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 January 29, 2005

 

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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES x  NO ¨

 

As of February 11, 2005, 6,463,952,333 shares of the registrant’s common stock were outstanding.

 



Table of Contents

Cisco Systems, Inc.

FORM 10-Q for the Quarter Ended January 29, 2005

 

INDEX

 

Part I.       Financial Information    Page
Item 1.   Financial Statements (Unaudited)     
    Consolidated Statements of Operations for the three and six months ended January 29, 2005 and January 24, 2004    3
    Consolidated Balance Sheets at January 29, 2005 and July 31, 2004    4
    Consolidated Statements of Cash Flows for the six months ended January 29, 2005 and January 24, 2004    5
    Consolidated Statements of Shareholders’ Equity for the six months ended January 29, 2005 and January 24, 2004    6
    Notes to Consolidated Financial Statements    7
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations    31
Item 3.   Quantitative and Qualitative Disclosures About Market Risk    64
Item 4.   Controls and Procedures    66
Part II.   Other Information     
Item 1.   Legal Proceedings    67
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds    67
Item 3.   Defaults Upon Senior Securities    68
Item 4.   Submission of Matters to a Vote of Security Holders    69
Item 5.   Other Information    69
Item 6.   Exhibits    69
    Signature    70

 

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Table of Contents
PART I.   FINANCIAL INFORMATION

 

Item 1.   Financial Statements (Unaudited)

 

Cisco Systems, Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per-share amounts)

(Unaudited)

 

    Three Months Ended

    Six Months Ended

 
    January 29,
2005


  January 24,
2004


    January 29,
2005


  January 24,
2004


 

NET SALES:

                           

Product

  $ 5,106   $ 4,550     $ 10,139   $ 8,813  

Service

    956     848       1,894     1,686  
   

 


 

 


Total net sales

    6,062     5,398       12,033     10,499  
   

 


 

 


COST OF SALES:

                           

Product

    1,669     1,425       3,315     2,741  

Service

    340     275       650     554  
   

 


 

 


Total cost of sales

    2,009     1,700       3,965     3,295  
   

 


 

 


GROSS MARGIN

    4,053     3,698       8,068     7,204  

OPERATING EXPENSES:

                           

Research and development

    811     770       1,616     1,525  

Sales and marketing

    1,142     1,110       2,262     2,197  

General and administrative

    228     210       458     422  

Amortization of purchased intangible assets

    57     60       117     122  

In-process research and development

    2     1       14     1  
   

 


 

 


Total operating expenses

    2,240     2,151       4,467     4,267  
   

 


 

 


OPERATING INCOME

    1,813     1,547       3,601     2,937  

Interest income

    127     124       257     261  

Other income, net

    17     136       57     137  
   

 


 

 


Interest and other income, net

    144     260       314     398  
   

 


 

 


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

    1,957     1,807       3,915     3,335  

Provision for income taxes

    557     516       1,119     958  
   

 


 

 


INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE

    1,400     1,291       2,796     2,377  

Cumulative effect of accounting change, net of tax

    —       (567 )     —       (567 )
   

 


 

 


NET INCOME

  $ 1,400   $ 724     $ 2,796   $ 1,810  
   

 


 

 


Income per share before cumulative effect of accounting change:

                           

Basic

  $ 0.21   $ 0.19     $ 0.43   $ 0.34  
   

 


 

 


Diluted

  $ 0.21   $ 0.18     $ 0.42   $ 0.33  
   

 


 

 


Net income per share:

                           

Basic

  $ 0.21   $ 0.11     $ 0.43   $ 0.26  
   

 


 

 


Diluted

  $ 0.21   $ 0.10     $ 0.42   $ 0.25  
   

 


 

 


Shares used in per-share calculation:

                           

Basic

    6,521     6,874       6,577     6,904  
   

 


 

 


Diluted

    6,652     7,110       6,713     7,110  
   

 


 

 


 

See Notes to Consolidated Financial Statements.

 

 

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Table of Contents

Cisco Systems, Inc.

CONSOLIDATED BALANCE SHEETS

(in millions, except par value)

(Unaudited)

 

    

January 29,

2005


  

July 31,

2004


ASSETS

             

Current assets:

             

Cash and cash equivalents

   $ 2,473    $ 3,722

Short-term investments

     3,291      4,947

Accounts receivable, net of allowance for doubtful accounts of $176 at January 29, 2005 and $179 at July 31, 2004

     2,278      1,825

Inventories

     1,255      1,207

Deferred tax assets

     1,881      1,827

Prepaid expenses and other current assets

     792      815
    

  

Total current assets

     11,970      14,343

Investments

     10,761      10,598

Property and equipment, net

     3,302      3,290

Goodwill

     4,674      4,198

Purchased intangible assets, net

     396      325

Other assets

     2,722      2,840
    

  

TOTAL ASSETS

   $ 33,825    $ 35,594
    

  

LIABILITIES AND SHAREHOLDERS’ EQUITY

             

Current liabilities:

             

Accounts payable

   $ 673    $ 657

Income taxes payable

     1,397      963

Accrued compensation

     1,219      1,466

Deferred revenue

     3,657      3,527

Other accrued liabilities

     2,126      2,090
    

  

Total current liabilities

     9,072      8,703

Deferred revenue

     990      975
    

  

Total liabilities

     10,062      9,678
    

  

Commitments and contingencies (Note 8)

             

Minority interest

     12      90

Shareholders’ equity:

             

Preferred stock, no par value: 5 shares authorized; none issued and outstanding

     —        —  

Common stock and additional paid-in capital, $0.001 par value: 20,000 shares authorized; 6,481 and 6,735 shares issued and outstanding at January 29, 2005 and July 31, 2004, respectively

     22,145      22,450

Retained earnings

     1,245      3,164

Accumulated other comprehensive income

     361      212
    

  

Total shareholders’ equity

     23,751      25,826
    

  

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 33,825    $ 35,594
    

  

 

See Notes to Consolidated Financial Statements.

 

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Table of Contents

Cisco Systems, Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

(Unaudited)

 

     Six Months Ended

 
     January 29,
2005


    January 24,
2004


 

Cash flows from operating activities:

                

Net income

   $ 2,796     $ 1,810  

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

                

Cumulative effect of accounting change, net of tax

     —         567  

Depreciation and amortization

     587       786  

Provision for doubtful accounts

     —         19  

Provision for inventory

     111       72  

Deferred income taxes

     (41 )     120  

Tax benefits from employee stock option plans

     126       328  

In-process research and development

     14       1  

Net (gains) losses and impairment charges on investments

     (74 )     (121 )

Change in operating assets and liabilities:

                

Accounts receivable

     (446 )     (704 )

Inventories

     (157 )     (131 )

Prepaid expenses and other current assets

     73       (2 )

Lease receivables, net

     (60 )     (45 )

Accounts payable

     8       42  

Income taxes payable

     424       12  

Accrued compensation

     (252 )     (70 )

Deferred revenue

     146       253  

Other accrued liabilities

     (7 )     (348 )
    


 


Net cash provided by operating activities

     3,248       2,589  
    


 


Cash flows from investing activities:

                

Purchases of short-term investments

     (2,825 )     (6,433 )

Proceeds from sales and maturities of short-term investments

     5,478       6,564  

Purchases of investments

     (7,541 )     (10,501 )

Proceeds from sales and maturities of investments

     6,479       11,636  

Acquisition of property and equipment

     (290 )     (393 )

Acquisition of businesses, net of cash and cash equivalents

     (553 )     (67 )

Change in investments in privately held companies

     (110 )     40  

Other

     93       83  
    


 


Net cash provided by investing activities

     731       929  
    


 


Cash flows from financing activities:

                

Issuance of common stock

     433       758  

Repurchase of common stock

     (5,706 )     (4,034 )

Other

     45       58  
    


 


Net cash used in financing activities

     (5,228 )     (3,218 )
    


 


Net (decrease) increase in cash and cash equivalents

     (1,249 )     300  

Cash and cash equivalents, beginning of period

     3,722       3,925  
    


 


Cash and cash equivalents, end of period

   $ 2,473     $ 4,225  
    


 


 

See Notes to Consolidated Financial Statements.

 

 

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Table of Contents

Cisco Systems, Inc.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in millions)

(Unaudited)

 

Six Months Ended January 24, 2004


  

Shares
of

Common
Stock


    Common
Stock and
Additional
Paid-In
Capital


   

Retained

Earnings


   

Accumulated

Other

Comprehensive

Income


   

Total

Shareholders’

Equity


 

BALANCE AT JULY 26, 2003

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

Net income

   —         —         1,810       —         1,810  

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

   —         —         —         (10 )     (10 )

Other

   —         —         —         88       88  
                                  


Comprehensive income

                                   1,888  
                                  


Issuance of common stock

   71       758       —         —         758  

Repurchase of common stock

   (187 )     (567 )     (3,467 )     —         (4,034 )

Tax benefits from employee stock option plans

   —         328       —         —         328  

Purchase acquisitions

   —         6       —         —         6  

Amortization of deferred stock-based compensation

   —         87       —         —         87  

Cumulative effect of accounting change, net of tax

   —         567       —         —         567  

Consolidation of variable interest entities

   —         7       —         —         7  
    

 


 


 


 


BALANCE AT JANUARY 24, 2004

   6,882     $ 22,302     $ 4,902     $ 432     $ 27,636  
    

 


 


 


 


 

Six Months Ended January 29, 2005


  

Shares
of

Common
Stock


    Common
Stock and
Additional
Paid-In
Capital


   

Retained

Earnings


   

Accumulated

Other

Comprehensive

Income


  

Total

Shareholders’

Equity


 

