligible for draw-down. As of July 31, 2004, the outstanding loan commitments were $61 million, of which $22 million was eligible for draw-down.

 

As of July 30, 2005, the Company had a commitment of approximately $25 million to purchase the remaining minority interest of Cisco Systems, K.K. (Japan), compared with approximately $59 million as of July 31, 2004.

 

The Company also has certain other funding commitments related to its privately held investments that are based on the achievement of certain agreed-upon milestones. The funding commitments were approximately $56 million as of July 30, 2005, compared with approximately $67 million as of July 31, 2004.

 

Variable Interest Entities

 

In the ordinary course of business, the Company has investments in privately held companies and provides structured financing to certain customers through its wholly owned subsidiaries, which may be considered to be variable interest entities. The Company has evaluated its investments in privately held companies and structured financings and determined that there were no significant unconsolidated variable interest entities as of July 30, 2005.

 

Guarantees and Product Warranties

 

FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee.

 

The requirements of FIN 45 are applicable to the Company’s product warranty liability and certain guarantees. The Company’s guarantees issued subject to the recognition and disclosure requirements of FIN 45 as of July 30, 2005 and July 31, 2004 were not material. As of July 30, 2005 and July 31, 2004, the Company’s product warranty liability recorded in other accrued liabilities was $259 million and $239 million, respectively. The following table summarizes the activity related to the product warranty liability during fiscal 2005 and 2004 (in millions):

 

     July 30,
2005


    July 31,
2004


 

Balance at beginning of fiscal year

   $ 239     $ 246  

Provision for warranties issued

     411       333  

Payments

     (391 )     (340 )
    


 


Balance at end of fiscal year

   $ 259     $ 239  
    


 


 

2005 Annual Report  59


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company accrues for warranty costs as part of its cost of sales based on associated material product costs, technical support labor costs, and associated overhead. The products sold are generally covered by a warranty for periods ranging from 90 days to five years, and for some products the Company provides a limited lifetime warranty.

 

In the normal course of business to facilitate sales of its products, the Company indemnifies other parties, including customers, lessors, and parties to other transactions with the Company, with respect to certain matters. The Company has agreed to hold the other parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. In addition, the Company has entered into indemnification agreements with its officers and directors, and the Company’s bylaws contain similar indemnification obligations to the Company’s agents.

 

It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material impact on the Company’s operating results, financial position, or cash flows.

 

Derivative Instruments

 

The Company uses derivative instruments to manage exposures to foreign currency, interest rate, and equity security price risks. The Company’s objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency, interest rates, and equity security prices. The Company’s derivatives expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the agreement. The Company seeks to reduce such risks by limiting its counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.

 

Foreign Currency Derivatives    The Company conducts business globally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. The Company enters into foreign exchange forward contracts to reduce the short-term effects of foreign currency fluctuations on certain foreign currency receivables, investments, and payables. The gains and losses on the foreign exchange forward contracts offset the transaction gains and losses on certain foreign currency receivables, investments, and payables recognized in earnings.

 

The Company does not enter into foreign exchange forward contracts for trading purposes. Gains and losses on the contracts are included in other income (loss), net, in the Consolidated Statements of Operations and offset foreign exchange gains and losses from the revaluation of intercompany balances or other current assets, investments, and liabilities denominated in currencies other than the functional currency of the reporting entity. The Company’s foreign exchange forward contracts related to current assets and liabilities generally range from one to three months in original maturity. Additionally, the Company has entered into foreign exchange forward contracts with maturities of up to two years related to long-term customer financings. The foreign exchange contracts related to investments generally have maturities of less than one year.

 

The Company periodically hedges certain foreign currency forecasted transactions related to certain operating expenses with currency options. These transactions are designated as cash flow hedges. The effective portion of the derivative’s gain or loss is initially reported as a component of accumulated 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. These currency option contracts generally have maturities of less than 18 months. The Company does not purchase currency options for trading purposes. Foreign exchange forward and option contracts as of July 30, 2005 are summarized as follows (in millions):

 

     Notional
Amount


   Fair
Value


 

Forward contracts:

               

Purchased

   $ 1,011    $ (5 )

Sold

   $ 450 <