10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

(Mark one)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 30, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission file number 0-18225

 

 

CISCO SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

 

California   77-0059951

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

170 West Tasman Drive

San Jose, California 95134

(Address of principal executive office and zip code)

(408) 526-4000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  x    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  x   Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

Number of shares of the registrant’s common stock outstanding as of November 18, 2010: 5,542,761,641

 

 

 


Table of Contents

Cisco Systems, Inc.

FORM 10-Q for the Quarter Ended October 30, 2010

INDEX

 

          Page  

Part I.

   Financial Information      3   

Item 1.

   Financial Statements (Unaudited)      3   
   Consolidated Balance Sheets at October 30, 2010 and July 31, 2010      3   
   Consolidated Statements of Operations for the three months ended October 30, 2010 and October 24, 2009      4   
   Consolidated Statements of Cash Flows for the three months ended October 30, 2010 and October 24, 2009      5   
   Consolidated Statements of Equity for the three months ended October 30, 2010 and October 24, 2009      6   
   Notes to Consolidated Financial Statements      7   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      33   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      56   

Item 4.

   Controls and Procedures      58   

Part II.

   Other Information      58   

Item 1.

   Legal Proceedings      58   

Item 1A.

   Risk Factors      59   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      73   

Item 3.

   Defaults Upon Senior Securities      74   

Item 4.

   Reserved      74   

Item 5.

   Other Information      74   

Item 6.

   Exhibits      74   
   Signature      75   

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

CISCO SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(in millions, except par value)

(Unaudited)

 

     October 30,
2010
     July 31,
2010
 

ASSETS

     

Current assets:

     

Cash and cash equivalents

   $ 3,796       $ 4,581   

Investments

     35,129         35,280   

Accounts receivable, net of allowance for doubtful accounts of $191 at October 30, 2010 and $235 at July 31, 2010

     4,471         4,929   

Inventories

     1,523         1,327   

Deferred tax assets

     1,992         2,126   

Other current assets

     3,495         3,178   
                 

Total current assets

     50,406         51,421   

Property and equipment, net

     3,984         3,941   

Goodwill

     16,742         16,674   

Purchased intangible assets, net

     3,176         3,274   

Other assets

     5,707         5,820   
                 

TOTAL ASSETS

   $ 80,015       $ 81,130   
                 

LIABILITIES AND EQUITY

     

Current liabilities:

     

Short-term debt

   $ 3,064       $ 3,096   

Accounts payable

     945         895   

Income taxes payable

     126         90   

Accrued compensation

     2,497         3,129   

Deferred revenue

     7,420         7,664   

Other current liabilities

     4,068         4,359   
                 

Total current liabilities

     18,120         19,233   

Long-term debt

     12,214         12,188   

Income taxes payable

     940         1,353   

Deferred revenue

     3,316         3,419   

Other long-term liabilities

     730         652   
                 

Total liabilities

     35,320         36,845   
                 

Commitments and contingencies (Note 11)

     

Equity:

     

Cisco 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; 5,577 and 5,655 shares issued and outstanding at October 30, 2010 and July 31, 2010, respectively

     37,691         37,793   

Retained earnings

     6,034         5,851   

Accumulated other comprehensive income

     950         623   
                 

Total Cisco shareholders’ equity

     44,675         44,267   

Noncontrolling interests

     20         18   
                 

Total equity

     44,695         44,285   
                 

TOTAL LIABILITIES AND EQUITY

   $ 80,015       $ 81,130   
                 

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per-share amounts)

(Unaudited)

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

NET SALES:

    

Product

   $ 8,700      $ 7,200   

Service

     2,050        1,821   
                

Total net sales

     10,750        9,021   
                

COST OF SALES:

    

Product

     3,249        2,486   

Service

     746        647   
                

Total cost of sales

     3,995        3,133   
                

GROSS MARGIN

     6,755        5,888   

OPERATING EXPENSES:

    

Research and development

     1,431        1,224   

Sales and marketing

     2,402        2,010   

General and administrative

     458        425   

Amortization of purchased intangible assets

     113        105   
                

Total operating expenses

     4,404        3,764   
                

OPERATING INCOME

     2,351        2,124   

Interest income

     160        168   

Interest expense

     (166 )     (114 )

Other income, net

     80        61   
                

Interest and other income, net

     74        115   
                

INCOME BEFORE PROVISION FOR INCOME TAXES

     2,425        2,239   

Provision for income taxes

     495        452   
                

NET INCOME

   $ 1,930      $ 1,787   
                

Net income per share:

    

Basic

   $ 0.34      $ 0.31   
                

Diluted

   $ 0.34      $ 0.30   
                

Shares used in per-share calculation:

    

Basic

     5,595        5,767   
                

Diluted

     5,675        5,871   
                

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

(Unaudited)

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

Cash flows from operating activities:

    

Net income

   $ 1,930      $ 1,787   

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

    

Depreciation, amortization and other noncash items

     553        429   

Share-based compensation expense

     407        321   

Provision for doubtful accounts

     (22     4   

Deferred income taxes

     338        93   

Excess tax benefits from share-based compensation

     (28     (21 )

Net gains on investments

     (108     (47 )

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

    

Accounts receivable

     506        38   

Inventories

     (193     (8 )

Lease receivables, net

     (100     (100 )

Accounts payable

     45        52   

Income taxes payable

     (408     (291 )

Accrued compensation

     (678     (313 )

Deferred revenue

     (367     (160 )

Other assets

     (8     (186 )

Other liabilities

     (200     (110 )
                

Net cash provided by operating activities

     1,667        1,488   
                

Cash flows from investing activities:

    

Purchases of investments

     (9,569     (9,537 )

Proceeds from sales of investments

     6,232        2,769   

Proceeds from maturities of investments

     3,574        5,664   

Acquisition of property and equipment

     (326     (160 )

Acquisition of businesses, net of cash and cash equivalents acquired

     (69     —     

Change in investments in privately held companies

     (28     (32 )

Other

     19        43   
                

Net cash used in investing activities

     (167     (1,253 )
                

Cash flows from financing activities:

    

Issuance of common stock

     374        634   

Repurchase of common stock

     (2,701     (1,869 )

Short-term borrowings, net

     (16     —     

Excess tax benefits from share-based compensation

     28        21   

Other

     30        35   
                

Net cash used in financing activities

     (2,285     (1,179 )
                

Net decrease in cash and cash equivalents

     (785     (944 )

Cash and cash equivalents, beginning of period

     4,581        5,718   
                

Cash and cash equivalents, end of period

   $ 3,796      $ 4,774   
                

Cash paid for:

    

Interest

   $ 270      $ 269   

Income taxes

   $ 565      $ 649   

See Notes to Consolidated Financial Statements.

 

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Table of Contents

CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF EQUITY

(in millions)

(Unaudited)

 

Three Months Ended October 24, 2009

  Shares of
Common
Stock
    Common Stock
and Additional
Paid-In

Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Total Cisco
Shareholders’
Equity
    Noncontrolling
Interests
    Total
Equity
 

BALANCE AT JULY 25, 2009

    5,785      $ 34,344      $ 3,868      $ 435      $ 38,647      $ 30      $ 38,677   

Net income

    —          —          1,787        —          1,787        —          1,787   

Change in:

             

Unrealized gains and losses on investments

    —          —          —          186        186        (6 )     180   

Derivative instruments

    —          —          —          61        61        —          61   

Cumulative translation adjustment and other

    —          —          —          163        163        —          163   
                               

Comprehensive income (loss)

            2,197        (6 )     2,191   
                               

Issuance of common stock

    45        634        —          —          634        —          634   

Repurchase of common stock

    (79 )     (516     (1,301 )     —          (1,817 )     —          (1,817

Tax benefits from employee stock incentive plans

    —          20        —          —          20        —          20   

Share-based compensation expense

    —          321        —          —          321        —          321   
                                                       

BALANCE AT OCTOBER 24, 2009

    5,751      $ 34,803      $ 4,354      $ 845      $ 40,002      $ 24      $ 40,026   
                                                       

Three Months Ended October 30, 2010

  Shares of
Common
Stock
    Common Stock
and Additional
Paid-In

Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Total Cisco
Shareholders’
Equity
    Noncontrolling
Interests
    Total
Equity
 

BALANCE AT JULY 31, 2010

    5,655      $ 37,793      $ 5,851      $ 623      $ 44,267      $ 18      $ 44,285   

Net income

    —          —          1,930        —          1,930        —          1,930   

Change in:

             

Unrealized gains and losses on investments

    —          —          —          40        40        2        42   

Derivative instruments

    —          —          —          49        49        —          49   

Cumulative translation adjustment and other

    —          —          —          238        238        —          238   
                               

Comprehensive income

            2,257        2        2,259   
                               

Issuance of common stock

    41        374        —          —          374        —          374   

Repurchase of common stock

    (119     (880     (1,747     —          (2,627     —          (2,627

Tax benefits from employee stock incentive plans

    —          (9     —          —          (9     —          (9

Purchase acquisitions

    —          6        —          —          6        —          6   

Share-based compensation expense

    —          407        —          —          407        —          407   
                                                       

BALANCE AT OCTOBER 30, 2010

    5,577      $ 37,691      $ 6,034      $ 950      $ 44,675      $ 20      $ 44,695   
                                                       

Supplemental Information

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of October 30, 2010, the Company’s Board of Directors had authorized an aggregate repurchase of up to $72 billion of common stock under this program with no termination date. In addition, on November 18, 2010, the Company’s Board of Directors authorized the repurchase of up to an additional $10 billion of the Company’s common stock under this program with no termination date. For additional information regarding stock repurchases, see Note 12 to the Consolidated Financial Statements. The stock repurchases since the inception of this program and the related impacts on Cisco shareholders’ equity are summarized in the following table (in millions):

 

     Shares of
Common
Stock
     Common Stock
and Additional
Paid-In

Capital
     Retained
Earnings
     Total Cisco
Shareholders’
Equity
 

Repurchases of common stock under the repurchase program

     3,240       $ 13,512       $ 53,970       $ 67,482   

See Notes to Consolidated Financial Statements.

 

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Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

The fiscal year for Cisco Systems, Inc. (the “Company” or “Cisco”) is the 52 or 53 weeks ending on the last Saturday in July. Fiscal 2011 is a 52-week fiscal year and fiscal 2010 was a 53-week fiscal year with the extra week included in the third quarter of fiscal 2010. The Consolidated Financial Statements include the accounts of Cisco and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. The Company conducts business globally and is primarily managed on a geographic basis. In the first quarter of fiscal 2011, in order to achieve operational efficiencies, the Company combined its Asia Pacific and Japan operations. Following this change, the Company is organized into the following four geographic segments: United States and Canada, European Markets, Emerging Markets, and Asia Pacific Markets. The Company has reclassified the geographic segment data for the prior period to conform to the current period’s presentation. The Emerging Markets segment remains unchanged and includes Eastern Europe, Latin America, the Middle East and Africa, and Russia and the Commonwealth of Independent States.

The accompanying financial data as of October 30, 2010 and for the three months ended October 30, 2010 and October 24, 2009 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. The July 31, 2010 Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2010.

The Company consolidates its investment in a venture fund managed by SOFTBANK Corp. and its affiliates (“SOFTBANK”) subject to the applicable accounting guidance. The noncontrolling interests attributed to SOFTBANK are presented as a separate component from the Company’s equity in the equity section of the Consolidated Balance Sheets. SOFTBANK’s share of the earnings in the venture fund is not presented separately in the Consolidated Statements of Operations and is included in other income, net, as this amount is not material for any of the fiscal periods presented.

In the opinion of management, all adjustments (which include normal recurring adjustments, except as disclosed herein) necessary to present fairly the statement of financial position as of October 30, 2010, and results of operations, cash flows, and equity for the three months ended October 30, 2010 and October 24, 2009, as applicable, have been made. The results of operations for the three months ended October 30, 2010 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

In addition to the segment reporting change referred to above, the Company has made certain reclassifications to prior period amounts in order to conform to the current period presentation. These items include reclassifications to prior period amounts related to net sales for similar groups of products, gross margin by geographic segment, and the allocation of share-based compensation expense within operating expenses due to the refinement of these respective categories.

The Company has evaluated subsequent events through the date that the financial statements were issued.

 

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2. Summary of Significant Accounting Policies

(a) New Accounting Standards or Updates Recently Adopted

In June 2009, the FASB issued revised guidance for the consolidation of variable interest entities. In February 2010, the FASB issued amendments to the consolidation requirements, exempting certain investment funds from the June 2009 guidance for the consolidation of variable interest entities. The June 2009 guidance for the consolidation of variable interest entities replaces the quantitative-based risks and rewards approach with a qualitative approach that focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits from the entity that could be potentially significant to the variable interest entity. The accounting guidance also requires an ongoing reassessment of whether an enterprise is the primary beneficiary and requires additional disclosures about an enterprise’s involvement in variable interest entities. This accounting guidance was effective for the Company beginning in the first quarter of fiscal 2011. The application of the revised guidance for the consolidation of variable interest entities did not have a material impact to the Company’s Consolidated Financial Statements. See Note 11.

In June 2009, the FASB issued revised guidance for the accounting of transfers of financial assets. This guidance eliminates the concept of a qualifying special-purpose entity, removes the scope exception for qualifying special-purpose entities when applying the accounting guidance related to the consolidation of variable interest entities, changes the requirements for derecognizing financial assets, and requires enhanced disclosure. This accounting guidance was effective for the Company beginning in the first quarter of fiscal 2011. The application of the revised guidance for the accounting of transfers of financial assets did not have a material impact to the Company’s Consolidated Financial Statements.

(b) Recent Accounting Standards or Updates Not Yet Effective

In July 2010, the FASB issued an accounting standard to provide guidance to enhance disclosures related to the credit quality of a company’s financing receivables portfolio and the associated allowance for credit losses. Pursuant to this accounting update, a company is required to provide a greater level of disaggregated information about its allowance for credit loss with the objective of facilitating users’ evaluation of the nature of credit risk inherent in the company’s portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. The revised disclosures related to the period end balances are effective for the Company beginning in the second quarter of fiscal 2011, and the revised disclosures related to activity during the reporting period are effective for the Company beginning in the third quarter of fiscal 2011. The Company is currently evaluating the impact of this accounting update on its financial disclosures.