BALANCE AT JULY 31, 2004

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

Net income

   —         —         2,796       —        2,796  

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

   —         —         —         59      59  

Other

   —         —         —         90      90  
                                 


Comprehensive income

                                  2,945  
                                 


Issuance of common stock

   42       433       —         —        433  

Repurchase of common stock

   (296 )     (991 )     (4,715 )     —        (5,706 )

Tax benefits from employee stock option plans

   —         126       —         —        126  

Purchase acquisitions

   —         51       —         —        51  

Amortization of deferred stock-based compensation

   —         76       —         —        76  
    

 


 


 

  


BALANCE AT JANUARY 29, 2005

   6,481     $ 22,145     $ 1,245     $ 361    $ 23,751  
    

 


 


 

  


 

Supplemental Information

 

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of January 29, 2005, the Company’s Board of Directors had authorized the repurchase of up to $35 billion of common stock under this program and the remaining authorized amount under the stock repurchase program was $12.4 billion with no termination date. For additional information regarding stock repurchases, see Note 9 to the Consolidated Financial Statements. The purchase price of shares of common stock repurchased was reflected as a reduction to retained earnings and common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock option plans are recorded as an increase to common stock and additional paid-in capital. The cumulative stock repurchases pursuant to this program as of January 29, 2005 are summarized in the table below (in millions):

 

    

Shares
of

Common
Stock


  

Common

Stock and

Additional

Paid-In

Capital


  

Retained

Earnings


  

Accumulated

Other

Comprehensive

Income


  

Total

Shareholders’

Equity


Repurchases of common stock

   1,252    $ 3,857    $ 18,767    $ —      $ 22,624

 

See Notes to Consolidated Financial Statements.

 

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

1.   DESCRIPTION OF BUSINESS

 

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

 

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Fiscal Year

 

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

 

Basis of Presentation

 

The accompanying financial data as of January 29, 2005 and for the three months and six months ended January 29, 2005 and January 24, 2004 has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. The July 31, 2004 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, 2004.

 

In the opinion of management, all adjustments (which include normal recurring adjustments, except as disclosed herein) necessary to present a fair statement of financial position as of January 29, 2005, results of operations for the three and six months ended January 29, 2005 and January 24, 2004, cash flows and shareholders’ equity for the six months ended January 29, 2005 and January 24, 2004, as applicable, have been made. The results of operations for the three and six months ended January 29, 2005 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

 

Employee Stock Benefit Plans

 

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

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

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

 

     Three Months Ended

    Six Months Ended

 
    

January 29,

2005


   

January 24,

2004


   

January 29,

2005


   

January 24,

2004


 

Net income — as reported

   $ 1,400     $ 724     $ 2,796     $ 1,810  

Compensation expense, net of tax

     (257 )     (312 )     (533 )     (639 )
    


 


 


 


Net income — pro forma

   $ 1,143     $ 412     $ 2,263     $ 1,171  
    


 


 


 


Basic net income per share — as reported

   $ 0.21     $ 0.11     $ 0.43     $ 0.26  
    


 


 


 


Diluted net income per share — as reported

   $ 0.21     $ 0.10     $ 0.42     $ 0.25  
    


 


 


 


Basic net income per share — pro forma

   $ 0.18     $ 0.06     $ 0.34     $ 0.17  
    


 


 


 


Diluted net income per share — pro forma

   $ 0.17     $ 0.06     $ 0.34     $ 0.16  
    


 


 


 


 

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

 

Computation of Net Income per Share

 

Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options and restricted common stock.

 

Recent Accounting Pronouncement

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based compensation payments. SFAS 123(R) is effective for all interim and annual periods beginning after June 15, 2005. The Company is currently evaluating the impact of SFAS 123(R) on its operating results and financial condition. See Note 10 for pro forma information required under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.”

 

Reclassifications

 

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

 

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

3.   BUSINESS COMBINATIONS

 

Purchase Acquisitions

 

During the second quarter of fiscal 2005, the Company completed the following acquisitions:

 

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

 

    Acquisition of NetSolve, Incorporated to add remote network and IT infrastructure management solutions that are designed to diagnose and solve a range of network and IT infrastructure issues related to LAN/WAN as well as Advanced Technologies such as IP telephony and security

 

    Acquisition of Perfigo, Inc. to expand the offerings in the Network Admission Control (NAC) program, an industrywide initiative, which is designed to enforce endpoint policy compliance and improve the security of networks

 

During the first quarter of fiscal 2005, the Company completed the following acquisitions:

 

    Acquisition of Actona Technologies, Inc. to expand the functionality of its branch office access router portfolio with intelligent network services that are designed to enable WAN-optimized file transfer and access and to extend its solutions for data center storage consolidation to the branch office

 

    Acquisition of dynamicsoft, Inc. to add Session Initiation Protocol (SIP)-based solutions to its solutions portfolio for the broadband communications market that are designed to allow telecommunications service providers to deliver advanced Internet Protocol (IP) voice, data and multimedia services

 

    Acquisition of Parc Technologies Limited to add to its planning and optimization tools for Multiprotocol Label Switching (MPLS) traffic engineering

 

    Acquisition of P-Cube Inc. to provide additional control and management capabilities for advanced IP services to service providers

 

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

 

A summary of the acquisitions completed in the first six months of fiscal 2005 is as follows (in millions):

 

Acquisition


  

Purchase

Consideration


  

Assumed

Liabilities


  

In-Process

R&D

Expense


   Goodwill

  

Purchased

Intangible

Assets


Actona Technologies, Inc.

   $ 90    $ 4    $ 4    $ 66    $ 21

dynamicsoft, Inc.

     69      19      2      39      25

Jahi Networks Inc.

     14      3      —        12      3

NetSolve, Incorporated

     146      6      —        78      31

Parc Technologies Limited

     14      5      —        6      6

P-Cube Inc.

     213      17      6      150      56

Perfigo, Inc.

     73      2      2      49      20

Procket Networks, Inc.

     92      10      —        76      26
    

  

  

  

  

Total

   $ 711    $ 66    $ 14    $ 476    $ 188
    

  

  

  

  

 

Under the terms of the definitive agreements, the purchase consideration for the acquisitions during the first six months of fiscal 2005 consisted of cash and the fair value of stock options assumed. The purchase consideration

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

for the Company’s acquisitions is also allocated to tangible assets and deferred stock-based compensation. Deferred stock-based compensation represents the intrinsic value of the unvested portion of any restricted shares exchanged, options assumed, or options canceled and replaced with the Company’s options and is amortized as compensation expense over the remaining respective vesting periods. The balance for deferred stock-based compensation is reflected as a reduction to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity.

 

The following table presents the activity of deferred stock-based compensation for the three and six months ended January 29, 2005 and January 24, 2004 (in millions):

 

     Three Months Ended

    Six Months Ended

 
    

January 29,

2005


    January 24,
2004


   

January 29,

2005


    January 24,
2004


 

Balance at beginning of period

   $ 169     $ 211     $ 153     $ 262  

Acquisitions

     15       1       71       1  

Amortization

     (36 )     (36 )     (76 )     (87 )

Canceled unvested options

     —         (14 )     —         (14 )
    


 


 


 


Balance at end of period

   $ 148     $ 162     $ 148     $ 162  
    


 


 


 


 

The Company’s methodology for allocating the purchase price for purchase acquisitions to in-process research and development (“in-process R&D”) is determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist. Total in-process R&D expense was $2 million and $14 million for the three and six months ended January 29, 2005, respectively. Total in-process R&D was $1 million for the three and six months ended January 24, 2004.

 

The Consolidated Financial Statements include the operating results of each business from the date of acquisition. Pro forma results of operations have not been presented because the effects of these acquisitions were not material to the Company’s results.

 

Purchased Intangible Assets

 

The following table presents details of the purchased intangible assets acquired during the six months ended January 29, 2005 (in millions, except years):

 

     TECHNOLOGY

  

CUSTOMER

RELATIONSHIPS


   OTHER

    

Acquisition


  

Estimated

Useful Life

(in years)


   Amount

  

Estimated

Useful Life

(in years)


   Amount

  

Estimated

Useful Life

(in years)


   Amount

   Total

Actona Technologies, Inc.

   4.5    $ 21    —      $ —      —      $ —      $ 21

dynamicsoft, Inc.

   4.0      17    2.5      6    2.0      2      25

Jahi Networks Inc.

   4.0      3    —        —      —        —        3

NetSolve, Incorporated

   3.5      24    5.5      7    —        —        31

Parc Technologies Limited

   5.5      6    —        —      —        —        6

P-Cube Inc.

   4.5      39    2.5      17    —        —        56

Perfigo, Inc.

   4.0      14    2.5      6    —        —        20

Procket Networks, Inc.

   7.5      22    2.5      3    1.0      1      26
         

       

       

  

Total

        $ 146         $ 39         $ 3    $ 188
         

       

       

  

 

10


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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

The following tables present details of the Company’s total purchased intangible assets as of January 29, 2005 and July 31, 2004 (in millions):

 

January 29, 2005


   Gross

  

Accumulated

Amortization


    Net

Technology

   $ 773    $ (516 )   $ 257

Customer relationships

     127      (34 )     93

Trade names

     90      (52 )     38

Other

     134      (126 )     8
    

  


 

Total

   $ 1,124    $ (728 )   $ 396
    

  


 

July 31, 2004


   Gross

  

Accumulated

Amortization


    Net

Technology

   $ 627    $ (452 )   $ 175

Technology licenses

     252      (239 )     13

Customer relationships

     88      (20 )     68

Trade names

     90      (43 )     47

Other

     131      (109 )     22
    

  


 

Total

   $ 1,188    $ (863 )   $ 325
    

  


 

 

The estimated future amortization expense of purchased intangible assets as of January 29, 2005 is as follows (in millions):

 

Fiscal Year


   Amount

2005 (remaining six months)

   $ 103

2006

     130

2007

     84

2008

     51

2009

     18

Thereafter

     10
    

Total

   $ 396
    

 

Goodwill

 

The following table presents the changes in goodwill allocated to the Company’s reportable segments during the six months ended January 29, 2005 (in millions):

 

    

Balance at

July 31,

2004


   Acquired

  

Balance at

January 29,
2005


Americas

   $ 2,716    $ 254    $ 2,970

EMEA

     678      130      808

Asia Pacific

     171      50      221

Japan

     633      42      675
    

  

  

Total

   $ 4,198    $ 476    $ 4,674
    

  

  

 

11


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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Acquisition of BCN Systems, Inc.

 

BCN Systems, Inc. (“BCN”) was a provider of networking software design. It was acquired by the Company in December 2004, and the Company expects this acquisition to contribute to the continued evolution of the Company’s routing platforms and support ongoing efforts to speed the delivery of next-generation data, voice, and video services over a converged network. The acquisition of BCN was completed for an aggregate purchase value of approximately $45 million, which may be increased by approximately $122 million depending upon the achievement of certain development and product milestones, and will be recorded as compensation expense. During the three months ended January 29, 2005, the Company recorded $3 million of compensation expense. Prior to the acquisition, the Company had consolidated BCN because the Company was the primary beneficiary as defined by FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN 46(R)”).

 

Acquisition of Andiamo Systems, Inc.

 

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

 

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

 

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

 

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

 

Subsequent to the adoption of FIN 46(R), changes to the value of Andiamo and the continued vesting of the employee stock and options resulted in an adjustment to the noncash stock compensation charge. The Company

 

12


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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

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

 

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

 

     Amount

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

   $ 567

Variable stock-based compensation

     58

Deferred stock-based compensation

     90

Net assets

     7
    

Total

   $ 722
    

 

 

13


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

4.   RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES

 

On April 16, 2001, the Company announced a restructuring program, which included a worldwide workforce reduction, consolidation of excess facilities, and restructuring of certain business functions. The liability for restructuring costs is recorded in other accrued liabilities in the Consolidated Balance Sheets. The following table summarizes the activity related to the liability for restructuring costs and other special charges as of January 29, 2005 (in millions):

 

    

Workforce

Reduction


   

Consolidation

of Excess

Facilities and

Other Charges


   

Impairment of
Goodwill and

Purchased

Intangible Assets


    Total

 

Initial charge in the third quarter of fiscal 2001

   $ 397     $ 484     $ 289     $ 1,170  

Non-cash charges

     (71 )     (141 )     (289 )     (501 )

Cash payments

     (265 )     (18 )     —         (283 )
    
  


 


 


 


Balance at July 28, 2001

     61       325       —         386  

Adjustments

     (35 )     128       —         93  

Cash payments

     (26 )     (131 )     —         (157 )
    
  


 


 


 


Balance at July 27, 2002

     —         322       —         322  

Adjustments

     —         45       —         45  

Cash payments

     —         (72 )     —         (72 )
    
  


 


 


 


Balance at July 26, 2003

     —         295       —         295  

Cash payments

     —         (230 )     —         (230 )
    
  


 


 


 


Balance at July 31, 2004

     —         65       —         65  

Cash payments

     —         (15 )     —         (15 )
    
  


 


 


 


Balance at January 29, 2005

   $ —       $ 50     $ —       $ 50  
    
  


 


 


 


 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

5.   BALANCE SHEET DETAILS

 

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

 

     January 29,
2005


   

July 31,

2004


 

Inventories:

                

Raw materials

   $ 68     $ 58  

Work in process

     415       416  

Finished goods:

                

Distributor inventory and deferred cost of sales

     379       316  

Manufacturing finished goods

     175       206  
    


 


Total finished goods

     554       522  

Service-related spares

     188       177  

Demonstration systems

     30       34  
    


 


Total

   $ 1,255     $ 1,207  
    


 


Property and equipment, net:

                

Land, buildings, and leasehold improvements

   $ 3,494     $ 3,429  

Computer equipment and related software

     1,216       1,120  

Production, engineering, and other equipment

     2,852       2,643  

Operating lease assets

     111       94  

Furniture and fixtures

     360       356  
    


 


       8,033       7,642  

Less accumulated depreciation and amortization

     (4,731 )     (4,352 )
    


 


Total

   $ 3,302     $ 3,290  
    


 


Other assets:

                

Deferred tax assets

   $ 1,039     $ 1,130  

Investments in privately held companies

     403       354  

Income tax receivable

     690       690  

Lease receivables, net

     272       231  

Other

     318       435  
    


 


Total

   $ 2,722     $ 2,840  
    


 


Deferred revenue:

                

Service

   $ 3,097     $ 3,047  

Product

     1,550       1,455  
    


 


Total

   $ 4,647     $ 4,502  
    


 


Reported as:

                

Current

   $ 3,657     $ 3,527  

Noncurrent

     990       975  
    


 


Total

   $ 4,647     $ 4,502  
    


 


 

15


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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

6.   LEASE RECEIVABLES, NET

 

Lease receivables represent sales-type and direct-financing leases resulting from the sale of the Company’s and complementary third-party products and services. These lease arrangements typically have terms from two to three years and are generally collateralized by a security interest in the underlying assets. The current portion of lease receivables, net, is recorded in prepaid expenses and other current assets, and the noncurrent portion is recorded in other assets in the Consolidated Balance Sheets. The net lease receivables are summarized as follows as of January 29, 2005 and July 31, 2004 (in millions):

 

     January 29,
2005


   

July 31,

2004


 

Gross lease receivables

   $ 657     $ 616  

Unearned income and other allowances

     (159 )     (170 )
    


 


Total

   $ 498     $ 446  
    


 


Reported as:

                

Current

   $ 226     $ 215  

Noncurrent

     272       231  
    


 


Total

   $ 498     $ 446  
    


 


 

Contractual maturities of the gross lease receivables at January 29, 2005 were as follows (in millions):

 

Fiscal Year


   Amount

2005 (remaining six months)

   $ 153

2006

     238

2007

     152

2008

     81

2009

     28

Thereafter

     5
    

Total

   $ 657
    

 

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

 

16


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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

7.   INVESTMENTS

 

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

 

January 29, 2005


  

Amortized

Cost


  

Gross

Unrealized

Gains


  

Gross

Unrealized

Losses


   

Fair

Value


Fixed income securities:

                            

U.S. government notes and bonds

   $ 3,960    $ 2    $ (26 )   $ 3,936

Corporate notes, bonds, and asset-backed securities

     8,414      9      (36 )     8,387

Municipal notes and bonds

     699      —        (1 )     698
    

  

  


 

Total fixed income securities

     13,073      11      (63 )     13,021

Publicly traded equity securities

     611      422      (2 )     1,031
    

  

  


 

Total

   $ 13,684    $ 433    $ (65 )   $ 14,052
    

  

  


 

Reported as:

                            

Short-term investments

                         $ 3,291

Investments

                           10,761
                          

Total

                         $ 14,052
                          

July 31, 2004


  

Amortized

Cost


  

Gross

Unrealized

Gains


  

Gross

Unrealized

Losses


   

Fair

Value


Fixed income securities:

                            

U.S. government notes and bonds

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

Corporate notes, bonds, and asset-backed securities

     9,333      14      (42 )     9,305

Municipal notes and bonds

     710      —        (1 )     709
    

  

  


 

Total fixed income securities

     14,451      23      (63 )     14,411

Publicly traded equity securities

     755      387      (8 )     1,134
    

  

  


 

Total

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

  

  


 

Reported as:

                            

Short-term investments

                         $ 4,947

Investments

                           10,598
                          

Total

                         $ 15,545
                          

 

The following table summarizes the contractual maturities of the Company’s fixed income securities at January 29, 2005 (in millions):

 

    

Amortized

Cost


  

Fair

Value


Less than one year

   $ 3,296    $ 3,291

Due in 1 to 2 years

     3,757      3,734

Due in 2 to 5 years

     5,045      5,020

Due after 5 years

     975      976
    

  

Total

   $ 13,073    $ 13,021
    

  

 

17


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

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

 

The following table summarizes the Company’s cash and cash equivalents and total investments (in millions):

 

     January 29,
2005


   July 31,
2004


Cash and cash equivalents

   $ 2,473    $ 3,722

Fixed income securities

     13,021      14,411

Publicly traded equity securities

     1,031      1,134
    

  

Total

   $ 16,525    $ 19,267
    

  

 

8.   COMMITMENTS AND CONTINGENCIES

 

Operating Leases

 

The Company leases office space in several U.S. locations, as well as locations elsewhere in the Americas; Europe, the Middle East, and Africa (“EMEA”); Asia Pacific; and Japan. Future annual minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of January 29, 2005 were as follows (in millions):

 

Fiscal Year


   Amount

2005 (remaining six months)

   $ 124

2006

     205

2007

     153

2008

     113

2009

     91

Thereafter

     668
    

Total

   $ 1,354
    

 

Purchase Commitments with Contract Manufacturers and Suppliers

 

The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help assure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the Company’s requirements. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Company’s requirements based on its business needs prior to firm orders being placed. Consequently, only a portion of the Company’s reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. As of January 29, 2005, the Company had total purchase commitments for inventory of approximately $953 million, compared with $951 million as of July 31, 2004.

 

In addition to the above, the Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the Company’s allowance for inventory. As of January 29, 2005, the liability for these firm, noncancelable, and unconditional purchase commitments was $102 million, compared with $141 million as of July 31, 2004, and was included in other accrued liabilities.