 

3. Business Combinations

The Company completed two business combinations during the three months ended October 30, 2010. A summary of the allocation of the aggregated purchase consideration is presented as follows (in millions):

 

     Purchase
Consideration
     Net Tangible
Assets
Acquired
     Purchased
Intangible
Assets
     Goodwill  

Total acquisitions

   $ 80       $ 1       $ 30       $ 49   

The total purchase consideration related to the Company’s business combinations completed during the three months ended October 30, 2010 consisted of both cash consideration and vested share-based awards assumed. Total cash and cash equivalents acquired from these business combinations were $3 million.

Total transaction costs related to business combination activities for the three months ended October 30, 2010 were $8 million, which were expensed as incurred and recorded as G&A expenses.

The Company continues to evaluate certain assets and liabilities related to business combinations completed during the recent periods. Additional information, which existed as of the acquisition date but was at that time unknown to the Company, may become known to the Company during the remainder of the measurement period, a period not to exceed 12 months from the acquisition date. Changes to amounts recorded as assets or liabilities may result in a corresponding adjustment to goodwill.

The goodwill generated from the Company’s business combinations completed during the three months ended October 30, 2010 is primarily related to expected synergies. The goodwill is not deductible for U.S. federal income tax purposes.

The Consolidated Financial Statements include the operating results of each business from the date of acquisition. Pro forma results of operations for the acquisitions completed during the three months ended October 30, 2010 have not been presented because the effects of the acquisitions, individually and in the aggregate, were not material to the Company’s financial results.

 

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4. Goodwill and Purchased Intangible Assets

(a) Goodwill

In the first quarter of fiscal 2011, in order to achieve operational efficiencies, the Company combined its Asia Pacific and Japan operations. Following this change, the Company is organized into the following four geographic segments: United States and Canada, European Markets, Emerging Markets, and Asia Pacific Markets. The goodwill of the former Asia Pacific and Japan geographic segments as of July 31, 2010 was allocated to the combined segment Asia Pacific Markets.

The following table presents the goodwill allocated to the Company’s reportable segments as of and during the three months ended October 30, 2010 (in millions):

 

     Balance at
July 31, 2010
     Acquisitions      Other      Balance at
October 30, 2010
 

United States and Canada

   $ 11,289       $ 18      $ —         $ 11,307   

European Markets

     2,729         17        19         2,765   

Emerging Markets

     762         —           —           762   

Asia Pacific Markets

     1,894         14        —           1,908   
                                   

Total

   $ 16,674       $ 49      $ 19       $ 16,742   
                                   

In the preceding table, “Other” primarily includes foreign currency translation.

(b) Purchased Intangible Assets

The following table presents details of the Company’s intangible assets acquired through business combinations completed during the three months ended October 30, 2010 (in millions, except years):

 

     FINITE LIVES      INDEFINITE
LIVES
        
     TECHNOLOGY      CUSTOMER
RELATIONSHIPS
     OTHER      IPR&D      TOTAL  
     Weighted-
Average
Useful Life
(in Years)
     Amount      Weighted-
Average
Useful Life
(in Years)
     Amount      Weighted-
Average
Useful Life
(in Years)
     Amount      Amount      Amount  

Total

     5.2       $ 29         —         $ —           3.0       $ 1       $ —         $ 30   

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

 

October 30, 2010

   Gross      Accumulated
Amortization
    Net  

Purchased intangible assets with finite lives:

       

Technology

   $ 2,427       $ (735   $ 1,692   

Customer relationships

     2,325         (1,121     1,204   

Other

     173         (93     80   
                         

Total purchased intangible assets with finite lives

     4,925         (1,949     2,976   

IPR&D, with indefinite lives

     200         —          200   
                         

Total

   $ 5,125       $ (1,949   $ 3,176   
                         

July 31, 2010

   Gross      Accumulated
Amortization
    Net  

Purchased intangible assets with finite lives:

       

Technology

   $ 2,396       $ (686 )   $ 1,710   

Customer relationships

     2,326         (1,045 )     1,281   

Other

     172         (85 )     87   
                         

Total purchased intangible assets with finite lives

     4,894         (1,816 )     3,078   

IPR&D, with indefinite lives

     196         —          196   
                         

Total

   $ 5,090       $ (1,816 )   $ 3,274   
                         

Purchased intangible assets include intangible assets acquired through business combinations as well as through direct purchases or licenses.

 

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The following table presents the amortization of purchased intangible assets (in millions):

 

     Three Months Ended  
     October 30,
2010
     October 24,
2009
 

Amortization of purchased intangible assets:

     

Cost of sales

   $ 106       $ 49   

Operating expenses

     113         105   
                 

Total

   $ 219       $ 154   
                 

The estimated future amortization expense of purchased intangible assets with finite lives as of October 30, 2010 is as follows (in millions):

 

Fiscal Year

   Amount  

2011 (remaining nine months)

   $ 639   

2012

     743   

2013

     628   

2014

     443   

2015

     336   

Thereafter

     187   
        

Total

   $ 2,976   
        

 

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5. Balance Sheet Details

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

 

     October 30,
2010
    July 31,
2010
 

Inventories:

    

Raw materials

   $ 331      $ 217   

Work in process

     54        50   

Finished goods:

    

Distributor inventory and deferred cost of sales

     586        587   

Manufactured finished goods

     314        260   
                

Total finished goods

     900        847   
                

Service-related spares

     174        161   

Demonstration systems

     64        52   
                

Total

   $ 1,523      $ 1,327   
                

Property and equipment, net:

    

Land, buildings, and building & leasehold improvements

   $ 4,519      $ 4,470   

Computer equipment and related software

     1,427        1,405   

Production, engineering, and other equipment

     4,879        4,702   

Operating lease assets

     263        255   

Furniture and fixtures

     479        476   
                
     11,567        11,308   

Less accumulated depreciation and amortization

     (7,583 )     (7,367 )
                

Total

   $ 3,984      $ 3,941   
                

Other assets:

    

Deferred tax assets

   $ 1,881      $ 2,079   

Investments in privately held companies

     779        756   

Lease receivables, net (1)

     1,265        1,176   

Financed service contracts, net (1)

     767        763   

Loan receivables, net (1)

     621        675   

Other

     394        371   
                

Total

   $ 5,707      $ 5,820   
                

Deferred revenue:

    

Service

   $ 7,169      $ 7,428   

Product:

    

Unrecognized revenue on product shipments and other deferred revenue

     2,737        2,788   

Cash receipts related to unrecognized revenue from two-tier distributors

     830        867   
                

Total product deferred revenue

     3,567        3,655   
                

Total

   $ 10,736      $ 11,083   
                

Reported as:

    

Current

   $ 7,420      $ 7,664   

Noncurrent

     3,316        3,419   
                

Total

   $ 10,736      $ 11,083   
                

 

(1)

Amounts represent the noncurrent portions of the respective balances. See Note 6 for the current portions of the respective balances, which are included in other current assets.

 

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6. Financing Receivables and Guarantees

(a) Financing Receivables

Financing receivables primarily consist of lease receivables, financed service contracts and loan receivables. Lease receivables represent sales-type and direct-financing leases resulting from the sale of the Company’s and complementary third-party products. These lease arrangements have terms of on average three years and are generally collateralized by a security interest in the underlying assets. The revenue related to financed service contracts, which is primarily associated with technical support services, is deferred and included in deferred service revenue. The revenue is recognized ratably over the period during which the related services are to be performed, which is typically from one to three years.

A summary of the Company’s financing receivables is presented as follows (in millions):

 

October 30, 2010

   Lease
Receivables
    Financed Service
Contracts
    Loan
Receivables
    Financing
Receivables
 

Gross

   $ 2,582      $ 1,758      $ 1,262      $ 5,602   

Unearned income

     (222     —          —          (222

Allowances

     (232     (23 )     (80 )     (335
                                

Total, net

   $ 2,128      $ 1,735      $ 1,182      $ 5,045   
                                

Reported as:

        

Current

   $ 863      $ 968      $ 561      $ 2,392   

Noncurrent

     1,265        767        621        2,653   
                                

Total, net

   $ 2,128      $ 1,735      $ 1,182      $ 5,045   
                                

July 31, 2010

   Lease
Receivables
    Financed Service
Contracts
    Loan
Receivables
    Financing
Receivables
 

Gross

   $ 2,411      $ 1,773      $ 1,249      $ 5,433   

Unearned income

     (215 )     —          —          (215

Allowances

     (207 )     (21 )     (73 )     (301
                                

Total, net

   $ 1,989      $ 1,752      $ 1,176      $ 4,917   
                                

Reported as:

        

Current

   $ 813      $ 989      $ 501      $ 2,303   

Noncurrent

     1,176        763        675        2,614   
                                

Total, net

   $ 1,989      $ 1,752      $ 1,176      $ 4,917   
                                

Contractual maturities of the gross lease receivables at October 30, 2010 are summarized as follows (in millions):

 

Fiscal Year

   Amount  

2011 (remaining nine months)

   $ 822   

2012

     818   

2013

     550   

2014

     287   

Thereafter

     105   
        

Total

   $ 2,582   
        

Actual cash collections may differ from the contractual maturities due to early customer buyouts, refinancings, or defaults.

 

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(b) Financing Guarantees

In the ordinary course of business, the Company provides financing guarantees that are generally for various third-party financing arrangements extended to channel partners and end-user customers.

Channel Partner Financing Guarantees

The Company facilitates arrangements for third-party financing extended to channel partners, consisting of revolving short-term financing, generally with payment terms ranging from 60 to 90 days. These financing arrangements facilitate the working capital requirements of the channel partners and, in some cases, the Company guarantees a portion of these arrangements. The volume of channel partner financing was $4.5 billion and $3.7 billion for the three months ended October 30, 2010 and October 24, 2009, respectively. The balance of the channel partner financing subject to guarantees was $1.4 billion as of each of October 30, 2010 and July 31, 2010. For the periods presented, payments under these guarantee arrangements were not material.

End-User Financing Guarantees

The Company also provides financing guarantees for third-party financing arrangements extended to end-user customers related to leases and loans that typically have terms of up to three years. The volume of financing provided by third parties for leases and loans on which the Company has provided guarantees was $283 million and $255 million for the three months ended October 30, 2010 and October 24, 2009, respectively.

Financing Guarantee Summary

The aggregate amount of financing guarantees outstanding at October 30, 2010 and July 31, 2010, representing the total maximum potential future payments under financing arrangements with third parties, and the related deferred revenue are summarized in the following table (in millions):

 

     October 30,
2010
     July 31,
2010
 

Maximum potential future payments relating to financing guarantees:

     

Channel partner

   $ 412       $ 448   

End user

     294         304   
                 

Total

   $ 706       $ 752   
                 

Deferred revenue associated with financing guarantees:

     

Channel partner

   $ 280       $ 277   

End user

     265         272   
                 

Total

   $ 545       $ 549   
                 

 

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7. Investments

(a) Summary of Available-for-Sale Investments

The following tables summarize the Company’s available-for-sale investments (in millions):

 

October 30, 2010

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 

Fixed income securities:

          

U.S. government securities

   $ 16,387       $ 32       $ (1 )   $ 16,418   

U.S. government agency securities (1)

     12,710         51         —          12,761   

Non-U.S. government and agency securities (2)

     1,502         16         —          1,518   

Corporate debt securities

     2,897         71         (17     2,951   

Asset-backed securities

     138         9         (5     142   
                                  

Total fixed income securities

     33,634         179         (23     33,790   

Publicly traded equity securities

     901         452         (14     1,339   
                                  

Total

   $ 34,535       $ 631       $ (37   $ 35,129   
                                  

July 31, 2010

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 

Fixed income securities:

          

U.S. government securities

   $ 16,570       $ 42       $ —        $ 16,612   

U.S. government agency securities (1)

     13,511         68         —          13,579   

Non-U.S. government and agency securities (2)

     1,452         15         —          1,467   

Corporate debt securities

     2,179         64         (21 )     2,222   

Asset-backed securities

     145         9         (5 )     149   
                                  

Total fixed income securities

     33,857         198         (26 )     34,029   

Publicly traded equity securities

     889         411         (49 )     1,251   
                                  

Total

   $ 34,746       $ 609       $ (75 )   $ 35,280   
                                  

 

(1)

Includes corporate debt securities that are guaranteed by the Federal Deposit Insurance Corporation (FDIC).

(2)

Includes corporate debt securities that are guaranteed by non-U.S. governments.

(b) Gains and Losses on Available-for-Sale Investments

The following table presents the net realized gains and losses related to the Company’s available-for-sale investments (in millions):

 

Three Months Ended

   October 30, 2010      October 24, 2009  

Net gains on investments in publicly traded equity securities

   $ 19       $ 11   

Net gains on investments in fixed income securities

     71         6   
                 

Total

   $ 90       $ 17   
                 

There were no impairment charges on available-for-sale investments for the three months ended October 30, 2010 and October 24, 2009.

The following table summarizes the activity related to credit losses for fixed income securities (in millions):

 

Three Months Ended

   October 30, 2010     October 24, 2009  

Balance at beginning of period

   $ (95   $ (153

Sales of other-than-temporarily impaired fixed income securities

     27        19   
                

Balance at end of period

   $ (68   $ (134
                

 

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The following tables present the breakdown of the available-for-sale investments with gross unrealized losses and the duration that those losses had been unrealized at October 30, 2010 and July 31, 2010 (in millions):

 

     UNREALIZED LOSSES
LESS  THAN 12 MONTHS
    UNREALIZED LOSSES
12  MONTHS OR GREATER
    TOTAL  

October 30, 2010

   Fair
Value
     Gross
Unrealized

Losses
    Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
 

Fixed income securities:

               

U.S. government securities

   $ 2,299       $ (1 )   $ —         $ —        $ 2,299       $ (1 )

Corporate debt securities

     476         (1 )     250         (16 )     726         (17 )

Asset-backed securities

     2         —          111         (5 )     113         (5 )
                                                   

Total fixed income securities

     2,777         (2 )     361         (21     3,138         (23 )

Publicly traded equity securities

     69         (6 )     422         (8     491         (14 )
                                                   

Total

   $ 2,846       $ (8 )   $ 783       $ (29 )   $ 3,629       $ (37 )
                                                   
     UNREALIZED LOSSES
LESS THAN 12 MONTHS
    UNREALIZED LOSSES
12 MONTHS OR GREATER
    TOTAL  

July 31, 2010

   Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
 

Fixed income securities:

               

Corporate debt securities

   $ 140       $ (1 )   $ 304       $ (20 )   $ 444       $ (21 )

Asset-backed securities

     2         —          115         (5 )     117         (5 )
                                                   

Total fixed income securities

     142         (1 )     419         (25 )     561         (26 )

Publicly traded equity securities

     168         (12 )     393         (37 )     561         (49 )
                                                   

Total

   $ 310       $ (13 )   $ 812       $ (62 )   $ 1,122       $ (75 )
                                                   

For fixed income securities that have unrealized losses as of October 30, 2010, the Company has determined that (i) it does not have the intent to sell any of these investments and (ii) it is not more likely than not that it will be required to sell any of these investments before recovery of the entire amortized cost basis. In addition, as of October 30, 2010, the Company anticipates that it will recover the entire amortized cost basis of such fixed income securities and has determined that no other-than-temporary impairments associated with credit losses were required to be recognized during the three months ended October 30, 2010.