 

18


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Other Commitments

 

The Company has entered into an agreement to invest approximately $800 million in venture funds managed by SOFTBANK Corp. and its affiliates (“SOFTBANK”) that are required to be funded on demand. The total commitment is to be invested in venture funds and as senior debt with entities as directed by SOFTBANK. The Company’s commitment to fund senior debt is contingent upon the achievement of certain agreed-upon milestones. As of January 29, 2005, the Company had invested $385 million in venture funds pursuant to the commitment, compared with $290 million as of July 31, 2004. In addition, as of January 29, 2005, the Company had invested $49 million in senior debt pursuant to the commitment, of which $34 million and $19 million has been repaid as of January 29, 2005 and July 31, 2004, respectively.

 

The Company provides structured financing to certain qualified customers for the purchase of equipment and other needs through its wholly owned subsidiaries. These loan commitments may be funded over a two- to three-year period, provided that these customers achieve specific business milestones and satisfy certain financial covenants. As of January 29, 2005, the outstanding loan commitments were approximately $39 million, of which approximately $25 million was eligible for draw-down. As of July 31, 2004, the outstanding loan commitments were approximately $61 million, of which approximately $22 million was eligible for draw-down.

 

As of January 29, 2005 and July 31, 2004, the Company had a commitment of approximately $59 million to purchase the remaining minority interest of Cisco Systems, K.K. (Japan).

 

The Company also has certain other funding commitments related to its privately held investments that are based on the achievement of certain agreed-upon milestones. The funding commitments were approximately $57 million as of January 29, 2005, compared with approximately $67 million as of July 31, 2004.

 

Variable Interest Entities

 

In the ordinary course of business, the Company has investments in privately held companies and provides structured financing to certain customers through its wholly owned subsidiaries, which may be considered to be variable interest entities. The Company has evaluated its investments in privately held companies and structured financings and determined that there were no significant unconsolidated variable interest entities as of January 29, 2005.

 

As of January 29, 2005, the Company had invested $15 million in Vihana, Inc., a developer of custom ASIC chips. The Company has consolidated Vihana, Inc. because the Company was the primary beneficiary as defined by FIN 46(R). During the first six months ended January 29, 2005, the Company recorded approximately $7 million of compensation expense and the remaining amount of compensation expense that may be recorded in future periods, depending on the achievement of certain milestones, was $23 million.

 

Guarantees and Product Warranties

 

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

 

The requirements of FIN 45 are applicable to the Company’s product warranty liability and certain guarantees. The Company’s guarantees issued subject to the recognition and disclosure requirements of FIN 45 as of January 29, 2005 and July 31, 2004 were not material. As of January 29, 2005 and July 31, 2004, the Company’s product warranty liability recorded in other accrued liabilities was $250 million and $239 million, respectively. The

 

19


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

following table summarizes the activity related to the product warranty liability for the six months ended January 29, 2005 and January 24, 2004 (in millions):

 

     Six Months Ended

 
     January 29,
2005


    January 24,
2004


 

Balance at beginning of period

   $ 239     $ 246  

Provision for warranties issued

     208       158  

Payments

     (197 )     (162 )
    


 


Balance at end of period

   $ 250     $ 242  
    


 


 

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

 

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

 

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

 

Derivative Instruments

 

The Company uses derivative instruments to manage exposures to foreign currency, interest rate and equity securities price risk. The Company’s objective in holding derivatives is to minimize the volatility of earnings and cash flows associated with changes in foreign currency, interest rates and equity securities prices. The Company’s derivatives expose the Company to credit risk to the extent that the counterparties may be unable to meet the terms of the agreement. The Company seeks to minimize such risk 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 default by counterparties.

 

Foreign Currency Derivatives

 

The Company conducts business on a global basis in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. The Company enters into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on certain foreign currency receivables, investments, and payables. The gains and losses on the foreign exchange forward contracts offset the transaction gains and losses on certain foreign currency receivables, investments, and payables recognized in earnings.

 

The Company does not enter into foreign exchange forward contracts for trading purposes. Gains and losses on the contracts are included in other income, net, in the Consolidated Statements of Operations and offset foreign

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

exchange gains or losses from the revaluation of intercompany balances or other current assets, investments, and liabilities denominated in currencies other than the functional currency of the reporting entity. The Company’s foreign exchange forward contracts related to current assets and liabilities generally range from one to three months in original maturity. Additionally, the Company has entered into foreign exchange forward contracts with maturities of up to two years related to long-term customer financings. The foreign exchange contracts related to investments generally have maturities of less than one year.

 

The Company periodically hedges certain foreign currency forecasted transactions related to certain operating expenses with currency options. These transactions are designated as cash flow hedges. The effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately. These currency option contracts generally have maturities of less than 18 months. The Company does not purchase currency options for trading purposes. Foreign exchange forward and option contracts as of January 29, 2005 are summarized as follows (in millions):

 

    

Notional

Amount


  

Fair

Value


 

Forward contracts:

               

Purchased

   $ 1,168    $ (2 )

Sold

   $ 436    $ (6 )

Option contracts:

               

Purchased

   $ 575    $ 17  

Sold

   $ 687    $ (2 )

 

Interest Rate Derivatives

 

The Company’s primary objective for holding fixed income and debt securities is to maximize its investment return while 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 January 29, 2005, the Company had entered into $1 billion of interest rate swaps designated as fair value hedges. Under the interest rate swap contracts, the Company makes fixed rate interest payments and receives interest payments based on the London InterBank Offered Rate (“LIBOR”). The effect of these swaps is to convert fixed-rate returns to LIBOR-based returns on a portion of the Company’s fixed income portfolio. The gains and losses related to changes in the value of the interest rate swaps are included in other income, net, in the Consolidated Statements of Operations and offset the changes in fair value of the underlying hedged investment. As of January 29, 2005, the fair value of the interest rate swaps was not material.

 

Equity Derivatives

 

The Company maintains a portfolio of publicly traded equity securities which are subject to market price risk. The Company may hold equity securities for strategic purposes or to provide diversification for the Company’s overall investment portfolio. In order to manage its exposure to changes in the value of certain equity securities, the Company may, from time to time, enter into equity derivative contracts. As of January 29, 2005, the Company had entered into forward sale agreements on certain publicly traded equity securities designated as fair value hedges. The gains and losses due to changes in the value of the hedging instruments are included in other income, net, in the Consolidated Statements of Operations and offset the change in the fair value of the underlying hedged investment. As of January 29, 2005 the notional and fair value amounts of the derivatives were $121.9 million and $2.7 million, respectively.

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Legal Proceedings

 

Beginning on April 20, 2001, a number of purported shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against Cisco and certain of its officers and directors. The lawsuits have been consolidated, and the consolidated action is purportedly brought on behalf of those who purchased the Company’s publicly traded securities between August 10, 1999 and February 6, 2001. Plaintiffs allege that defendants have made false and misleading statements, purport to assert claims for violations of the federal securities laws, and seek unspecified compensatory damages and other relief. Cisco believes the claims are without merit and intends to defend the actions vigorously.

 

In addition, beginning on April 23, 2001, a number of purported shareholder derivative lawsuits were filed in the Superior Court of California, County of Santa Clara, and in the Superior Court of California, County of San Mateo. There is a procedure in place for the coordination of such actions (one of which has been dismissed and is currently on appeal). Two purported derivative suits were filed in the United States District Court for the Northern District of California, and those federal court actions have been consolidated. The consolidated federal court derivative action was dismissed by the court, and plaintiffs have appealed from that decision. The complaints in the various derivative actions include claims for breach of fiduciary duty, waste of corporate assets, mismanagement, unjust enrichment, and violations of the California Corporations Code; seek compensatory and other damages, disgorgement, and other relief; and are based on essentially the same allegations as the class actions.

 

With respect to the above-described shareholder litigation, Cisco believes there is no legal basis for liability. However, due to the uncertainty surrounding the litigation process, Cisco is unable to reasonably estimate a range of loss, if any, at this time.

 

On February 16, 2005, the Company was advised that a purported shareholder derivative lawsuit had been filed in the Superior Court of California, County of Santa Clara, against various officers and directors of the Company and naming the Company as a nominal defendant. The lawsuit includes claims for breach of fiduciary duty, unjust enrichment, constructive trust and violations of the California Corporations Code, is based upon allegations of wrongdoing in connection with option grants and compensation to officers and directors, the timing of option grants, and the Company’s share repurchase plan, and seeks unspecified compensation and other damages, rescission of options and other relief.

 

In addition, the Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. 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 the Company’s consolidated financial position, results of operations, or cash flows.

 

9.   SHAREHOLDERS’ EQUITY

 

Stock Repurchase Program

 

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of January 29, 2005, the Company’s Board of Directors had authorized the repurchase of up to $35 billion of common stock under this program. During the first six months of fiscal 2005, the Company repurchased and retired 296 million shares of Cisco common stock at an average price of $19.27 per share for an aggregate purchase price of $5.7 billion. As of January 29, 2005, the Company had repurchased and retired 1.3 billion shares of Cisco common stock at an average price of $18.07 per share for an aggregate purchase price of $22.6 billion since inception of the stock repurchase program, and the remaining authorized amount for stock repurchases under this program was $12.4 billion with no termination date.

 

The purchase price for the shares of the Company’s common stock repurchased was reflected as a reduction to shareholders’ equity. In accordance with Accounting Principles Board Opinion No. 6, “Status of Accounting

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Research Bulletins,” the Company is required to allocate the purchase price of the repurchased shares as a reduction to retained earnings and common stock and additional paid-in capital.

 

Comprehensive Income

 

The components of comprehensive income are as follows (in millions):

 

     Three Months Ended

   Six Months Ended

 
     January 29,
2005


    January 24,
2004


   January 29,
2005


    January 24,
2004


 

Net income

   $ 1,400     $ 724    $ 2,796     $ 1,810  

Other comprehensive income:

                               

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

     (142 )     18      (19 )     (10 )

Other

     28       44      90       88  
    


 

  


 


Other comprehensive income before minority interest

     1,286       786      2,867       1,888  

Minority interest

     116       —        78       —    
    


 

  


 


Total

   $ 1,402     $ 786    $ 2,945     $ 1,888  
    


 

  


 


 

The Company consolidates its investment in a venture fund managed by SOFTBANK. During the six months ended January 29, 2005, SOFTBANK’s aggregate minority share of the venture fund decreased by $78 million, from $84 million as of July 31, 2004 to $6 million as of January 29, 2005, as a result of a noncash distribution of the venture fund assets to its partners.