The Company has evaluated its publicly traded equity securities as of October 30, 2010 and has determined that there was no indication of other-than-temporary impairments in the respective categories of unrealized losses. This determination was based on several factors, which 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 issuer, and the Company’s intent and ability to hold the publicly traded equity securities for a period of time sufficient to allow for any anticipated recovery in market value.

(c) Maturities of Fixed Income Securities

The following table summarizes the maturities of the Company’s fixed income securities at October 30, 2010 (in millions):

 

     Amortized
Cost
     Fair
Value
 

Less than 1 year

   $ 20,554       $ 20,587   

Due in 1 to 2 years

     8,230         8,289   

Due in 2 to 5 years

     4,521         4,581   

Due after 5 years

     329         333   
                 

Total

   $ 33,634       $ 33,790   
                 

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

 

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(d) Securities Lending

The Company periodically engages in securities lending activities with certain of its available-for-sale investments. These transactions, with a daily balance averaging less than 25% of the Company’s total available-for-sale investments portfolio, are accounted for as a secured lending of the securities, and the securities are typically loaned only on an overnight basis. The Company requires collateral equal to at least 102% of the fair market value of the loaned security in the form of cash or liquid, high-quality assets. The Company engages in these secured lending transactions only with highly creditworthy counterparties, and the associated portfolio custodian has agreed to indemnify the Company against any collateral losses. As of October 30, 2010 and July 31 2010, the Company had no outstanding securities lending transactions. The Company did not experience any losses in connection with the secured lending of securities during the periods presented.

 

8. Fair Value

Pursuant to the accounting guidance for fair value measurements and its subsequent updates, fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact, and it considers assumptions that market participants would use when pricing the asset or liability.

(a) Fair Value Hierarchy

The accounting guidance for fair value measurement also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard establishes a fair value hierarchy based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The fair value hierarchy is as follows:

Level 1 Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.

Level 2 Level 2 applies to assets or liabilities for which there are inputs other than quoted prices that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.

Level 3 Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.

 

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(b) Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis as of October 30, 2010 and July 31, 2010 were as follows (in millions):

 

     OCTOBER 30, 2010      JULY 31, 2010  
     FAIR VALUE MEASUREMENTS      FAIR VALUE MEASUREMENTS  
     Level 1      Level 2      Level 3      Total
Balance
     Level 1      Level 2      Level 3      Total
Balance
 

Assets

                       

Cash equivalents:

                       

Money market funds

   $ 2,240       $ —         $ —         $ 2,240       $ 2,521       $ —         $ —         $ 2,521   

U.S. government securities

     —           70         —           70         —           235         —           235   

U.S. government agency securities (1)

     —           50         —           50         —           40         —           40   

Corporate debt securities

     —           —           —           —           —           1         —           1   

Available-for-sale investments:

                       

U.S. government securities

     —           16,418         —           16,418         —           16,612         —           16,612   

U.S. government agency securities (1)

     —           12,761         —           12,761         —           13,579         —           13,579   

Non-U.S. government and agency securities (2)

     —           1,518         —           1,518         —           1,467         —           1,467   

Corporate debt securities

     —           2,951         —           2,951         —           2,222         —           2,222   

Asset-backed securities

     —           —           142         142         —           —           149         149   

Publicly traded equity securities

     1,339         —           —           1,339         1,251         —           —           1,251   

Derivative assets

     —           242         2         244         —           160         3         163   
                                                                       

Total

   $ 3,579       $ 34,010       $ 144       $ 37,733       $ 3,772       $ 34,316       $ 152       $ 38,240   
                                                                       

Liabilities:

                       

Derivative liabilities

   $ —         $ 17       $ —         $ 17       $ —         $ 19       $ —         $ 19   
                                                                       

Total

   $ —         $ 17       $ —         $ 17       $ —         $ 19       $ —         $ 19   
                                                                       

 

(1)

Includes corporate debt securities that are guaranteed by the FDIC.

(2)

Includes corporate debt securities that are guaranteed by non-U.S. governments.

Level 2 fixed income securities are priced using quoted market prices for similar instruments; nonbinding market prices that are corroborated by observable market data; or in limited circumstances, discounted cash flow techniques. The Company uses inputs such as actual trade data, benchmark yields, broker/dealer quotes, and other similar data, which are obtained from quoted market prices, independent pricing vendors or other sources, to determine the ultimate fair value of these assets and liabilities. The Company uses such pricing data as the primary input to make its assessments and determinations as to the ultimate valuation of its investment portfolio and has not made, during the periods presented, any material adjustments to such inputs. The Company is ultimately responsible for the financial statements and underlying estimates. The Company’s derivative instruments are primarily classified as Level 2, as they are not actively traded and are valued using pricing models that use observable market inputs. The Company did not have any transfers between Level 1 and Level 2 fair value measurements during the three months ended October 30, 2010.

Level 3 assets include asset-backed securities and certain derivative instruments, the values of which are determined based on discounted cash flow models using inputs that the Company could not corroborate with market data.

 

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The following tables present a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended October 30, 2010 and October 24, 2009 (in millions):

 

     Asset-Backed
Securities
    Derivative Assets     Total  

Balance at July 31, 2010

   $ 149      $ 3      $ 152   

Total gains and losses (realized and unrealized):

      

Included in operating expenses

     —          (1     (1

Included in other comprehensive income

     (1     —          (1

Purchases, sales and maturities

     (6     —          (6
                        

Balance at October 30, 2010

   $ 142      $ 2      $ 144   
                        

Losses attributable to assets still held as of October 30, 2010

   $ —        $ (1   $ (1 )
                        
     Asset-Backed
Securities
    Derivative Assets     Total  

Balance at July 25, 2009

   $ 223      $ 4     $ 227   

Total gains and losses (realized and unrealized):

      

Included in other income, net

     (6     —          (6

Included in operating expenses

     —          (2     (2

Included in other comprehensive income

     23        —          23   

Purchases, sales and maturities

     (63     —          (63
                        

Balance at October 24, 2009

   $ 177      $ 2      $ 179   
                        

(c) Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The following tables present the Company’s financial instruments and nonfinancial assets that were measured at fair value on a nonrecurring basis during the indicated periods and the related recognized gains and losses for the periods (in millions):

 

    

FAIR VALUE MEASUREMENTS USING

 

Three Months Ended October 30, 2010

   Net Carrying
Value as of
October 30, 2010
     Level 1      Level 2      Level 3      Total Losses for  the
Three Months Ended
October 30, 2010
 

Investments in privately held companies

   $ 9       $ —         $ —         $ 9       $ (3 )
    

FAIR VALUE MEASUREMENTS USING

 

Three Months Ended October 24, 2009

   Net Carrying
Value as of
October 24, 2009
     Level 1      Level 2      Level 3      Total Losses for the
Three Months Ended
October 24, 2009
 

Investments in privately held companies

   $ 23       $ —         $ —         $ 23       $ (10 )

Property held for sale

   $ 4       $ —         $ —         $ 4       $ (2 )

The assets in the preceding tables were classified as Level 3 assets because the Company used unobservable inputs to value them, reflecting the Company’s assessment of the assumptions market participants would use in pricing these assets due to the absence of quoted market prices and inherent lack of liquidity. These assets were measured at fair value due to events or circumstances the Company identified that significantly impacted the fair value of these investments during the three months ended October 30, 2010 and October 24, 2009.

The fair value for investments in privately held companies was measured using financial metrics, comparison to other private and public companies, and analysis of the financial condition and near-term prospects of the issuers, including recent financing activities and their capital structure as well as other economic variables. The losses for the investments in privately held companies were recorded to other income, net.

The fair values for property held for sale were measured using discounted cash flow techniques. The net losses for property held for sale were included in general and administrative (“G&A”) expenses.

 

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(d) Other

The fair value of certain of the Company’s financial instruments that are not measured at fair value, including accounts receivable, accounts payable, accrued compensation, and other current liabilities, approximates the carrying amount because of their short maturities. In addition, the fair value of the Company’s loan receivables and financed service contracts also approximates the carrying amount. The fair value of the Company’s debt is disclosed in Note 9 and was determined using quoted market prices for those securities.

 

9. Borrowings

(a) Debt

The following table summarizes the Company’s debt (in millions, except percentages):

 

     October 30, 2010     July 31, 2010  
     Amount     Effective
Rate
    Amount     Effective
Rate
 

Senior notes:

        

5.25% fixed-rate notes, due 2011 (“2011 Notes”)

   $ 3,000        3.12   $ 3,000        3.12

2.90% fixed-rate notes, due 2014 (“2014 Notes”)

     500        3.11     500        3.11

5.50% fixed-rate notes, due 2016 (“2016 Notes”)

     3,000        3.09 %     3,000        3.18 %

4.95% fixed-rate notes, due 2019 (“2019 Notes”)

     2,000        5.08     2,000        5.08

4.45% fixed-rate notes, due 2020 (“2020 Notes”)

     2,500        4.50 %     2,500        4.50 %

5.90% fixed-rate notes, due 2039 (“2039 Notes”)

     2,000        6.11     2,000        6.11

5.50% fixed-rate notes, due 2040 (“2040 Notes”)

     2,000        5.67 %     2,000        5.67 %
                    

Total senior notes

     15,000          15,000     

Other notes and borrowings

     43          59     

Unaccreted discount

     (72       (73  

Hedge accounting adjustment

     307          298     
                    

Total

   $ 15,278        $ 15,284     
                    

Reported as:

        

Short-term debt

   $ 3,064        $ 3,096     

Long-term debt

     12,214          12,188     
                    

Total

   $ 15,278        $ 15,284     
                    

The effective rates for the fixed-rate debt include the interest on the notes; the accretion of the discount; and, if applicable, adjustments related to hedging. Based on market prices, the fair value of the Company’s senior notes was $16.6 billion and $16.3 billion as of October 30, 2010 and July 31, 2010, respectively. Interest is payable semiannually on each class of the senior fixed-rate notes. The notes are redeemable by the Company at any time, subject to a make-whole premium. The Company was in compliance with all covenants on the senior notes and other notes and borrowings as of October 30, 2010.

Other notes and borrowings include notes and credit facilities with a number of financial institutions that are available to certain foreign subsidiaries of the Company. The amount of borrowings outstanding under these arrangements was $43 million and $59 million at October 30, 2010 and July 31, 2010, respectively.

(b) Credit Facility

The Company has a credit agreement with certain institutional lenders providing for a $3.0 billion unsecured revolving credit facility that is scheduled to expire on August 17, 2012. Any advances under the credit agreement will accrue interest at rates that are equal to, based on certain conditions, either (i) the higher of the Federal Funds rate plus 0.50% or Bank of America’s “prime rate” as announced from time to time or (ii) the London Interbank Offered Rate (“LIBOR”) plus a margin that is based on the Company’s senior debt credit ratings as published by Standard & Poor’s Ratings Services and Moody’s Investors Service, Inc. The credit agreement requires the Company to comply with certain covenants, including that it maintain an interest coverage ratio as defined in the agreement. The Company was in compliance with the required interest coverage ratio and the other covenants as of October 30, 2010.

The Company may also, upon the agreement of either the then-existing lenders or additional lenders not currently parties to the agreement, increase the commitments under the credit facility by up to an additional $1.9 billion and/or extend the expiration date of the credit facility up to August 15, 2014. As of October 30, 2010, the Company had not borrowed any funds under the credit facility.

 

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10. Derivative Instruments

(a) Summary of Derivative Instruments

The Company uses derivative instruments primarily to manage exposures to foreign currency exchange rate, interest rate, and equity price risks. The Company’s primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates, interest rates, and equity 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 does, however, seek to mitigate 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.

The fair values of the Company’s derivative instruments and the line items on the Consolidated Balance Sheets to which they were recorded are summarized as follows (in millions):

 

     DERIVATIVE ASSETS     

DERIVATIVE LIABILITIES

 
     Balance Sheet Line Item      October 30,
2010
     July 31,
2010
    

Balance Sheet Line Item

   October 30,
2010
     July 31,
2010
 

Derivatives designated as hedging instruments:

                 

Foreign currency derivatives

     Other current assets       $ 125       $ 82       Other current liabilities    $ 10       $ 7   

Interest rate derivatives

     Other assets         101         72       Other long-term liabilities      —           —     
                                         

Total

        226         154            10         7   
                                         

Derivatives not designated as hedging instruments:

                 

Foreign currency derivatives

     Other current assets         16         6       Other current liabilities      7         12   

Equity derivatives

     Other current assets         1         1       Other current liabilities      —           —     

Equity derivatives

     Other assets         1         2       Other long-term liabilities      —           —     
                                         

Total

        18         9            7         12   
                                         

Total

      $ 244       $ 163          $ 17       $ 19   
                                         

The effects of the Company’s cash flow hedging instruments on other comprehensive income (OCI) and the Consolidated Statements of Operations for the three months ended October 30, 2010 and October 24, 2009 are summarized as follows (in millions):

 

     GAINS (LOSSES) RECOGNIZED IN OCI
ON DERIVATIVES

(EFFECTIVE PORTION)
FOR THE THREE MONTHS ENDED
    

GAINS (LOSSES) RECLASSIFIED FROM AOCI

INTO INCOME
(EFFECTIVE PORTION)

FOR THE THREE MONTHS ENDED

 

Derivatives Designated as Cash Flow
Hedging Instruments

   October 30,
2010
     October 24,
2009
    

Line Item in Statements of Operations

   October 30,
2010
     October 24,
2009
 

Foreign currency derivatives

   $ 55       $ 44       Operating expenses    $ 6       $ (7 )
         Cost of sales-service      1         (1 )

Interest rate derivatives

     —           15       Interest expense      —           —     
                                      

Total

   $ 55       $ 59          $ 7       $ (8 )
                                      

During the three months ended October 30, 2010 and October 24, 2009, the amounts recognized in earnings on derivative instruments designated as cash flow hedges related to the ineffective portion were not material, and the Company did not exclude any component of the changes in fair value of the derivative instruments from the assessment of hedge effectiveness.

As of October 30, 2010, the Company estimates that approximately $88 million of net derivative gains related to its cash flow hedges included in accumulated other comprehensive income (AOCI) will be reclassified into earnings within the next 12 months.

 

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The effect on the Consolidated Statements of Operations of derivative instruments designated as fair value hedges and the underlying hedged items is summarized as follows (in millions):

 

          GAINS (LOSSES) ON DERIVATIVE
INSTRUMENTS FOR THE THREE
MONTHS ENDED
     GAINS (LOSSES) RELATED TO
HEDGED ITEMS FOR THE
THREE MONTHS ENDED
 

Derivatives Designated as

Fair Value Hedging Instruments

  

Line Item in Statements
of Operations

   October 30,
2010
     October 24,
2009
     October 30,
2010
    October 24,
2009
 

Equity derivatives

   Other income, net    $ —         $ —         $ —        $ —     

Interest rate derivatives

   Interest expense      30         —           (32 )     —     
                                     

Total

      $ 30       $ —         $ (32 )   $ —     
                                     

The effect on the Consolidated Statements of Operations of derivative instruments not designated as hedges is summarized as follows (in millions):

 

          GAINS (LOSSES) FOR THE THREE MONTHS ENDED  

Derivatives not Designated as

Hedging Instruments

  

Line Item in Statements
of Operations

   October 30,
2010
     October 24,
2009
 

Foreign currency derivatives

  

Other income, net

   $ 114       $ 126   

Equity derivatives

  

Operating expenses

     11         13   

Equity derivatives

  

Other income, net

     5         4   
                    

Total

      $ 130       $ 143   
                    

(b) Foreign Currency Exchange Risk

The Company conducts business globally in numerous currencies. Therefore, it is exposed to adverse movements in foreign currency exchange rates. To limit the exposure related to foreign currency changes, the Company enters into foreign currency contracts. The Company does not enter into such contracts for trading purposes.

The Company hedges foreign currency forecasted transactions related to certain operating expenses and service cost of sales with currency option and forward contracts. These currency option and forward contracts, designated as cash flow hedges, generally have maturities of less than 18 months. The Company assesses effectiveness based on changes in total fair value of the derivatives. The effective portion of the derivative instrument’s gain or loss is initially reported as a component of AOCI and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion, if any, of the gain or loss is reported in earnings immediately. The Company did not discontinue any hedges during any of the periods presented because it was probable that the original forecasted transaction would not occur.

The Company enters into foreign exchange forward and option contracts to reduce the short-term effects of foreign currency fluctuations on assets and liabilities such as foreign currency receivables, including long-term customer financings, investments, and payables. These derivatives are not designated as hedging instruments. Gains and losses on the contracts are included in other income, net, and substantially offset foreign exchange gains and losses from the remeasurement of intercompany balances or other current assets, investments, or liabilities denominated in currencies other than the functional currency of the reporting entity.

During the three months ended October 24, 2009, the Company entered into foreign exchange forward and options contracts denominated in Norwegian kroner to hedge against a portion of the foreign currency exchange risk associated with the purchase consideration for Tandberg ASA (“Tandberg”). These contracts were not designated as hedging instruments and were substantially settled in the third quarter of fiscal 2010 in connection with the close of the acquisition.

The Company hedges certain net investments in its foreign subsidiaries with forward contracts which generally have maturities of up to six months. The Company recognized a loss of $5 million in OCI for the effective portion of its net investment hedges for the three months ended October 30, 2010. The Company’s net investment hedges are not included in the preceding tables.

The notional amounts of the Company’s foreign currency derivatives are summarized as follows (in millions):

 

     October 30,
2010
     July 31,
2010
 

Cash flow hedging instruments

   $ 2,257       $ 2,611   

No hedge designation

     4,463         4,619   

Net investment hedging instruments

     110         105   
                 

Total

   $ 6,830       $ 7,335   
                 

 

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(c) Interest Rate Risk

Interest Rate Derivatives, Investments

The Company’s primary objective for holding fixed income securities is to achieve an appropriate investment return consistent with preserving principal and managing risk. To realize these objectives, the Company may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. As of October 30, 2010 and July 31, 2010, the Company did not have any outstanding interest rate derivatives related to its fixed income securities.

Interest Rate Derivatives Designated as Cash Flow Hedge, Long-Term Debt

During the three months ended October 24, 2009, the Company entered into $2.5 billion of interest rate derivatives designated as cash flow hedges to hedge against interest rate movements in connection with the anticipated issuance of senior notes in November 2009. The effective portion of these hedges was recorded to AOCI, net of tax, and is amortized to interest expense over the respective lives of the notes. These derivative instruments were settled in connection with the actual issuance of the senior notes in November 2009.

Interest Rate Derivatives Designated as Fair Value Hedge, Long-Term Debt

The Company has entered into interest rate swaps with a $1.5 billion notional amount that are designated as fair value hedges for a portion of the 2016 Notes. Under these interest rate swaps, the Company receives fixed-rate interest payments and makes interest payments based on LIBOR plus a fixed number of basis points. The effect of these swaps is to convert fixed-rate interest expense on a portion of the 2016 Notes to a floating rate interest expense. The gains and losses related to changes in the fair value of the interest rate swaps are included in interest expense and substantially offset changes in the fair value of the hedged portion of the underlying hedged debt. The fair value of the interest rate swaps was $101 million and $72 million as of October 30, 2010 and July 31, 2010, respectively, and was reflected in other assets.

(d) Equity Price Risk

The Company may hold equity securities for strategic purposes or to diversify its overall investment portfolio. The publicly traded equity securities in the Company’s portfolio are subject to price risk. To manage its exposure to changes in the fair value of certain equity securities, the Company may enter into equity derivatives that are designated as fair value hedges. The changes in the value of the hedging instruments are included in other income, net, and offset the change in the fair value of the underlying hedged investment. In addition, the Company periodically manages the risk of its investment portfolio by entering into equity derivatives that are not designated as accounting hedges. The changes in the fair value of these derivatives were also included in other income, net. As of October 30, 2010 and July 31, 2010, the Company did not have any equity derivatives outstanding related to its investment portfolio.

The Company is also exposed to variability in compensation charges related to certain deferred compensation obligations to employees. Although not designated as accounting hedges, the Company utilizes equity derivatives to economically hedge this exposure. As of October 30, 2010 and July 31, 2010, the notional amount of the derivative instruments used to hedge such liabilities was $216 million and $169 million, respectively.

(e) Credit-Risk-Related Contingent Features

Certain derivative instruments are executed under agreements that have provisions requiring the Company and counterparty to maintain a specified credit rating from certain credit rating agencies. If the Company’s or counterparty’s credit rating falls below a specified credit rating, either party has the right to request collateral on the derivatives’ net liability position. Such provisions did not affect the Company’s financial position as of October 30, 2010 and July 31, 2010.

 

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11. Commitments and Contingencies

(a) Operating Leases

The Company leases office space in several U.S. locations. Outside the United States, larger leased sites include sites in Australia, Belgium, China, Germany, India, Israel, Italy, Japan, Norway, and the United Kingdom. The Company also leases equipment and vehicles. Future minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of October 30, 2010 are as follows (in millions):

 

Fiscal Year

   Amount  

2011 (remaining nine months)

   $ 283   

2012

     262   

2013

     184   

2014

     129   

Thereafter

     444   
        

Total

   $ 1,302   
        

(b) 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 ensure 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. A significant portion of the Company’s reported purchase commitments arising from these agreements consists of firm, noncancelable, and unconditional commitments. 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. As of October 30, 2010 and July 31, 2010, the Company had total purchase commitments for inventory of $4,048 million and $4,319 million, respectively.

The Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the valuation of the Company’s excess and obsolete inventory. As of October 30, 2010 and July 31, 2010, the liability for these purchase commitments was $136 million and $135 million, respectively, and was included in other current liabilities.

(c) Other Commitments

In connection with the Company’s business combinations and asset purchases, the Company has agreed to pay certain additional amounts contingent upon the achievement of certain agreed upon technology, development, product, or other milestones or upon the continued employment with the Company of certain employees of the acquired entities. The Company recognized such compensation expense of $37 million and $34 million during the three months ended October 30, 2010 and October 24, 2009, respectively. The largest component of such compensation expense during these periods was related to milestone achievements by former noncontrolling interest holders of Nuova Systems, Inc. (“Nuova Systems”), the remaining interest of which the Company purchased in fiscal 2008. As of October 30, 2010, the Company estimated that future compensation expense and contingent consideration of up to $175 million may be recognized pursuant to these business combination and asset purchase agreements.

The Company also has certain funding commitments, primarily related to its investments in privately held companies and venture funds, some of which are based on the achievement of certain agreed-upon milestones, and some of which are required to be funded on demand. The funding commitments were $257 million and $279 million as of October 30, 2010 and July 31, 2010, respectively.

(d) Variable Interest Entities

In the ordinary course of business, the Company makes investments in privately held companies and provides financing to certain customers. These privately held companies and customers may be considered to be variable interest entities. The Company evaluates on an ongoing basis its investments in these privately held companies and its customer financings and has determined that as of October 30, 2010 there were no material unconsolidated variable interest entities. Additionally, the Company’s potential maximum exposure to loss with these investments was not material.

 

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(e) Product Warranties and Guarantees

The following table summarizes the activity related to the product warranty liability during the three months ended October 30, 2010 and October 24, 2009 (in millions):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

Balance at beginning of period

   $ 360      $ 321   

Provision for warranties issued

     110        108   

Payments

     (120 )     (104 )
                

Balance at end of period

   $ 350      $ 325   
                

The Company accrues for warranty costs as part of its cost of sales based on associated material product costs, labor costs for technical support staff, and associated overhead. The Company’s products 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, 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 Company’s limited history with 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 effect on the Company’s operating results, financial position, or cash flows.

The Company also provides financing guarantees, which are generally for various third-party financing arrangements to channel partners and other end-user customers. See Note 6. The Company’s other guarantee arrangements as of October 30, 2010 and July 31, 2010 that are subject to recognition and disclosure requirements were not material.

(f) Legal Proceedings

Brazilian authorities have investigated the Company’s Brazilian subsidiary and certain of its current and former employees, as well as a Brazilian importer of the Company’s products, and its affiliates and employees, relating to alleged evasion of import taxes and alleged improper transactions involving the subsidiary and the importer. Brazilian authorities have assessed claims against the Company’s Brazilian subsidiary based on a theory of joint liability with the Brazilian importer for import taxes and related penalties. The claims are for calendar years 2003 through 2007 and aggregate to approximately $200 million for the alleged evasion of import taxes, $250 million for interest, and approximately $1.7 billion for various penalties, all determined using an exchange rate as of October 30, 2010. The Company has completed a thorough review of the matter and believes the asserted tax claims against it are without merit, and the Company intends to defend the claims vigorously. While the Company believes there is no legal basis for its alleged liability, due to the complexities and uncertainty surrounding the judicial process in Brazil and the nature of the claims asserting joint liability with the importer, the Company is unable to determine the likelihood of an unfavorable outcome against it and is unable to reasonably estimate a range of loss, if any. The Company does not expect a final judicial determination for several years.

In addition, the Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

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12. Shareholders’ Equity

(a) Stock Repurchase Program

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of October 30, 2010, the Company’s Board of Directors had authorized an aggregate repurchase of up to $72 billion of common stock under this program and the remaining authorized repurchase amount was $4.5 billion with no termination date. In addition, on November 18, 2010, the Company’s Board of Directors authorized the repurchase of up to an additional $10 billion of the Company’s common stock under this program with no termination date. A summary of the stock repurchase activity under the stock repurchase program, reported based on the trade date, is summarized as follows (in millions, except per-share amounts):

 

Three Months Ended October 30, 2010

   Shares
Repurchased
     Weighted-
Average Price
per Share
     Amount
Repurchased
 

Cumulative balance at July 31, 2010

     3,127       $ 20.78       $ 64,982   

Repurchase of common stock under the stock repurchase program

     113         22.14         2,500   
                    

Cumulative balance at October 30, 2010

     3,240       $ 20.83       $ 67,482   
                    

The purchase price for the shares of the Company’s stock repurchased is reflected as a reduction to shareholders’ equity. The Company is required to allocate the purchase price of the repurchased shares as (i) a reduction to retained earnings until retained earnings are zero and then as an increase to accumulated deficit and (ii) a reduction of common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock incentive plans are recorded as an increase to common stock and additional paid-in capital.

(b) Other Repurchases of Common Stock

For the three months ended October 30, 2010 and October 24, 2009, the Company repurchased approximately 6.3 million and 2.8 million shares, or $127 million and $65 million of common stock, respectively, in settlement of employee tax withholding obligations due upon the vesting of restricted stock or stock units.