 

10.   EMPLOYEE STOCK BENEFIT PLANS

 

Employee Stock Purchase Plan

 

The Company has an Employee Stock Purchase Plan, which includes its sub plan, the International Employee Stock Purchase Plan (together the “Purchase Plan”), under which 321.4 million shares of the Company’s common stock have been reserved for issuance. Eligible employees may purchase a limited number of shares of the Company’s common stock at a discount of up to 15% of the market value at certain plan-defined dates. The Purchase Plan terminates on January 3, 2010. During the three months ended January 29, 2005 and January 24, 2004, 9.9 million and 13.1 million shares were issued under the Purchase Plan, respectively. At January 29, 2005, 128.7 million shares were available for issuance under the Purchase Plan.

 

Employee Stock Option Plans

 

Stock Option Program Description

 

The Company has two plans under which it grants options: the 1996 Stock Incentive Plan (the “1996 Plan”) and the 1997 Supplemental Stock Incentive Plan (the “Supplemental Plan”).

 

Stock option grants 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 stock option grants are based on competitive practices, operating results of the Company, and government regulations. Since the inception of the 1996 Plan, the Company has granted options to virtually all employees, and the majority has been granted to employees below the vice president level. Officers and members of the Company’s Board of Directors are not eligible to participate in the Supplemental Plan.

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Distribution and Dilutive Effect of Options

 

The following table illustrates the grant dilution and exercise dilution (in millions, except percentages):

 

     Six Months Ended

 
     January 29,
2005


    January 24,
2004


 

Shares of common stock outstanding

   6,481     6,882  
    

 

Granted and assumed

   201     161  

Canceled

   (31 )   (26 )
    

 

Net options granted

   170     135  
    

 

Grant dilution (1)

   2.6 %   2.0 %
    

 

Exercised

   32     59  

Exercise dilution (2)

   0.5 %   0.9 %
    

 

 

Note 1: The percentage for grant dilution is computed based on net options granted as a percentage of shares of common stock outstanding.

 

Note 2: The percentage for exercise dilution is computed based on options exercised as a percentage of shares of common stock outstanding.

 

Basic and diluted shares outstanding for the six months ended January 29, 2005 were 6.6 billion shares and 6.7 billion shares, respectively. Diluted shares outstanding include the dilutive impact of in-the-money options, which is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the tax-effected proceeds that would be hypothetically received from the exercise of all in-the-money options are assumed to be used to repurchase shares. During the six months ended January 29, 2005, the dilutive impact of in-the-money employee stock options was approximately 135 million shares or 2.1% of the basic shares outstanding based on Cisco’s average share price of $19.12.

 

The following table summarizes the options granted to the Named Executive Officers during the periods indicated. The Named Executive Officers represent the Company’s Chief Executive Officer and the four other most highly paid executive officers whose salary and bonus for the fiscal year ended July 31, 2004 and July 26, 2003, respectively, were in excess of $100,000 (in millions, except percentages):

 

     Six Months Ended

 
     January 29,
2005


    January 24,
2004


 

Options granted to the Named Executive Officers

   3.9     2  
    

 

Options granted to the Named Executive Officers as a % of net options granted

   2.3 %   1.5 %
    

 

Options granted to the Named Executive Officers as a % of outstanding shares

   0.06 %   0.03 %
    

 

Cumulative options held by Named Executive Officers as % of total options outstanding

   3.8 %   4.3 %
    

 

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

General Option Information

 

A summary of option activity follows (in millions, except per-share amounts). The Company has, in connection with the acquisitions of various companies, assumed the stock option plans of the acquired companies or issued replacement options.

 

    

Options

Available

for

Grant


    Options Outstanding

      

Number

Outstanding


   

Weighted-

Average

Exercise

Price per

Share


Balance at July 26, 2003

   526     1,303     $ 25.29

Granted and assumed

   (195 )   195       20.00

Exercised

   —       (96 )     10.03

Canceled

   52     (52 )     32.33

Additional shares reserved

   7     —         —  
    

 

     

Balance at July 31, 2004

   390     1,350     $ 25.34

Granted and assumed

   (201 )   201       18.90

Exercised

   —       (32 )     8.40

Canceled

   31     (31 )     31.08

Additional shares reserved

   8     —         —  
    

 

     

Balance at January 29, 2005

   228     1,488     $ 24.71
    

 

     

 

The following table summarizes significant ranges of outstanding and exercisable options as of January 29, 2005 (in millions, except years and per-share amounts):

 

Range of

Exercise Prices


   Options Outstanding

   Options Exercisable

  

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–  9.75

   193    3.46    $ 7.12    $ 2,081    145    $ 6.52    $ 1,650

   9.76–13.04

   151    4.70      12.52      812    101      12.33      563

 13.05–16.15

   173    5.75      15.61      396    102      15.67      227

 16.16–18.57

   102    5.85      18.16      17    60      18.21      11

 18.58–19.18

   166    8.47      19.15      —      3      18.74      —  

 19.19–19.59

   151    7.60      19.56      —      38      19.59      —  

 19.60–26.42

   185    5.39      23.13      —      116      24.05      —  

 26.43–50.38

   179    4.43      43.30      —      153      42.89      —  

 50.39–72.56

   188    4.18      57.42      —      180      57.35      —  
    
              

  
         

Total

   1,488    5.44    $ 24.71    $ 3,306    898    $ 28.24    $ 2,451
    
              

  
         

 

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on Cisco’s closing stock price of $17.90 as of January 28, 2005, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of January 29, 2005 was 362 million. As of July 31, 2004, 823 million outstanding options were exercisable, and the weighted average exercise price was $28.09.

 

25


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

The following table presents the option exercises for the six months ended January 29, 2005, and option values as of that date for the Named Executive Officers (in millions):

 

    

Number of

Shares

Acquired on

Exercise


  

Value

Realized


  

Number of Securities

Underlying Unexercised

Options at January 29, 2005


  

Intrinsic Value of

Unexercised In-the-Money

Options at January 29, 2005


           Exercisable

   Unexercisable

   Exercisable

   Unexercisable

Named Executive Officers

   3    $ 38    42    14    $ 155    $ 16

 

Pro Forma Information

 

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

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


   

January 24,

2004


    January 29,
2005


   

January 24,

2004


 

Net income — as reported

   $ 1,400     $ 724     $ 2,796     $ 1,810  

Compensation expense, net of tax

     (257 )     (312 )     (533 )     (639 )
    


 


 


 


Net income — pro forma

   $ 1,143     $ 412     $ 2,263     $ 1,171  
    


 


 


 


Basic net income per share — as reported

   $ 0.21     $ 0.11     $ 0.43     $ 0.26  
    


 


 


 


Diluted net income per share — as reported

   $ 0.21     $ 0.10     $ 0.42     $ 0.25  
    


 


 


 


Basic net income per share — pro forma

   $ 0.18     $ 0.06     $ 0.34     $ 0.17  
    


 


 


 


Diluted net income per share — pro forma

   $ 0.17     $ 0.06     $ 0.34     $ 0.16  
    


 


 


 


 

The value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


   

January 24,

2004


    January 29,
2005


   

January 24,

2004


 

Expected dividend

   0.0 %   0.0 %   0.0 %   0.0 %

Risk-free interest rate

   3.6 %   3.6 %   3.5 %   3.9 %

Expected volatility

   39.7 %   40.1 %   39.6 %   40.1 %

Expected life (in years)

   3.3     5.4     3.3     5.6  

 

The Black-Scholes option pricing model was developed for use in estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the expected stock price volatility and expected life. The Company is responsible for determining the assumptions for the expected volatility and expected life of its stock options used in estimating the fair value of those options. The Company uses third-party analysis to assist in developing the expected volatility and expected life of its stock options. The expected life and expected volatility of the stock options is based upon historical and other economic data trended into the future. The Company uses an option

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

pricing model to indirectly estimate the expected life of the stock options. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models do not provide a reliable measure of the fair value of the Company’s employee stock options. Under the Black-Scholes option pricing model, the weighted-average estimated values of employee stock options granted during the three and six months ended January 29, 2005 were $6.26 and $6.19, respectively, and for the three and six months ended January 24, 2004 were $10.02 and $8.61 respectively.

 

11.   INCOME TAXES

 

The Company paid net income taxes of $617 million and $490 million for the six months ended January 29, 2005 and January 24, 2004, respectively. The Company’s income taxes currently payable for federal and state purposes have been reduced by the tax benefits from employee stock option transactions. These benefits totaled $126 million and $328 million for the six months ended January 29, 2005 and January 24, 2004, respectively, and were reflected as an increase to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity.

 

The Company’s federal income tax returns for fiscal years ended July 25, 1998 through July 28, 2001 are under examination, and the Internal Revenue Service has proposed certain adjustments. The Company believes that adequate amounts have been reserved for any adjustments that may ultimately result from these examinations.

 

On October 22, 2004, the American Jobs Creation Act of 2004 (the “ Jobs Creation Act”) was signed into law. The Jobs Creation Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and, as of today, uncertainty remains as to how to interpret numerous provisions of the Jobs Creation Act. Based on the Company’s analysis of the Jobs Creation Act, although not yet finalized, it is reasonably possible that under the repatriation provisions of the Jobs Creation Act the Company may repatriate some amount of earnings between $0 and $1.5 billion, with the respective tax liability between $0 and $150 million. The Company expects to be in a position to finalize its assessment by July 30, 2005.