(c) Comprehensive Income

The components of comprehensive income for the three months ended October 30, 2010 and October 24, 2009 are as follows (in millions):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

Net income

   $ 1,930      $ 1,787   

Other comprehensive income:

    

Change in unrealized gains and losses on investments, net of tax expense of $17 and $30 for the first quarters of fiscal 2011 and 2010, respectively

     42        180   

Change in derivative instruments, net of tax expense of $6 for the first quarter of fiscal 2010

     49        61   

Change in cumulative translation adjustment and other, net of tax expense of $10 and $21 for the first quarters of fiscal 2011 and 2010, respectively

     238        163   
                

Comprehensive income

     2,259        2,191   

Comprehensive (income) loss attributable to noncontrolling interests

     (2 )     6   
                

Comprehensive income attributable to Cisco

   $ 2,257      $ 2,197   
                

The components of AOCI, net of tax, are summarized as follows (in millions):

 

     October 30,
2010
     July 31,
2010
 

Net unrealized gains on investments

   $ 373       $ 333   

Net unrealized gains on derivative instruments

     76         27   

Cumulative translation adjustment and other

     501         263   
                 

Total

   $ 950       $ 623   
                 

 

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13. Employee Benefit Plans

(a) Employee Stock Purchase Plan

The Company has an Employee Stock Purchase Plan, which includes its subplan, the International Employee Stock Purchase Plan (together, the “Purchase Plan”), under which 471.4 million shares of the Company’s common stock have been reserved for issuance as of October 30, 2010. Effective July 1, 2009, eligible employees are offered shares through a 24-month offering period, which consists of four consecutive 6-month purchase periods. Employees may purchase a limited number of shares of the Company’s stock at a discount of up to 15% of the lesser of the market value at the beginning of the offering period or the end of each 6-month purchase period. Prior to July 1, 2009 the offering period was six months. The Purchase Plan is scheduled to terminate on January 3, 2020. The Company did not issue any shares under the Purchase Plan during the periods presented. As of October 30, 2010, 156 million shares were available for issuance under the Purchase Plan.

(b) Employee Stock Incentive Plans

Stock Incentive Plan Program Description As of October 30, 2010, the Company had five stock incentive plans: the 2005 Stock Incentive Plan (the “2005 Plan”); the 1996 Stock Incentive Plan (the “1996 Plan”); the 1997 Supplemental Stock Incentive Plan (the “Supplemental Plan”); the Cisco Systems, Inc. SA Acquisition Long-Term Incentive Plan (the “SA Acquisition Plan”); and the Cisco Systems, Inc. WebEx Acquisition Long-Term Incentive Plan (the “WebEx Acquisition Plan”). In addition, the Company has, in connection with the acquisitions of various companies, assumed the share-based awards granted under stock incentive plans of the acquired companies or issued share-based awards in replacement thereof. Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, government regulations, and other factors. Since the inception of the stock incentive plans, the Company has granted share-based awards to a significant percentage of its employees, and the majority has been granted to employees below the vice president level. The Company’s primary stock incentive plans are summarized as follows:

2005 Plan As amended on November 15, 2007, the maximum number of shares issuable under the 2005 Plan over its term is 559 million shares plus the amount of any shares underlying awards outstanding on November 15, 2007 under the 1996 Plan, the SA Acquisition Plan, and the WebEx Acquisition Plan that are forfeited or are terminated for any other reason before being exercised or settled. If any awards granted under the 2005 Plan are forfeited or are terminated for any other reason before being exercised or settled, then the shares underlying the awards will again be available under the 2005 Plan.

Prior to November 12, 2009, the number of shares available for issuance under the 2005 Plan was reduced by 2.5 shares for each share awarded as a stock grant or stock unit. Pursuant to an amendment approved by the Company’s shareholders on November 12, 2009, following that amendment the number of shares available for issuance under the 2005 Plan is reduced by 1.5 shares for each share awarded as a stock grant or a stock unit, and any shares underlying awards outstanding under the 1996 Plan, the SA Acquisition Plan, and the WebEx Acquisition Plan that expire unexercised at the end of their maximum terms become available for reissuance under the 2005 Plan. The 2005 Plan permits the granting of stock options, stock, stock units, and stock appreciation rights to employees (including employee directors and officers), consultants of the Company and its subsidiaries and affiliates, and non-employee directors of the Company. Stock options and stock appreciation rights granted under the 2005 Plan have an exercise price of at least 100% of the fair market value of the underlying stock on the grant date and prior to November 12, 2009 have an expiration date no later than nine years from the grant date. The expiration date for stock options and stock appreciation rights granted subsequent to the amendment approved on November 12, 2009 shall be no later than ten years from the grant date. The stock options will generally become exercisable for 20% or 25% of the option shares one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Stock grants and stock units will generally vest with respect to 20% or 25% of the shares covered by the grant on each of the first through fifth or fourth anniversaries of the date of the grant, respectively. The Compensation and Management Development Committee of the Board of Directors has the discretion to use different vesting schedules. Stock appreciation rights may be awarded in combination with stock options or stock grants, and such awards shall provide that the stock appreciation rights will not be exercisable unless the related stock options or stock grants are forfeited. Stock grants may be awarded in combination with non-statutory stock options, and such awards may provide that the stock grants will be forfeited in the event that the related non-statutory stock options are exercised.

1996 Plan The 1996 Plan expired on December 31, 2006, and the Company can no longer make equity awards under the 1996 Plan. The maximum number of shares issuable over the term of the 1996 Plan was 2.5 billion shares. Stock options granted under the 1996 Plan have an exercise price of at least 100% of the fair market value of the underlying stock on the grant date and expire no later than nine years from the grant date. The stock options generally become exercisable for 20% or 25% of the option shares one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Certain other grants have utilized a 60-month ratable vesting schedule. In addition, the Board of Directors, or other committees administering the plan, has the discretion to use a different vesting schedule and have done so from time to time.

 

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Supplemental Plan The Supplemental Plan expired on December 31, 2007, and the Company can no longer make equity awards under the Supplemental Plan. Officers and members of the Company’s Board of Directors were not eligible to participate in the Supplemental Plan. Nine million shares were reserved for issuance under the Supplemental Plan.

Acquisition Plans In connection with the Company’s acquisitions of Scientific-Atlanta, Inc. (“Scientific-Atlanta”) and WebEx Communications, Inc. (“WebEx”), the Company adopted the SA Acquisition Plan and the WebEx Acquisition Plan, respectively, each effective upon completion of the applicable acquisition. These plans constitute assumptions, amendments, restatements, and renamings of the 2003 Long-Term Incentive Plan of Scientific-Atlanta and the WebEx Communications, Inc. Amended and Restated 2000 Stock Incentive Plan, respectively. The plans permit the grant of stock options, stock, stock units, and stock appreciation rights to certain employees of the Company and its subsidiaries and affiliates who had been employed by Scientific-Atlanta or its subsidiaries or WebEx or its subsidiaries, as applicable. As a result of the shareholder approval of the amendment and extension of the 2005 Plan, as of November 15, 2007, the Company will no longer make stock option grants or direct share issuances under either the SA Acquisition Plan or the WebEx Acquisition Plan.

General Share-Based Award Information

Stock Option Awards

A summary of the stock option activity is as follows (in millions, except per-share amounts):

 

     STOCK OPTIONS OUTSTANDING  
     Number
Outstanding
    Weighted-
Average
Exercise Price
per Share
 

BALANCE AT JULY 25, 2009

     1,004      $ 24.29   

Granted and assumed

     15        13.23   

Exercised

     (158 )     17.88   

Canceled/forfeited/expired

     (129 )     47.31   
          

BALANCE AT JULY 31, 2010

     732        21.39   

Exercised

     (23 )     16.63   

Canceled/forfeited/expired

     (5 )     29.32   
          

BALANCE AT OCTOBER 30, 2010

     704      $ 21.49   
          

The following table summarizes significant ranges of outstanding and exercisable stock options as of October 30, 2010 (in millions, except years and share prices):

 

     STOCK OPTIONS OUTSTANDING      STOCK OPTIONS EXERCISABLE  

Range of Exercise Prices

   Number
Outstanding
     Weighted-
Average
Remaining
Contractual
Life
(in Years)
     Weighted-
Average
Exercise
Price per
Share
     Aggregate
Intrinsic
Value
     Number
Exercisable
     Weighted-
Average
Exercise
Price per
Share
     Aggregate
Intrinsic
Value
 

$  0.01 – 15.00

     68         2.30       $ 10.56       $ 839         63       $ 10.78       $ 758   

  15.01 – 18.00

     123         3.20         17.46         664         121         17.46         653   

  18.01 – 20.00

     173         2.66         19.29         618         170         19.29         601   

  20.01 – 25.00

     184         4.04         22.49         109         152         22.44         98   

  25.01 – 35.00

     155         5.81         30.63         —           98         30.57         —     

  35.01 – 70.00

     1         0.43         54.74         —           1         54.74         —     
                                            

Total

     704         3.77       $ 21.49       $ 2,230         605       $ 20.72       $ 2,110   
                                            

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price of $22.86 as of October 29, 2010, which would have been received by the option holders had those option holders exercised their stock options as of that date. The total number of in-the-money stock options exercisable as of October 30, 2010 was 404 million. As of July 31, 2010, 606 million outstanding stock options were exercisable and the weighted-average exercise price was $20.51.

 

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Restricted Stock and Stock Unit Awards

A summary of the restricted stock and stock unit activity is as follows (in millions, except per-share amounts):

 

     Restricted
Stock/Stock
Units
    Weighted-
Average Grant
Date Price per
Share
     Aggregated
Fair Market
Value
 

BALANCE AT JULY 25, 2009

     62      $ 21.25      

Granted and assumed

     54        23.40      

Vested

     (16 )     21.56       $ 378   

Canceled/forfeited

     (3 )     22.40      
             

BALANCE AT JULY 31, 2010

     97      $ 22.35      

Granted and assumed

     44        21.93      

Vested

     (18 )     23.36       $ 373   

Canceled/forfeited

     (2 )     22.00      
             

BALANCE AT OCTOBER 30, 2010

     121      $ 22.05      
             

Certain of the restricted stock units awarded in fiscal 2011 are contingent on the future achievement of financial performance metrics. The performance measures for these performance-based restricted stock units are revenue and earnings per share with pre-established adjustments.

Share-Based Awards Available for Grant

A summary of share-based awards available for grant is as follows (in millions):

 

     Share-
Based

Awards
Available
for Grant
 

BALANCE AT JULY 25, 2009

     253   

Options granted and assumed

     (15 )

Restricted stock, stock units, and other share-based awards granted and assumed

     (81 )

Share-based awards canceled/forfeited/expired

     123   

Additional shares reserved

     15   
        

BALANCE AT JULY 31, 2010

     295   

Restricted stock, stock units, and other share-based awards granted and assumed

     (66

Share-based awards canceled/forfeited/expired

     6   

Additional shares reserved

     1   
        

BALANCE AT OCTOBER 30, 2010

     236   
        

As reflected in the preceding table, for each share awarded as restricted stock or subject to a restricted stock unit award under the 2005 Plan beginning November 15, 2007 and prior to November 12, 2009, an equivalent of 2.5 shares was deducted from the available share-based award balance. Effective as of November 12, 2009, the equivalent number of shares was revised to 1.5 shares for each share awarded as restricted stock or subject to a restricted stock unit award under the 2005 Plan beginning on such date.

 

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Expense and Valuation Information for Share-Based Awards

Share-Based Compensation Expense

Share-based compensation expense consists primarily of expenses for stock options, stock purchase rights, restricted stock, and restricted stock units granted to employees. The following table summarizes share-based compensation expense (in millions):

 

     Three Months Ended  
     October 30,
2010
     October 24,
2009
 

Cost of sales – product

   $ 15       $ 12   

Cost of sales – service

     43         33   
                 

Share-based compensation expense in cost of sales

     58         45   
                 

Research and development

     121         97   

Sales and marketing

     164         128   

General and administrative

     64         51   
                 

Share-based compensation expense in operating expenses

     349         276   
                 

Total share-based compensation expense

   $ 407       $ 321   
                 

As of October 30, 2010, total compensation cost related to unvested share-based awards not yet recognized was $3.8 billion, which is expected to be recognized over approximately 2.7 years on a weighted-average basis. The income tax benefit for share-based compensation expense was $109 million and $85 million for the three months ended October 30, 2010 and October 24, 2009, respectively.

Valuation of Share-Based Awards

The fair value of restricted stock and restricted stock units was measured as if awards were vested and issued on the grant date. The Company estimates the value of employee stock options on the date of grant using a lattice-binomial model and estimates the value of employee stock purchase rights on the date of grant using the Black-Scholes model. The lattice-binomial model is more capable of incorporating the features of the Company’s employee stock options, such as the vesting provisions and various restrictions including restrictions on transfer and hedging, among others, and the options are often exercised prior to their contractual maturity. The use of the lattice-binomial model also requires extensive actual employee exercise behavior data for the relative probability estimation purpose, and a number of complex assumptions including expected volatility, risk-free interest rate, expected dividends, kurtosis, and skewness. The Company did not grant a material number of options during the three months ended October 30, 2010 or October 24, 2009.

Accuracy of Fair Value Estimates

The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, its lattice-binomial and Black-Scholes models. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based payment awards. The Company’s determination of the fair value of share-based payment awards is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because the Company’s employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models may not provide an accurate measure of the fair value or be indicative of the fair value that would be observed in a willing buyer/willing seller market for the Company’s employee stock options.

 

14. Income Taxes

The following table provides details of income taxes (in millions, except percentages):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

Income before provision for income taxes

   $ 2,425      $ 2,239   

Provision for income taxes

   $ 495      $ 452   

Effective tax rate

     20.4     20.2 %

 

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As of October 30, 2010, the Company had $2.7 billion of unrecognized tax benefits, of which $2.4 billion, if recognized, would favorably impact the effective tax rate. The Company regularly engages in discussions and negotiations with tax authorities regarding tax matters in various jurisdictions. It is reasonably possible that certain federal, foreign, and state tax matters may be concluded in the next 12 months. Specific positions that may be resolved include issues involving transfer pricing and various other matters. The Company estimates that the unrecognized tax benefits at October 30, 2010 could be reduced by approximately $275 million in the next 12 months.

 

15. Segment Information and Major Customers

The Company designs, manufactures, and sells Internet Protocol (IP)-based networking and other products related to the communications and IT industry and provides services associated with these products and their use. Cisco products include Routers, Switches, New Products, and Other. These products, primarily integrated by Cisco IOS Software, link geographically dispersed local-area networks (LANs), metropolitan-area networks (MANs) and wide-area networks (WANs).

(a) Net Sales and Gross Margin by Segment

The Company conducts business globally and is primarily managed on a geographic basis. In the first quarter of fiscal 2011, in order to achieve operational efficiencies, the Company combined its Asia Pacific and Japan operations. Following this change, the Company is organized into the following four geographic segments: United States and Canada, European Markets, Emerging Markets, and Asia Pacific Markets.

The Company’s management makes financial decisions and allocates resources based on the information it receives from its internal management system. Sales are attributed to a geographic segment based on the ordering location of the customer. The Company does not allocate research and development, sales and marketing, or general and administrative expenses to its geographic segments in this internal management system because management does not include the information in its measurement of the performance of the operating segments. In addition, the Company does not allocate amortization of acquisition-related intangible assets, share-based compensation expense, charges related to asset impairments and restructurings, and certain other charges to the gross margin for each segment because management does not include this information in its measurement of the performance of the operating segments.

Summarized financial information by segment for the three months ended October 30, 2010 and October 24, 2009, based on the Company’s internal management system and as utilized by the Company’s Chief Operating Decision Maker (CODM), is as follows (in millions):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
 

Net sales:

    

United States and Canada (1)

   $ 5,878      $ 4,990   

European Markets

     2,018        1,822   

Emerging Markets

     1,215        863   

Asia Pacific Markets

     1,639        1,346   
                

Total

   $ 10,750      $ 9,021   
                

Gross margin (2):

    

United States and Canada

   $ 3,788      $ 3,285   

European Markets

     1,315        1,246   

Emerging Markets

     757        544   

Asia Pacific Markets

     1,054        902   
                

Segment total

     6,914        5,977   

Unallocated corporate items (3)

     (159     (89 )
                

Total

   $ 6,755      $ 5,888   
                

 

(1)

Net sales in the United States were $5.4 billion and $4.7 billion for the three months ended October 30, 2010 and October 24, 2009, respectively.

(2)

Certain reclassifications have been made to prior period amounts to conform to the current period’s presentation.

(3)

The unallocated corporate items include the effects of amortization of acquisition-related intangible assets and share-based compensation expense.

 

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(b) Net Sales for Groups of Similar Products and Services

Effective at the end of the first quarter of fiscal 2011, the Company revised the categorization of certain of its products into a category called New Products. The New Products category replaces the prior category of Advanced Technologies and also includes certain products previously classified as Other products. The New Products category consists of products related to collaboration, data center, security, wireless, and video connected home. The Other category now consists primarily of optical networking products and emerging technologies.

The following table presents net sales for groups of similar products and services (in millions):

 

     Three Months Ended  
     October 30,
2010
     October 24,
2009
 

Net sales (1):

     

Routers

   $ 1,804       $ 1,600   

Switches

     3,551         2,851   

New Products

     3,114         2,545   

Other

     231         204   
                 

Product

     8,700         7,200   

Service

     2,050         1,821   
                 

Total

   $ 10,750       $ 9,021   
                 

 

(1)

Certain reclassifications have been made to prior period amounts to conform to the current period’s presentation.

(c) Additional Segment Information

The majority of the Company’s assets, excluding cash and cash equivalents and investments, as of October 30, 2010 and July 31, 2010 were attributable to its U.S. operations. The Company’s total cash and cash equivalents and investments held outside of the United States in various foreign subsidiaries was $35.1 billion as of October 30, 2010, and the remaining $3.8 billion was held in the United States. For the three months ended October 30, 2010 and October 24, 2009, no single customer accounted for 10% or more of the Company’s net sales.

Property and equipment information is based on the physical location of the assets. The following table presents property and equipment information for geographic areas (in millions):

 

     October 30,
2010
     July 31,
2010
 

Property and equipment, net:

     

United States

   $ 3,327       $ 3,283   

International

     657         658   
                 

Total

   $ 3,984       $ 3,941   
                 

 

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16. Net Income per Share

The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):

 

     Three Months Ended  
     October 30,
2010
     October 24,
2009
 

Net income

   $ 1,930       $ 1,787   
                 

Weighted-average shares—basic

     5,595         5,767   

Effect of dilutive potential common shares

     80         104   
                 

Weighted-average shares—diluted

     5,675         5,871   
                 

Net income per share—basic

   $ 0.34       $ 0.31   
                 

Net income per share—diluted

   $ 0.34       $ 0.30   
                 

Antidilutive employee share-based awards, excluded

     327         465   

Employee equity share options, unvested shares, and similar equity instruments granted by the Company are treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options, unvested restricted stock, and restricted stock units. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible, are collectively assumed to be used to repurchase shares.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including 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”). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. 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,” “endeavors,” “strives,” “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, under “Part II, Item 1A. Risk Factors,” and elsewhere herein. 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

A summary of our results is as follows (in millions, except percentages and per-share amounts):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
    Variance  

Net sales

   $ 10,750      $ 9,021        19.2

Gross margin percentage

     62.8     65.3     (2.5 )pts. 

Operating expenses

   $ 4,404      $ 3,764        17.0

Operating expenses as a percentage of revenue

     41.0     41.7     (0.7 )pts. 

Operating margin percentage

     21.9     23.5     (1.6 )pts. 

Net income

   $ 1,930      $ 1,787        8.0

Net income as a percentage of revenue

     18.0     19.8     (1.8 )pts. 

Earnings per share—diluted

   $ 0.34      $ 0.30        13.3

In the first quarter of fiscal 2011, net sales increased 19% from the first quarter of fiscal 2010. We experienced net sales increases across each of our geographic segments for both product and service sales, across each of our product categories and across all of our customer markets, with the exception of the consumer market. On a year-over-year basis, total gross margin in the first quarter of fiscal 2011 declined by 2.5 percentage points from the first quarter of fiscal 2010. The decrease was primarily a result of higher sales discounts and product pricing, and unfavorable product mix. We also experienced unfavorable costs associated with the carryover effect of the fiscal 2010 supply constraints we experienced. Operating expense as a percentage of revenue declined by 0.7 percentage points. In the first quarter of fiscal 2011, operating expenses increased by 17%, slower than the 19% increase in revenue. As a percentage of revenue, research and development and general and administrative expenses declined, sales and marketing expenses as a percentage of revenue were unchanged from the prior year period. Diluted earnings per share increased by 13% from the prior year period; the increase resulted from an increase in net income of 8% along with a decline in our outstanding diluted share count of 196 million shares.

As we entered fiscal 2011, we characterized the economic environment as unusually uncertain. We believe there were a number of positive aspects to our results for the first quarter of fiscal 2011, as evidenced by the solid year-over-year growth rates we experienced in many areas of our business. In particular, revenue growth in our Switches, Routers and New Products categories were strong. Within our New Products category we reported solid revenue growth with our collaboration and data center offerings.

 

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While we experienced solid results in the first quarter of fiscal 2011, we also saw some declines in our business momentum in various markets, especially during the third month of the first quarter. We believe that some of the deceleration in business momentum that we experienced will adversely impact our growth over the next several quarters. While the decline in our business during fiscal 2009 was broad based and impacted all geographic segments and customer markets, the challenges in our business at present appear to be centered on several specific areas. The challenges were most prevalent from a geographic perspective in our European Markets segment and from a customer markets perspective, in portions of the public sector and service provider markets. Sales in our public sector market increased as a result of increased sales to the U.S. federal government during the first quarter of fiscal 2011, however we began to experience, and expect to continue to experience some challenges related to lower spending by state, local governments and K-12 education within the United States, as well as lower spending by certain public sector customers in our European Markets segment and in Japan. In addition, we experienced weakness in our business momentum to the cable providers within our service provider market, primarily in sales of traditional cable set-top boxes in our United States and Canada segment. We expect these challenges with regard to traditional cable set-top boxes in the United States and Canada segment will continue over the next several quarters.

In light of these challenges, we expect that our revenue for the second quarter of fiscal 2011 will grow at a slower rate than we had previously anticipated at the beginning of fiscal 2011, which will in turn have a negative impact on our full fiscal year revenue growth rate, as compared with our expectations at the beginning of fiscal 2011. As many of our headcount-related investments were based on projections of higher revenue, we expect that operating expenses as a percentage of revenue will increase in the second quarter of fiscal 2011. To mitigate this impact, we expect to undertake certain cost control initiatives, and to reallocate resources to focus on areas with higher business momentum and opportunity. The lower than expected revenue levels, our anticipated seasonality, and the higher than anticipated operating expenses as a percentage of revenue, may result in downward pressure to our operating margin. Taking all of the preceding factors into consideration, we expect that our operating income, net income, and earnings per share for the second quarter of fiscal 2011 will likely decline on a year-over-year basis.

Strategy and Focus Areas

Our strategy centers on the network as the platform. Notwithstanding the aforementioned challenges, our basic strategy remains intact. Consistent with our strategy during fiscal 2010, we continue to seek to expand our share of our customers’ information technology spending. We will endeavor to achieve this objective by focusing on our core networking capabilities while continuing to expand into product markets in which the role of the network as the platform is increasing and which are similar, related, or adjacent to markets in which we currently are active, which product markets we refer to as market adjacencies. We have continued our focus on our core networking capabilities and have expanded our movement into market adjacencies, primarily through the realignment of resources.

We refer to the evolutionary process by which adjacencies arise as market transitions. Market transitions on which we are focusing primary attention include those related to the increased role of virtualization/the cloud, video, collaboration, and networked Web 2.0 technologies. For example, a market in which a significant market transition is under way is the enterprise data center market, where a transition to virtualization / the cloud is under way. We believe the market is at an inflection point, as awareness grows that intelligent networks are becoming the platform for productivity improvement and global competitiveness. We further believe that disruption in the enterprise data center market is accelerating, due to changing technology trends such as the increasing adoption of virtualization, the rise in scalable processing, and the advent of cloud computing and cloud-based IT resource deployments and business models. These key terms are defined as follows:

Virtualization: refers to the process of aggregating the current siloed data center resources into unified, shared resource pools that can be dynamically delivered to applications on demand thus enabling the ability to move content and applications between devices and the network.

The cloud: refers to an information technology hosting and delivery system in which resources, such as servers or software applications, are no longer tethered to a user’s physical infrastructure but which instead are delivered to and consumed by the user “on demand” as an Internet-based service, whether singularly or with multiple other users simultaneously.

This virtualization and cloud-driven market transition in the enterprise data center market is being brought about through the convergence of networking, computing, storage, and software technologies. We are seeking to take advantage of this market transition through, among other things, our Cisco Unified Computing System platform and Cisco Nexus product families, which are designed to integrate the previously siloed technologies in the enterprise data center with a unified architecture. We are also seeking to capitalize on this market transition through the development of other cloud-based product and service offerings through which we intend to enable customers to develop and deploy their own cloud-based IT solutions, including software-as-a-service (SaaS) and other-as-a-service (XaaS) solutions.

 

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The competitive landscape in the enterprise data center market is changing, and we expect there will be a new class of very large, well-financed, and aggressive competitors, each bringing its own new class of products to address this new market. However, with respect to this market, we believe the network will be the intersection of innovation through an open ecosystem and standards. We expect to see acquisitions, further industry consolidation, and new alliances among companies as they seek to serve the enterprise data center market. As we enter this next market phase, we expect that we will strengthen certain strategic alliances, compete more with certain strategic alliances and partners, and perhaps also encounter new competitors in our attempt to deliver the best solutions for our customers.

Other market transitions on which we are focusing particular attention include those related to the increased role of video, collaboration, and networked Web 2.0 technologies. The key market transitions relative to the convergence of video, collaboration, and networked Web 2.0 technologies, which we believe will drive productivity and growth in network loads, appear to be evolving even more quickly and more significantly than we had previously anticipated. Cisco TelePresence systems are one example of product offerings that have incorporated video, collaboration, and networked Web 2.0 technologies, as customers evolve their communications and business models. We are focused on simplifying and expanding the creation, distribution, and use of end-to-end video solutions for businesses and consumers, and our fiscal 2010 acquisition of Tandberg ASA (“Tandberg”) is an example of our increased emphasis on the video market segment.

We believe that the architectural approach that has served us well in addressing the market adjacencies in the communications and information technology industry will be adaptable to other market adjacencies. Examples of market adjacencies where we aim to apply this approach are mobility, the consumer, and electrical services infrastructure. With regard to mobility, the growth of IP traffic on handheld devices is driving the need for more robust architectures, equipment and services in order to accommodate not only an increasing number of worldwide mobile device users, but also increased user demand for broadband-quality business network and consumer web applications to be seamlessly delivered on such devices. Our fiscal 2010 acquisition of Starent Networks, Corp. (“Starent”) reflects our recognition of the significance of this market adjacency and our intent to offer solutions that help expand IP network load capabilities for mobile devices. For the consumer market, through collaboration with technology partners, retailers, service providers, and content publishers, we are striving to create compelling consumer experiences and make the network the platform for a variety of services in the home, as broadband development moves from a device-centric phase to a network-centric model. In the electrical services infrastructure market, we are developing architecture for managing energy in a highly secure fashion on electrical grids at various steps from energy generation to consumption in homes and commercial buildings.

We are currently undergoing product transitions within several of our product families, and we believe that many of these product transitions are gaining momentum based on the strong year-over-year product revenue growth across these product families. We believe that our strategy and our ability to innovate and execute may enable us to improve our relative competitive position in many of our product areas even in uncertain or difficult business conditions, and therefore may continue to provide us with long-term growth opportunities.

Revenue

For the first quarter of fiscal 2011, our total revenue increased by 19% year over year. Within total revenue, net product revenue increased 21% and net service revenue increased 13%. The revenue increase for the period was in part the result of revenue from our acquisitions of Starent in the second quarter of fiscal 2010 and Tandberg in the third quarter of fiscal 2010. From our geographic segment perspective, net revenue increased on a year-over-year basis by 18% in the United States and Canada segment, 11% in our European Markets segment, 41% in Emerging Markets, and 22% in our Asia Pacific Markets segment (which now includes Japan). Customer market revenue performance in the first quarter of fiscal 2011 as compared with the first quarter of fiscal 2010 consisted of increases in the enterprise and public sector, commercial, and service provider markets. Our consumer market experienced a sales decline on a year-over-year basis for the first quarter of fiscal 2011.