 

12.   SEGMENT INFORMATION AND MAJOR CUSTOMERS

 

The Company’s operations involve the design, development, manufacturing, marketing, and technical support of networking and communications products and services. Cisco products include routers, switches, Advanced Technologies, and other networking equipment. These products, primarily integrated by Cisco IOS® Software, link geographically dispersed LANs and WANs.

 

The Company conducts business globally and is managed geographically. 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 theater 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 theaters in this internal management system, because management does not currently use the information to measure the performance of the operating segments. Based on established criteria, the Company has four reportable segments: the Americas, EMEA, Asia Pacific, and Japan.

 

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Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

Summarized financial information by theater for the three and six months ended January 29, 2005 and January 24, 2004, as taken from the internal management system, is as follows (in millions):

 

     Three Months Ended

   Six Months Ended

     January 29,
2005


  

January 24,

2004


   January 29,
2005


  

January 24,

2004


Net sales:

                           

Americas

   $ 3,314    $ 2,953    $ 6,711    $ 5,827

EMEA

     1,701      1,525      3,317      2,901

Asia Pacific

     623      546      1,189      1,057

Japan

     424      374      816      714
    

  

  

  

Total

   $ 6,062    $ 5,398    $ 12,033    $ 10,499
    

  

  

  

Gross margin:

                           

Americas

   $ 2,168    $ 1,992    $ 4,412    $ 3,937

EMEA

     1,184      1,057      2,302      2,015

Asia Pacific

     420      371      805      727

Japan

     281      278      549      525
    

  

  

  

Total

   $ 4,053    $ 3,698    $ 8,068    $ 7,204
    

  

  

  

 

The Americas theater included non-U.S. net sales of $304 million and $279 million for the three months ended January 29, 2005 and January 24, 2004, respectively. The Americas theater included non-U.S. net sales of $571 million and $493 million for the six months ended January 29, 2005 and January 24, 2004, respectively.

 

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

 

     Three Months Ended

   Six Months Ended

    

January 29,

2005


  

January 24,

2004


  

January 29,

2005


  

January 24,

2004


Net sales:

                           

Routers

   $ 1,329    $ 1,426    $ 2,580    $ 2,700

Switches

     2,424      2,094      5,023      4,155

Advanced Technologies

     1,153      817      2,118      1,543

Other

     200      213      418      415
    

  

  

  

Product

     5,106      4,550      10,139      8,813

Service

     956      848      1,894      1,686
    

  

  

  

Total

   $ 6,062    $ 5,398    $ 12,033    $ 10,499
    

  

  

  

 

The Company refers to some of its products and technologies as Advanced Technologies. The Company has currently identified six Advanced Technologies for particular focus: home networking, IP telephony, optical networking, security, storage area networking, and wireless technology. The Company may identify additional Advanced Technologies for focus and investment in the future, and the Company’s investments in some previously identified Advanced Technologies may be curtailed or eliminated depending on market developments. The Company reclassified net sales for switches and Advanced Technology products in fiscal 2004 to conform to the current period’s presentation related to a refinement in the reporting of certain rebate programs for these products.

 

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Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

The majority of the Company’s assets as of January 29, 2005 and July 31, 2004 were attributable to its U.S. operations. For the three and six months ended January 29, 2005 and January 24, 2004, 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):

 

     January 29,
2005


   July 31,
2004


Property and equipment, net:

             

United States

   $ 2,932    $ 2,919

International

     370      371
    

  

Total

   $ 3,302    $ 3,290
    

  

 

13.   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

    Six Months Ended

 
    

January 29,

2005


  

January 24,

2004


   

January 29,

2005


  

January 24,

2004


 

Income before cumulative effect of accounting change

   $ 1,400    $ 1,291     $ 2,796    $ 2,377  

Cumulative effect of accounting change

     —        (567 )     —        (567 )
    

  


 

  


Net income

   $ 1,400    $ 724     $ 2,796    $ 1,810  
    

  


 

  


Weighted-average shares — basic

     6,521      6,874       6,577      6,904  

Effect of dilutive potential common shares

     131      236       136      206  
    

  


 

  


Weighted-average shares — diluted

     6,652      7,110       6,713      7,110  
    

  


 

  


Income per share before cumulative effect of accounting change:

                              

Basic

   $ 0.21    $ 0.19     $ 0.43    $ 0.34  
    

  


 

  


Diluted

   $ 0.21    $ 0.18     $ 0.42    $ 0.33  
    

  


 

  


Per share amount of cumulative effect of accounting change:

                              

Basic

   $ —      $ 0.08     $ —      $ 0.08  
    

  


 

  


Diluted

   $ —      $ 0.08     $ —      $ 0.08  
    

  


 

  


Net income per share:

                              

Basic

   $ 0.21    $ 0.11     $ 0.43    $ 0.26  
    

  


 

  


Diluted

   $ 0.21    $ 0.10     $ 0.42    $ 0.25  
    

  


 

  


 

Dilutive potential common shares consist primarily of employee stock options and restricted common stock. Employee stock options to purchase approximately 859 million and 468 million shares for the three months ended January 29, 2005 and January 24, 2004, respectively, and 838 million shares and 511 million shares in the first

 

29


Table of Contents

Cisco Systems, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

six months of fiscal 2005 and 2004, respectively were outstanding, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the average share price of the common shares, and, therefore, the effect would have been antidilutive.

 

14.   PENDING BUSINESS COMBINATIONS

 

As of January 29, 2005, the Company announced definitive agreements to acquire Airespace, Inc. and Protego Networks, Inc. for a purchase price of approximately $450 million and $65 million, respectively. The acquisition of Protego Networks, Inc. closed in the third quarter of fiscal 2005 and the acquisition of Airespace, Inc. is pending regulatory review.

 

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Table of Contents
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”). These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” variations of such words, and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses (including the potential growth of Advanced Technologies), 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 “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

 

Our results for the second quarter and the first six months of fiscal 2005 reflected increases in net sales, net income, and net income per share from the corresponding period of fiscal 2004. Revenue increased in each of our geographic segments. During the second quarter and the first six months of fiscal 2005, sales of our switches increased by 16% and 21%, respectively. For the three and six month periods, we experienced increased sales of our Advanced Technologies products of 41% and 37%, respectively, reflecting an increase in sales of each of our six Advanced Technologies product categories. Our router revenue decreased by 7% and 4%, respectively, for the same periods. However, our router revenue increased by 6% relative to the first quarter of fiscal 2005. Our gross margins declined from the second quarter and the first six months of last fiscal year largely because of a change in the mix of our product sales. This was primarily due to higher sales of certain lower margin switching products and home networking products and gross margin was also affected by a decline in our service margins related to our continued investment in this portion of our business. Operating expenses as a percentage of net sales have continued to decline year over year. We have continued to encounter price-focused competition, including competitors from Asia, and in particular, China.

 

During the second quarter and the first six months of fiscal 2005, we generated cash flows from operations of $1.8 billion and $3.2 billion, respectively. Our cash and cash equivalents and total investments were $16.5 billion at the end of the second quarter of fiscal 2005, compared with $19.3 billion at July 31, 2004. We used $2.7 billion of cash to repurchase 140 million shares of our common stock during the quarter. For the first six months of fiscal 2005, we used $5.7 billion of cash to repurchase 296 million shares of our common stock. Regarding accounts receivable, days sales outstanding at the end of the second quarter of fiscal 2005 were 34 days, compared with 28 days at the end of the fourth quarter of fiscal 2004. Our inventory level increased by $48 million from our prior fiscal year end, July 31, 2004, and annualized inventory turns improved to 6.5, compared with 6.4 in the fourth quarter of fiscal 2004.

 

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

 

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Financial Statements in the Annual Report on Form 10-K for the fiscal year ended July 31, 2004 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 are impacted significantly by judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies.

 

Revenue Recognition

 

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

 

Our total deferred revenue for products was $1.55 billion and $1.45 billion as of January 29, 2005 and July 31, 2004, respectively. Service revenue is generally deferred and, in most cases, recognized ratably over the period during which the services are to be performed, which is typically from one to three years. Our total deferred revenue for services was $3.1 billion and $3.0 billion as of January 29, 2005 and July 31, 2004, respectively.

 

Contracts, Internet commerce agreements, and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

 

When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. The amount of product and service revenue recognized is impacted by our judgments as to whether an arrangement includes multiple elements and, if so, whether vendor-specific objective evidence of fair value exists. Changes to the elements in an arrangement and our ability to establish vendor-specific objective evidence for those elements could affect the timing of the revenue recognition.

 

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

 

Allowance for Doubtful Accounts and Sales Returns

 

Our accounts receivable balance, net of allowance for doubtful accounts, was $2.3 billion and $1.8 billion as of January 29, 2005 and July 31, 2004, respectively. The allowance for doubtful accounts was $176 million, or 7.2% of the gross accounts receivable balance, as of January 29, 2005 and $179 million, or 8.9% of the gross accounts receivable balance, as of July 31, 2004. The allowance is based on our assessment of the collectibility of

 

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customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customer’s ability to pay.

 

There was no provision for doubtful accounts for the first six months of fiscal 2005. Our provision for doubtful accounts was $19 million for the first six months of fiscal 2004. 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 January 29, 2005 and July 31, 2004 was $88 million and $74 million, respectively, and was recorded as a reduction of our accounts receivable. If actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected.

 

Allowance for Inventory

 

Our inventory balance was $1.3 billion and $1.2 billion as of January 29, 2005 and July 31, 2004, respectively. Our inventory allowance was $135 million and $139 million as of January 29, 2005 and July 31, 2004, respectively. We provide allowances for inventory based on excess and obsolete inventories determined primarily by future demand forecasts. The allowance is measured as the difference between the cost of the inventory and market based upon assumptions about future demand and is charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

 

Our provision for inventory was $111 million and $72 million for the first six months of fiscal 2005 and 2004, respectively. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory allowances, and our gross margin could be adversely affected. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times and the risk of inventory obsolescence.

 

Warranty Costs

 

The liability for product warranties, included in other accrued liabilities, was $250 million as of January 29, 2005, compared with $239 million as of July 31, 2004. See Note 8 to the Consolidated Financial Statements. Our products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products we provide a limited lifetime warranty. We accrue for warranty costs as part of our cost of sales based on associated material costs, technical support labor costs, and associated overhead. Material cost is estimated based primarily upon historical trends in the volume of product returns within the warranty period and the cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities.

 

The provision for product warranties issued for the first six months of fiscal 2005 and 2004 was $208 million and $158 million, respectively. The increase in the provision for product warranties was due to higher shipment volume of our products and an increase in warranty claims. If we continue to experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than the expectations on which the accrual has been based, our gross margin could be adversely affected.

 

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Investment Impairments

 

Our publicly traded equity securities are reflected in the Consolidated Balance Sheets at a fair value of $1.0 billion as of January 29, 2005, compared with $1.1 billion as of July 31, 2004. See Note 7 to the Consolidated Financial Statements. We recognize an impairment charge when the declines in the fair values of our publicly traded equity securities below their cost basis are judged to be other-than-temporary. The ultimate value realized on these equity securities is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Our ongoing consideration of these factors could result in additional impairment charges in the future, which could adversely affect our net income. Our impairment charges on investments in publicly held companies were $5 million during the second quarter of fiscal 2005 and the first six months of fiscal 2005. There were no impairment charges on investments in publicly held companies in fiscal 2004.

 

We also have investments in privately held companies, some of which are in the startup or development stages. As of January 29, 2005, our investments in privately held companies were $403 million, compared with $354 million as of July 31, 2004, and were included in other assets. See Note 5 to the Consolidated Financial Statements. We monitor these investments for impairment and make appropriate reductions in carrying values if we determine an impairment charge is required, based primarily on the financial condition and near-term prospects of these companies. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. Our impairment charges on investments in privately held companies were $5 million and $44 million during the second quarter of fiscal 2005 and 2004, respectively, and were $23 million and $85 million for the first six months of fiscal 2005 and 2004, respectively.

 

Goodwill Impairments

 

Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques in the high-technology communications equipment industry. Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. We perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances for each reporting unit. The goodwill recorded in the Consolidated Balance Sheets as of January 29, 2005 and July 31, 2004 was $4.7 billion and $4.2 billion, respectively. In response to changes in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. We recorded no charges for impairment of goodwill during fiscal 2005 or fiscal 2004.

 

Income Taxes

 

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

 

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Our effective tax rates differ from the statutory rate primarily due to acquisition-related costs, research and experimentation tax credits, state taxes, and the tax impact of foreign operations. The effective tax rate was 28.5% in the second quarter of fiscal 2005 and 28.6% for the first six months of fiscal 2005. The effective tax rate was 28.6% in the second quarter of fiscal 2004 and 28.7% for the first six months of fiscal 2004. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

 

Loss Contingencies

 

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

 

Net Sales

 

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

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


    January 29,
2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


 

Net sales:

                                                          

Americas

   $ 3,314     $ 2,953     $ 361    12.2 %   $ 6,711     $ 5,827     $ 884    15.2 %

Percentage of net sales

     54.7 %     54.7 %                  55.8 %     55.5 %             

EMEA

     1,701       1,525       176    11.5 %     3,317       2,901       416    14.3 %

Percentage of net sales

     28.0 %     28.3 %                  27.5 %     27.6 %             

Asia Pacific

     623       546       77    14.1 %     1,189       1,057       132    12.5 %

Percentage of net sales

     10.3 %     10.1 %                  9.9 %     10.1 %             

Japan

     424       374       50    13.4 %     816       714       102    14.3 %

Percentage of net sales

     7.0 %     6.9 %                  6.8 %     6.8 %             
    


 


 

        


 


 

      

Total

   $ 6,062     $ 5,398     $ 664    12.3 %   $ 12,033     $ 10,499     $ 1,534    14.6 %
    


 


 

        


 


 

      

 

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

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


  

January 24,

2004


  

Variance

in

Dollars


  

Variance

in

Percent


    January 29,
2005


  

January 24,

2004


  

Variance

in

Dollars


  

Variance

in

Percent


 

Net sales:

                                                      

Product

   $ 5,106    $ 4,550    $ 556    12.2 %   $ 10,139    $ 8,813    $ 1,326    15.0 %

Service

     956      848      108    12.7 %     1,894      1,686      208    12.3 %
    

  

  

        

  

  

      

Total

   $ 6,062    $ 5,398    $ 664    12.3 %   $ 12,033    $ 10,499    $ 1,534    14.6 %
    

  

  

        

  

  

      

 

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The increase in net product sales was due to the impact of the continued gradual recovery in the global economic environment coupled with increased information technology-related capital spending in our enterprise, service provider, commercial, and consumer markets. The increase in service revenue was primarily due to increased technical support service contract initiations and renewals associated with higher product sales that have resulted in a larger installed base of equipment being serviced.

 

Net Product Sales by Theater

 

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

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


    January 29,
2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


 

Net product sales:

                                                          

Americas

   $ 2,621     $ 2,322     $ 299    12.9 %   $ 5,325     $ 4,574     $ 751    16.4 %

Percentage of net product sales

     51.4 %     51.0 %                  52.5 %     51.9 %             

EMEA

     1,534       1,377       157    11.4 %     2,987       2,608       379    14.5 %

Percentage of net product sales

     30.0 %     30.3 %                  29.5 %     29.6 %             

Asia Pacific

     564       502       62    12.4 %     1,076       968       108    11.2 %

Percentage of net product sales

     11.0 %     11.0 %                  10.6 %     11.0 %             

Japan

     387       349       38    10.9 %     751       663       88    13.3 %

Percentage of net product sales

     7.6 %     7.7 %                  7.4 %     7.5 %             
    


 


 

        


 


 

      

Total

   $ 5,106     $ 4,550     $ 556    12.2 %   $ 10,139     $ 8,813     $ 1,326    15.0 %
    


 


 

        


 


 

      

 

The increase in net product sales occurred across all geographic theaters with the Americas and EMEA theaters contributing 82.0% and 85.2% of the total increase in the second quarter and the first six months of fiscal 2005, compared with the same periods in fiscal 2004, respectively.

 

Net product sales in the Americas theater consist of net product sales in the United States and Americas International, which includes Canada, Mexico, and Latin America. The increase in net product sales in the Americas theater was due to an increase in net product sales to all of our customer markets in the United States. Sales increased in all elements of our enterprise market except for sales to the United States federal government, where we experienced weakness in sales due to, we believe, a realignment of spending priorities as funds are being refocused toward geopolitical and Middle East issues.

 

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

 

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Net Product Sales by Groups of Similar Products

 

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

 

     Three Months Ended

    Six Months Ended

 
     January 29,
2005


   

January 24,

2004


   

Variance
in

Dollars


   

Variance

in

Percent


    January 29,
2005


   

January 24,

2004


   

Variance
in

Dollars


   

Variance
in

Percent


 

Net product sales:

                                                            

Routers

   $ 1,329     $ 1,426     $ (97 )   (6.8 )%   $ 2,580     $ 2,700     $ (120 )   (4.4 )%

Percentage of net product sales

     26.0 %     31.3 %                   25.4 %     30.6 %              

Switches

     2,424       2,094       330     15.8 %     5,023       4,155       868     20.9 %

Percentage of net product sales

     47.5 %     46.0 %                   49.6 %     47.2 %              

Advanced Technologies

     1,153       817       336     41.1 %     2,118       1,543       575     37.3 %

Percentage of net product sales

     22.6 %     18.0 %                   20.9 %     17.5 %              

Other

     200       213       (13 )   (6.1 )%     418       415       3     0.7 %

Percentage of net product sales

     3.9 %     4.7 %                   4.1 %     4.7 %              
    


 


 


       


 


 


     

Total

   $ 5,106     $ 4,550     $ 556     12.2 %   $ 10,139     $ 8,813     $ 1,326     15.0 %
    


 


 


       


 


 


     

 

Routers

 

The decrease in net product sales related to routers in the second quarter and the first six months of fiscal 2005 was primarily due to lower sales of high-end routers. Sales of high-end routers, which represent a larger proportion of our total router sales than midrange and low-end routers, decreased by approximately $110 million and $120 million for the second quarter and the first six month periods, respectively. On a sequential basis relative to the first quarter of fiscal 2005, our router sales increased by approximately $80 million primarily due to sales of high-end routers which increased by approximately $50 million as a result of higher sales to service providers. Our high-end router sales are primarily to service providers who tend to make large and sporadic purchases. In addition, our router sales in fiscal 2005 may have been affected by new product introductions and increased competition from price-focused competitors.

 

Switches

 

The increase in net product sales related to switches in the second quarter of fiscal 2005 was due to sales of LAN fixed switches, which increased by approximately $230 million, and LAN modular switches, which increased by approximately $110 million. The increase in net product sales related to switches in the first six months of fiscal 2005 was due to sales of LAN fixed switches, which increased by approximately $440 million, and LAN modular switches, which also increased by approximately $440 million. The increase in sales of LAN switches was a result of the continued adoption of new technologies by our customers, resulting in higher sales of our high-end modular switch, the Cisco Catalyst 6500, and fixed switches, including the Cisco Catalyst 3750 and Catalyst 3560 platforms, introduced in the fourth quarter of fiscal 2003 and second quarter of fiscal 2004, respectively.