The 21% increase in product revenue was driven by year-over-year growth across our product categories. In particular, we experienced revenue increases in our Router products category of 13%, principally as a result of strength in the high-end category. We had year-over-year revenue growth of 25% in our Switches product category, chiefly as a result of strong revenue growth in both modular and fixed-configuration offerings. Our New Products category experienced a year-over-year revenue increase of 22%. The increase was spread across almost all of the sub-categories within New Products, led by revenue growth rates of 45% in collaboration products and 59% in data center products.

 

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Gross Margin

In the first quarter of fiscal 2011, our gross margin percentage decreased by approximately 2.5 percentage points compared with the first quarter of fiscal 2010. Within this total gross margin change, product gross margin declined 2.8 percentage points while service gross margin declined 0.9 percentage points. The decrease in our product gross margin percentage was a result of higher sales discounts, product pricing and unfavorable product mix. We also experienced unfavorable costs associated with the carryover effect of the supply chain constraint issues we faced in fiscal 2010. In the first quarter of fiscal 2011 as compared to the corresponding period in fiscal 2010, increased amortization expense from purchased intangible assets and higher share-based compensation expense added to the decline in product gross margin. Partially offsetting these decreases were cost savings and higher shipment volume. The decline in services gross margin from the corresponding period in fiscal 2010 was due to unfavorable mix impacts and increased share-based compensation expense. Our gross margins could also be adversely impacted by economic downturns or uncertain economic conditions, our movement into market adjacencies, and the geographic mix of our revenue.

Operating Expenses

Operating expenses in the first quarter of fiscal 2011 increased by 17% while decreasing by 0.7 percentage points as a percentage of revenue, each as compared to the first quarter of fiscal 2010. For the first quarter of fiscal 2011, higher headcount-related and higher discretionary expenses collectively contributed to the increase in operating expenses, as did higher share-based compensation expense. As noted above, in light of our expectations that our revenue will grow at a slower rate than we had previously anticipated during the second quarter of fiscal 2011 and the fact that many of our headcount-related expenses were based on projections of higher revenue, we expect that operating expense as a percentage of revenue will increase in the second quarter of fiscal 2011.

Other Key Financial Measures

The following is a summary of our other key financial measures for the first quarter of fiscal 2011:

 

   

We generated cash flows from operations of $1.7 billion and $1.5 billion during the first quarter of fiscal 2011 and 2010, respectively. Our cash and cash equivalents, together with our investments, were $38.9 billion at the end of the first quarter of fiscal 2011, compared with $39.9 billion at the end of fiscal 2010.

 

   

Our deferred revenue at the end of the first quarter of fiscal 2011 was $10.7 billion, compared with $11.1 billion at the end of fiscal 2010.

 

   

We repurchased 113 million shares of our common stock under our stock repurchase program for $2.5 billion during the first quarter of fiscal 2011. In addition, on November 18, 2010, our Board of Directors authorized the repurchase of up to an additional $10 billion of our common stock under this program with no termination date.

 

   

Days sales outstanding in accounts receivable (DSO) at the end of the first quarter of fiscal 2011 was 38 days, compared with 41 days at the end of fiscal 2010.

 

   

Our inventory balance was $1.5 billion at the end of the first quarter of fiscal 2011, compared with $1.3 billion at the end of fiscal 2010. Annualized inventory turns were 11.2 in the first quarter of fiscal 2011 and were 12.6 in the fourth quarter of fiscal 2010.

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 in our Annual Report on Form 10-K for the fiscal year ended July 31, 2010, as updated where applicable in Note 2 herein, 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

Revenue is recognized when all of the following criteria have been met:

 

   

Persuasive evidence of an arrangement exists. Contracts, Internet commerce agreements, and customer purchase orders are generally used to determine the existence of an arrangement.

 

   

Delivery has occurred. Shipping documents and customer acceptance, when applicable, are used to verify delivery.

 

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The fee is fixed or determinable. 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.

 

   

Collectibility is reasonably assured. 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.

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. When a sale involves multiple deliverables, such as sales of products that include services, the multiple deliverables are evaluated to determine the unit of accounting, and the entire fee from the arrangement is allocated to each unit of accounting based on the relative selling price. Revenue is recognized when the revenue recognition criteria for each unit of accounting are met.

The amount of product and service revenue recognized in a given period is affected by our judgment as to whether an arrangement includes multiple deliverables and, if so, our valuation of the units of accounting for the multiple deliverables. According to the accounting guidance prescribed in Accounting Standards Codification (ASC) 605, Revenue Recognition, we use vendor-specific objective evidence of selling price (VSOE) for each of those units, when available. We determine VSOE based on our normal pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for a product or service fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical standalone transactions falling within plus or minus 15% of the median selling price. VSOE exists across most of our product and service offerings. In certain limited circumstances when VSOE does not exist, we apply the selling price hierarchy to applicable multiple-deliverable arrangements. Under the selling price hierarchy, third-party evidence of selling price (TPE) will be considered if VSOE does not exist, and estimated selling price (ESP) will be used if neither VSOE nor TPE is available. Generally, we are not able to determine TPE because our go-to-market strategy differs from that of others in our markets, and the extent of customization varies among comparable products or services from our peers. In determining ESP, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. We typically arrive at an ESP for a product or service that is not sold separately by considering company specific factors such as geographies, competitive landscape, internal costs, gross margin objectives, pricing practices used to establish bundled pricing, and existing portfolio pricing and discounting.

Some of our sales arrangements have multiple deliverables containing software and related software support components. Such sale arrangements are subject to the accounting guidance in ASC 985-605, Software-Revenue Recognition.

As our business and offerings evolve over time, our pricing practices may be required to be modified accordingly, which could result in changes in selling prices, including both VSOE and ESP in subsequent periods. There were no material impacts during the quarter nor do we currently expect a material impact in the next twelve months on our revenue recognition due to any changes in our VSOE, TPE, or ESP.

Revenue deferrals relate to the timing of revenue recognition for specific transactions based on financing arrangements, service, support, and other factors. Financing arrangements may include sales-type, direct-financing, and operating leases, loans, and guarantees of third-party financing. Our deferred revenue for products was $3.6 billion and $3.7 billion as of October 30, 2010 and July 31, 2010, respectively. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which typically is from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our deferred revenue for services was $7.2 billion and $7.4 billion as of October 30, 2010 and July 31, 2010, respectively.

We make sales to distributors and retail partners and generally 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 under these programs were to deviate significantly from our estimates, which are based on historical experience, our revenue could be adversely affected.

 

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Allowances for Receivables and Sales Returns

The allowances for receivables were as follows (in millions, except percentages):

 

     October 30,
2010
    July 31,
2010
 

Allowance for doubtful accounts

   $ 191      $ 235   

Percentage of gross accounts receivable

     4.1 %     4.6 %

Allowance for lease receivables

   $ 232      $ 207   

Percentage of gross lease receivables

     9.0 %     8.6

Allowance for loan receivables

   $ 80      $ 73   

Percentage of gross loan receivables

     6.3 %     5.8 %

The allowances are based on our assessment of the collectibility of customer accounts. We regularly review the adequacy of these allowances by considering factors such as historical experience, credit quality, age of the receivable balances, and economic conditions that may affect a customer’s ability to pay. In addition, we perform credit reviews and statistical portfolio analysis to assess the credit quality of our receivables. We also consider the concentration of receivables outstanding with a particular customer in assessing the adequacy of our allowances. The decline in our allowance for doubtful accounts as a percentage of our gross accounts receivable was primarily due to the write-off of certain uncollectible receivables which had been fully reserved. 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 October 30, 2010 and July 31, 2010 was $93 million and $90 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.

Inventory Valuation and Liability for Purchase Commitments with Contract Manufacturers and Suppliers

Our inventory balance was $1.5 billion and $1.3 billion as of October 30, 2010 and July 31, 2010, respectively. Inventory is written down based on excess and obsolete inventories determined primarily by future demand forecasts. Inventory write-downs are measured as the difference between the cost of the inventory and market, based upon assumptions about future demand, and are 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.

We record a liability for firm, noncancelable, and unconditional purchase commitments with contract manufacturers and suppliers for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory. As of October 30, 2010, the liability for these purchase commitments was $136 million, compared with $135 million as of July 31, 2010, and was included in other current liabilities.

Our provision for inventory was $19 million for both the first quarters of fiscal 2011 and 2010. The provision for the liability related to purchase commitments with contract manufacturers and suppliers was $12 million and $7 million for the first quarter of fiscal 2011 and 2010, 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 write-downs and our liability for purchase commitments with contract manufacturers and suppliers and gross margin could be adversely affected. We regularly evaluate our exposure for inventory write-downs and the adequacy of our liability for purchase commitments. Inventory and supply chain management remain areas of focus as we balance the need to maintain supply chain flexibility to help ensure competitive lead times with the risk of inventory obsolescence, particularly in light of current macroeconomic uncertainties and conditions and the resulting potential for changes in future demand forecast.

Warranty Costs

The liability for product warranties, included in other current liabilities, was $350 million as of October 30, 2010, compared with $360 million as of July 31, 2010. See Note 11 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.

 

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The provision for product warranties issued during the first quarter of fiscal 2011 and 2010 was $110 million and $108 million, respectively. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our gross margin could be adversely affected.

Share-Based Compensation Expense

Total share-based compensation expense for the three months ended October 30, 2010 and October 24, 2009 was $407 million and $321 million, respectively. The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. For employee stock options and employee stock purchase rights, these variables include, but are not limited to, the expected stock price volatility over the term of the awards, risk-free interest rate, and expected dividends as of the grant date. For employee stock options, we used the implied volatility for two-year traded options on our stock as the expected volatility assumption required in the lattice-binomial model. For employee stock purchase rights, we used the implied volatility for traded options (with lives corresponding to the expected life of the employee stock purchase rights) on our stock. The selection of the implied volatility approach was based upon the availability of actively traded options on our stock and our assessment that implied volatility is more representative of future stock price trends than historical volatility. The valuation of employee stock options is also impacted by kurtosis, and skewness, which are technical measures of the distribution of stock price returns, and the actual and projected employee stock option exercise behaviors.

Because share-based compensation expense is based on awards ultimately expected to vest, it has been reduced for forfeitures. If factors change and we employ different assumptions in the application of our option-pricing model in future periods or if we experience different forfeiture rates, the compensation expense that is derived may differ significantly from what we have recorded in the current period.

Fair Value Measurements

Our fixed income and publicly traded equity securities, collectively, are reflected in the Consolidated Balance Sheets at a fair value of $35.1 billion as of October 30, 2010, compared with $35.3 billion as of July 31, 2010. Our fixed income investment portfolio as of October 30, 2010 consisted primarily of the highest quality investment grade securities. See Note 7 to the Consolidated Financial Statements.

As described more fully in Note 8 to the Consolidated Financial Statements, a valuation hierarchy is based on the level of independent, objective evidence available regarding the value of the investments. It encompasses three classes of investments: Level 1 consists of securities for which there are quoted prices in active markets for identical securities; Level 2 consists of securities for which observable inputs other than Level 1 inputs are used, such as prices for similar securities in active markets or for identical securities in less active markets and model-derived valuations for which the variables are derived from, or corroborated by, observable market data; and Level 3 consists of securities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value.

Our Level 2 securities are valued using quoted market prices for similar instruments, nonbinding market prices that are corroborated by observable market data, or discounted cash flow techniques in limited circumstances. We use inputs such as actual trade data, benchmark yields, broker/dealer quotes, and other similar data, which are obtained from independent pricing vendors, quoted market prices, or other sources to determine the ultimate fair value of our assets and liabilities. We use such pricing data as the primary input, to which we have not made any material adjustments during the periods presented, to make our assessments and determinations as to the ultimate valuation of our investment portfolio. We are ultimately responsible for the financial statements and underlying estimates.

The inputs and fair value are reviewed for reasonableness, may be further validated by comparison to publicly available information and could be adjusted based on market indices or other information that management deems material to their estimate of fair value. In the current market environment, the assessment of fair value can be difficult and subjective. However, given the relative reliability of the inputs we use to value our investment portfolio, and because substantially all of our valuation inputs are obtained using quoted market prices for similar or identical assets, we do not believe that the nature of estimates and assumptions affected by levels of subjectivity and judgment was material to the valuation of the investment portfolio as of October 30, 2010. Level 3 assets do not represent a significant portion of our total investment portfolio as of October 30, 2010.

Other-Than-Temporary Impairments

We recognize an impairment charge when the declines in the fair values of our fixed income or publicly traded equity securities below their cost basis are judged to be other than temporary. The ultimate value realized on these securities, to the extent unhedged, is subject to market price volatility until they are sold.

 

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If the fair value of a debt security is less than its amortized cost, we assess whether the impairment is other than temporary. An impairment is considered other than temporary if (i) we have the intent to sell the security, (ii) it is more likely than not that we will be required to sell the security before recovery of its entire amortized cost basis, or (iii) we do not expect to recover the entire amortized cost of the security. If an impairment is considered other than temporary based on (i) or (ii) described above, the entire difference between the amortized cost basis and the fair value of the security is recognized in earnings. If an impairment is considered other than temporary based on condition (iii), the amount representing credit losses, defined as the difference between the present value of the cash flows expected to be collected and the amortized cost of the debt security, will be recognized in earnings and the amount relating to all other factors will be recognized in other comprehensive income (OCI). In estimating the amount and timing of cash flows expected to be collected, we consider all available information including past events, current conditions, the remaining payment terms of the security, the financial condition of the issuer, expected defaults, and the value of underlying collateral.

For publicly traded equity securities, 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 issuer, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

There were no impairment charges on investments in fixed income securities and publicly traded equity securities that were recognized in earnings in the first quarter of fiscal 2011 or the first quarter of fiscal 2010. Our ongoing consideration of all the factors described above could result in additional impairment charges in the future, which could adversely affect our net income.

We also have investments in privately held companies, some of which are in the startup or development stages. As of October 30, 2010, our investments in privately held companies were $779 million, compared with $756 million as of July 31, 2010, and were included in other assets. See Note 5 to the Consolidated Financial Statements. We monitor these investments for events or circumstances indicative of potential impairment and will make appropriate reductions in carrying values if we determine that 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 $3 million and $10 million during the first quarters of fiscal 2011 and 2010, respectively.

Goodwill and Purchased Intangible Asset Impairments

Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques. Goodwill represents a residual value as of the acquisition date, which in most cases results in measuring goodwill as the excess of the purchase consideration transferred plus the fair value of any noncontrolling interest in the acquired company over the fair value of net assets acquired, including any contingent consideration. We perform goodwill impairment tests on an annual basis in the fourth fiscal quarter and between annual tests in certain circumstances for each reporting unit. Effective in fiscal 2010, the assessment of fair value for goodwill and purchased intangible assets is based on factors that market participants would use in an orderly transaction in accordance with the new accounting guidance for the fair value measurement of nonfinancial assets.

In the first quarter of fiscal 2011, in order to achieve operational efficiencies, we combined its Asia Pacific and Japan operations. Following this change, our business is organized in the following four geographic segments: United States and Canada, European Markets, Emerging Markets, and Asia Pacific Markets. As a result, the goodwill of the former Asia Pacific and Japan geographic segments as of July 31, 2010 was allocated to the combined segment Asia Pacific Markets. The goodwill recorded in the Consolidated Balance Sheets as of October 30, 2010 and July 31, 2010 was $16.7 billion for both periods. 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 the first quarter of fiscal 2011 and 2010, respectively.

We make judgments about the recoverability of purchased intangible assets with finite lives whenever events or changes in circumstances indicate that an impairment may exist. Recoverability of purchased intangible assets with finite lives is measured by comparing the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. We review indefinite-lived intangible assets for impairment annually or whenever events or changes in circumstances indicate the carrying value may not be recoverable. Recoverability of indefinite-lived intangible assets is measured by comparing the carrying amount of the asset to the future discounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. Assumptions and estimates about future values and remaining useful lives of our purchased intangible assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends and internal factors such as changes in our business strategy and our internal forecasts. Our impairment charges related to purchased intangible assets were not material for the periods presented. Our ongoing consideration of all the factors described previously could result in additional impairment charges in the future, which could adversely affect our net income.

 

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Income Taxes

We are subject to income taxes in the United States and numerous foreign jurisdictions. Our effective tax rates differ from the statutory rate primarily due to the tax impact of state taxes, foreign operations, research and development (R&D) tax credits, tax audit settlements, nondeductible compensation, international realignments, and transfer pricing adjustments. Our effective tax rate was 20.4% and 20.2% in the first quarter of fiscal 2011 and fiscal 2010, respectively.

Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. 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.

Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in countries that have lower tax rates and higher than anticipated in countries that have higher tax rates; by changes in the valuation of our deferred tax assets and liabilities; by expiration of or lapses in the R&D tax credit laws; by transfer pricing adjustments including the effect of acquisitions on our intercompany R&D cost sharing arrangement and legal structure; by tax effects of nondeductible compensation; by tax costs related to intercompany realignments; by changes in accounting principles; or by changes in tax laws and regulations including possible U.S. changes to the taxation of earnings of our foreign subsidiaries, the deductibility of expenses attributable to foreign income, or the foreign tax credit rules. Significant judgment is required to determine the recognition and measurement attributes prescribed in the accounting guidance for uncertainty in income taxes. The accounting guidance for uncertainty in income taxes applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely impact our provision for income taxes or additional paid-in capital. Further, as a result of certain of our ongoing employment and capital investment actions and commitments, our income in certain countries is subject to reduced tax rates and in some cases is wholly exempt from tax. Our failure to meet these commitments could adversely impact our provision for income taxes. 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. There can be no assurance that the outcomes from these continuous examinations will not have an adverse impact on our operating results and financial condition.

Loss Contingencies

We are subject to the possibility of various losses 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.

Third parties, including customers, have in the past and may in the future assert claims or initiate litigation related to exclusive patent, copyright, trademark, and other intellectual property rights to technologies and related standards that are relevant to us. These assertions have increased over time as a result of our growth and the general increase in the pace of patent claims assertions, particularly in the United States. If any infringement or other intellectual property claim made against us by any third party is successful, or if we fail to develop non-infringing technology or license the proprietary rights on commercially reasonable terms and conditions, our business, operating results, and financial condition could be materially and adversely affected.

 

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Net Sales

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

 

     Three Months Ended  
     October 30,
2010
     October 24,
2009
     Variance
in
Dollars
     Variance
in
Percent
 

Net sales:

           

Product

   $ 8,700       $ 7,200       $ 1,500         20.8 %

Service

     2,050         1,821         229         12.6 %
                             

Total

   $ 10,750       $ 9,021       $ 1,729         19.2 %
                             

We manage our business primarily on a geographic basis, based on four geographic segments. Our net sales, which include product and service revenue, for each segment are summarized in the following table (in millions, except percentages):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
    Variance
in
Dollars
     Variance
in
Percent
 

Net sales:

         

United States and Canada

   $ 5,878      $ 4,990      $ 888         17.8 %

Percentage of net sales

     54.7 %     55.3     

European Markets

     2,018        1,822        196         10.8 %

Percentage of net sales

     18.8 %     20.2     

Emerging Markets

     1,215        863        352         40.8 %

Percentage of net sales

     11.3 %     9.6     

Asia Pacific Markets

     1,639        1,346        293         21.8 %

Percentage of net sales

     15.2 %     14.9     
                           

Total

   $ 10,750      $ 9,021      $ 1,729         19.2 %
                           

For the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010, net sales increased by 19%, with sales increases experienced across our four geographic segments. Our year-over-year increase in net sales was due in part to the relative weakness of the corresponding period in fiscal 2010, as the increase in our business due to the partial economic recovery in fiscal 2010 was not yet fully reflected in our results that quarter. We had double-digit percentage point increases in both net product and services sales in comparison to the prior year period. Net product and service sales both experienced growth across each of our geographic segments.

We conduct business globally in numerous currencies. The direct effect of foreign currency fluctuations on sales has not been material because our sales are primarily denominated in U.S. dollars. However, if the U.S. dollar strengthens relative to other currencies, such strengthening could have an indirect effect on our sales to the extent it raises the cost of our products to non-U.S. customers and thereby reduces demand. A weaker U.S. dollar could have the opposite effect. However, the precise indirect effect of currency fluctuations is difficult to measure or predict because our sales are influenced by many factors in addition to the impact of such currency fluctuations.

In addition to the impact of macroeconomic factors, net sales by segment in a particular period may be significantly impacted by several factors related to revenue recognition, including the complexity of transactions such as multiple-element arrangements; the mix of financing arrangements provided to our channel partners and customers; and final acceptance of the product, system, or solution, among other factors. In addition, certain customers tend to make large and sporadic purchases and the net sales related to these transactions may also be affected by the timing of revenue recognition, which in turn would impact the net sales of the relevant segment.

 

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Net Product Sales by Segment

The following table presents the breakdown of net product sales by segment (in millions, except percentages):

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
    Variance
in
Dollars
     Variance
in
Percent
 

Net product sales:

         

United States and Canada

   $ 4,596      $ 3,832      $ 764         19.9 %

Percentage of net product sales

     52.8 %     53.2     

European Markets

     1,709        1,532        177         11.6 %

Percentage of net product sales

     19.6 %     21.3     

Emerging Markets

     1,030        708        322         45.5 %

Percentage of net product sales

     11.8 %     9.8     

Asia Pacific Markets

     1,365        1,128        237         21.0 %

Percentage of net product sales

     15.8 %     15.7     
                           

Total

   $ 8,700      $ 7,200      $ 1,500         20.8 %
                           

United States and Canada

Net product sales in the United States and Canada segment for the first quarter of fiscal 2011 increased compared with the corresponding period of fiscal 2010. The increase in net product sales was across most of our customer markets in the United States and Canada segment, led by the enterprise and commercial markets. Sales in the consumer market declined during the first quarter of fiscal 2011 from the prior year period. Net product sales to the public sector increased primarily due to increased sales to the U.S. federal government. In the third month of the quarter we began to experience some weakness in our business momentum in sales to state, local governments and K-12 education, which we believe may be attributable in part to budget constraints and which we believe may affect our results in future quarters. While we also experienced a year-over-year increase in net product sales to the service provider market for the first quarter of fiscal 2011, we also saw indicators of a decline in our business momentum with cable providers, in particular with sales of traditional cable set-top boxes.

European Markets

Net product sales in the European Markets segment during the first quarter of fiscal 2011 increased compared with the corresponding period of fiscal 2010. The increase in net product sales in the European Markets segment was driven by increased sales in the enterprise and service provider markets. Net product sales in the consumer markets increased slightly while sales in the commercial market experienced a decline. For the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010 net product sales increased in all of our major countries in the European Markets segment. While we experienced an increase in net product sales to our European Markets segment during the first quarter of fiscal 2011 compared with the first quarter of fiscal 2010, in the third month of the quarter we began to experience some weakness in this segment, particularly with regard to our sales to the public sector market, which we believe was due to budget-driven austerity measures being taken across this region. We expect that these challenges may continue over the next several quarters.

Emerging Markets

For the first quarter of fiscal 2011, net product sales in the Emerging Markets segment increased compared with the first quarter of fiscal 2010. The net product sales increase was experienced across all of our customer markets within Emerging Markets with the exception of the consumer market. Net product sales growth was strong in the enterprise, commercial and service provider markets. From a country perspective, we experienced strong net product sales increases in Russia, Mexico and Brazil, among other countries.

Asia Pacific Markets

The increase in net product sales in the Asia Pacific Markets segment in the first quarter of fiscal 2011, compared with the corresponding period of fiscal 2010, was attributable to sales growth across most customer markets, led by strong growth in our enterprise and commercial markets. Our service provider market also experienced sales growth. We experienced increased net product sales in significant countries to us such as China, India and Japan, partially offset by a net product sales decline in Australia. While we experienced a year-over-year increase in net product sales to this segment during the first quarter of fiscal 2011, we saw some weakness in our Japanese government business and we expect continued challenges in that area over the next several quarters.

 

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Net Product Sales by Groups of Similar Products

In addition to the primary view on a geographic basis, we also prepare financial information related to groups of similar products and customer markets for various purposes. We have regrouped our presentation of products and technologies formerly grouped as either Advanced Technologies or Other products, with our new categories being called New Products and Other. Our New Products category replaces Advanced Technologies and includes some products that had previously been in the category called Other. Our New Products category consists of the following sub-categories: video connected home (networked home, Pure Digital products, video systems, and cable products), collaboration (unified communications and Cisco TelePresence), security, wireless, and data center (application networking services, storage, and Cisco Unified Computing System products). The Other product category consists primarily of optical networking products and emerging technologies.

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

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
    Variance
in
Dollars
     Variance
in
Percent
 

Net product sales:

         

Routers

   $ 1,804      $ 1,600      $ 204         12.8 %

Percentage of net product sales

     20.7 %     22.2 %     

Switches

     3,551        2,851        700         24.6 %

Percentage of net product sales

     40.8 %     39.6 %     

New Products

     3,114        2,545        569         22.4 %

Percentage of net product sales

     35.8 %     35.3 %     

Other

     231        204        27         13.2. %

Percentage of net product sales

     2.7 %     2.9 %     
                           

Total

   $ 8,700      $ 7,200      $ 1,500         20.8 %
                           

Routers

We categorize our routers primarily as high-end, midrange, and low-end routers. The growth in sales of our Routers product category in the first quarter of fiscal 2011 was driven by a 16% increase in sales of our high-end routers. Within high-end router products, the increase was driven by sales of the Cisco ASR 1000 and 9000 Series Aggregation Services Routers, and the inclusion of the Cisco ASR 5000 products from our acquisition of Starent, partially offset by lower sales of our Cisco 12000 Series Routers and Cisco CRS-1 Carrier Routing System. Our sales of midrange and low-end routers increased by 7% and 8%, respectively, for the first quarter of fiscal 2011 compared to the first quarter of fiscal 2010.

Switches

The increase in net product sales in our Switches product category in the first quarter of fiscal 2011 compared with fiscal 2010 was due primarily to higher sales of our modular and LAN fixed-configuration switches of approximately $340 million and $355 million, respectively. The increase in sales of modular switches was primarily due to the increased sales of our Cisco Nexus 7000 and Cisco Catalyst 4500 Series Switches. The increase in LAN fixed-configuration switches was primarily due to increased sales of Cisco Catalyst 2960 and 3750 Series Switches and Cisco Nexus 5000 and 2000 Series Switches.

New Products

In the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010, net product sales within our New Products category increased by 22% to $3.1 billion. The increase in net product sales was due to the following:

 

   

Sales of video connected home products increased by 11% or $97 million, due to increased sales of video systems, primarily digital set-top boxes; increased sales of cable products; and increased sales of Flip Video cameras. These increases were partially offset by decreased sales of networked home products. While we experienced a year-over-year increase in net product sales for video systems, we experienced some weakness in our business momentum in this area, specifically as it pertains to cable providers, and in particular traditional cable set-top boxes, in the United States and Canada. We expect that these challenges may continue over the next several quarters.

 

   

Sales of collaboration products increased by 45% or $318 million, primarily due to the inclusion of Tandberg sales within our Cisco TelePresence systems products following our acquisition of Tandberg in the third quarter of fiscal 2010, as well as due to higher sales of unified communications products, primarily IP phones and collaborative web-based offerings.

 

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Sales of security products decreased by 2% or $8 million. Our decreased sales of security products were a result of the lower sales of module and line cards related to our routers and LAN switches, partially offset by increased sales of our web and email security products.

 

   

Sales of data center products increased by 59% or $134 million, due to a combination of increased sales of Cisco Unified Computing System products and storage sales, partially offset by slightly lower sales of application networking services products.

 

   

Sales of wireless products increased by 9% or $28 million, which was primarily due to the customer adoption of and migration to the Cisco Unified Wireless Network architecture.

Other Product Revenue

The increase in other product revenue during the first quarter of fiscal 2011 was related to higher sales of optical networking products and, to a lesser extent, sales of certain of our emerging technology products.

Net Service Sales by Segment

 

     Three Months Ended  
     October 30,
2010
    October 24,
2009
    Variance
in
Dollars
     Variance
in
Percent
 

Net service sales:

         

United States and Canada

   $ 1,282      $ 1,158      $ 124         10.7 %

Percentage of net service sales

     62.5 %     63.6     

European Markets

     309        290        19         6.6 %

Percentage of net service sales

     15.1 %     15.9     

Emerging Markets

     185        155        30