 

Advanced Technologies

 

During the second quarter and first six months of fiscal 2005, we experienced higher sales in all of our Advanced Technologies, compared to the corresponding periods in fiscal 2004. The increase in the second quarter of fiscal 2005 was due to sales of security products, which increased by approximately $80 million; home networking products, which increased by approximately $70 million; IP telephony products, which increased by

 

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approximately $70 million; wireless LAN products, which increased by approximately $50 million; optical products, which increased by approximately $40 million; and storage products, which increased by approximately $30 million. The increase in net product sales related to Advanced Technologies in the first six months of fiscal 2005 was due to sales of home networking products, which increased by approximately $150 million; security products, which increased by approximately $130 million; wireless LAN products, which increased by approximately $90 million; IP telephony products, which increased by approximately $90 million; and storage products and optical products, which each increased by approximately $60 million. Increased sales in security products were primarily due to module and line-card sales related to our routers and LAN modular switches as customers continue to emphasize network security. Higher sales of home networking products were related to the growth of our wireless and wired router businesses. The increase in sales of IP telephony products was primarily due to sales of IP phones and associated software as our customers transition from an analog to IP-based infrastructure. Wireless LAN and storage product sales increased primarily due to new customers and continued deployments with existing customers. Increased sales in optical products were due to sales of the Cisco ONS 15454E platform.

 

Factors That May Impact Net Product Sales

 

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

 

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

 

Net Service Revenue

 

The increase in net service revenue in the second quarter and the first six months of fiscal 2005, compared with fiscal 2004 was primarily due to increased technical support service contract initiations and renewals associated with higher product sales that have resulted in a larger installed base of equipment being serviced. Net

 

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service revenue is generally deferred and, in most cases, recognized ratably over the service period, which is typically one to three years.

 

Gross Margin

 

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

 

     Three Months Ended

    Six Months Ended

 
     Amount

   Percentage

    Amount

   Percentage

 
    

January 29,

2005


  

January 24,

2004


  

January 29,

2005


   

January 24,

2004


   

January 29,

2005


  

January 24,

2004


  

January 29,

2005


   

January 24,

2004


 

Gross margin:

                                                    

Americas

   $ 2,168    $ 1,992    65.4 %   67.5 %   $ 4,412    $ 3,937    65.7 %   67.6 %

EMEA

     1,184      1,057    69.6 %   69.3 %     2,302      2,015    69.4 %   69.5 %

Asia Pacific

     420      371    67.4 %   67.9 %     805      727    67.7 %   68.8 %

Japan

     281      278    66.3 %   74.3 %     549      525    67.3 %   73.5 %
    

  

              

  

            

Total

   $ 4,053    $ 3,698    66.9 %   68.5 %   $ 8,068    $ 7,204    67.0 %   68.6 %
    

  

              

  

            

 

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

 

     Three Months Ended

    Six Months Ended

 
     Amount

   Percentage

    Amount

   Percentage

 
    

January 29,

2005


  

January 24,

2004


  

January 29,

2005


   

January 24,

2004


   

January 29,

2005


  

January 24,

2004


  

January 29,

2005


   

January 24,

2004


 

Gross margin:

                                                    

Product

   $ 3,437    $ 3,125    67.3 %   68.7 %   $ 6,824    $ 6,072    67.3 %   68.9 %

Service

     616      573    64.4 %   67.6 %     1,244      1,132    65.7 %   67.1 %
    

  

              

  

            

Total

   $ 4,053    $ 3,698    66.9 %   68.5 %   $ 8,068    $ 7,204    67.0 %   68.6 %
    

  

              

  

            

 

Product Gross Margin

 

Product gross margin in the second quarter of fiscal 2005 decreased by 1.4%, compared with the second quarter of fiscal 2004. Changes in the mix of products sold decreased product gross margin by approximately 3% primarily due to higher sales of certain lower margin switching products and increased sales of home networking products. Product pricing reductions and sales discounts decreased product gross margin by approximately 1%. However, lower overall manufacturing costs related to lower component costs and value engineering and other manufacturing costs increased product gross margin by approximately 1.5%. Value engineering is the process by which the production costs are reduced through component redesign, board configuration, test processes, and transformation processes. Higher shipment volumes also increased product gross margin by approximately 1%.

 

Product gross margin for the first six months of fiscal 2005 decreased by 1.6%, compared with the first six months of fiscal 2004. Changes in the mix of products sold decreased product gross margin by approximately 3% primarily due to higher sales of certain lower margin switching products and increased sales of home networking products. Product pricing reductions and sales discounts decreased product gross margin by approximately 1%. In addition, a higher provision for warranty decreased product gross margin by approximately 1% and a higher provision for inventory decreased product gross margin by approximately 0.5%. However, lower overall manufacturing costs increased product gross margin by approximately 2%. Higher shipment volumes also increased product gross margin by less than 2%.

 

Product gross margin may continue to be adversely affected in the future by: changes in the mix of products sold, including further periods of increased growth of some of our lower-margin products; introduction of new products, including products with price-performance advantages; our ability to reduce production costs; entry into new markets, including markets with different pricing and cost structures; changes in distribution channels;

 

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price competition, including competitors from Asia and especially China; changes in geographic mix; sales discounts; increases in material or labor costs; excess inventory and obsolescence charges; warranty costs; changes in shipment volume; loss of cost savings due to changes in component pricing; impact of value engineering; inventory holding charges; and how well we execute on our strategy and operating plans.

 

Service Gross Margin

 

Service gross margin decreased by 3.2% and 1.4% during the second quarter and first six months of fiscal 2005, compared with the second quarter and first six months of fiscal 2004, respectively. The decrease in service gross margin was primarily due to increased investments in this portion of our business during fiscal 2005. One specific area of investment is advanced services, comprising highly specialized employees. As we add personnel and resources to support growth in this business, our service margins will typically be adversely affected in the near term. We have also added investments in our technical support business.

 

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

 

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

 

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

 

     Three Months Ended

    Six Months Ended

 
    

January 29,

2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


   

January 29,

2005


   

January 24,

2004


   

Variance

in

Dollars


  

Variance

in

Percent


 

Research and development

   $ 811     $ 770     $ 41    5.3 %   $ 1,616     $ 1,525     $ 91    6.0 %

Percentage of net sales

     13.4 %     14.3 %                  13.4 %     14.5 %             

Sales and marketing

     1,142       1,110       32    2.9 %     2,262       2,197       65    3.0 %

Percentage of net sales

     18.8 %     20.6 %                  18.8 %     20.9 %             

General and administrative

     228       210       18    8.6 %     458       422       36    8.5 %

Percentage of net sales

     3.8 %     3.9 %                  3.8 %     4.0 %             
    


 


 

        


 


 

      

Total

   $ 2,181     $ 2,090     $ 91    4.4 %   $ 4,336     $ 4,144     $ 192    4.6 %
    


 


 

        


 


 

      

Percentage of net sales

     36.0 %     38.7 %                  36.0 %     39.5 %             
    


 


              


 


            

 

The majority of the increase in this category was related to R&D and sales and marketing expenses as follows:

 

R&D expenses in the second quarter of fiscal 2005 increased primarily due to higher headcount-related expenses of $14 million and higher amortization of deferred stock-based compensation expense of $19 million. R&D expenses in the first six months of fiscal 2005 increased primarily due to higher discretionary spending of approximately $40 million, higher headcount-related expenses of $31 million, and higher amortization of deferred stock-based compensation expense of $16 million. The increase in R&D expenses reflects our continued investment in R&D efforts in routers, switches, Advanced Technologies, and other product technologies. We have also continued to purchase or license technology in order to bring a broad range of products to market in a timely fashion. If we believe that we are unable to enter a particular market in a timely manner with internally developed products, we may license technology from other businesses or acquire businesses as an alternative to internal R&D. All of our R&D costs have been expensed as incurred.

 

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Sales and marketing expenses in the second quarter of fiscal 2005 increased due to an increase in sales expenses of $10 million and marketing expenses of $22 million. Sales expenses increased primarily due to the effect of foreign currency fluctuations of approximately $30 million, net of hedging, partially offset by a decrease in headcount-related expenses of $15 million and lower amortization of deferred stock-based compensation of $8 million. The $15 million decrease in headcount-related expense was primarily due to an adjustment in sales commissions of approximately $30 million. Marketing expenses increased primarily due to various marketing programs globally and other marketing investments. Sales and marketing expenses in the first six months of fiscal 2005 increased due to increase in sales expenses of $35 million and marketing expenses of $30 million. Sales expenses increased primarily due to the effect of foreign currency fluctuations of approximately $55 million, net of hedging, an increase in headcount-related expenses of approximately $20 million (including an adjustment of approximately $40 million which reduced sales commissions) partially offset by a decrease in sales program expenses of approximately $30 million. Marketing expenses increased primarily due to various marketing programs globally and other marketing investments.

 

We have continued to increase our headcount during the quarter and the first six months of fiscal 2005. We expect to incur higher R&D and sales expenses due to additional headcount in connection with our hiring plans and acquisitions scheduled to close. Our headcount increased by 876 employees during the second quarter of fiscal 2005 and 1,591 employees during the first six months of fiscal 2005. Approximately 350 and 700 of the additional employees were attributable to our acquisitions completed in the second quarter and first six months of fiscal 2005, respectively.

 

Amortization of Purchased Intangible Assets

 

Amortization of purchased intangible assets included in operating expenses was $57 million in the second quarter of fiscal 2005, compared with $60 million in the second quarter of fiscal 2004. Amortization of purchased intangible assets included in operating expenses was $117 million in the first six months of fiscal 2005, compared with $122 million in the first six months of fiscal 2004. For additional information regarding purchased intangibles, see Note 3 to the Consolidated Financial Statements.

 

In-Process Research and Development

 

Our methodology for allocating the purchase price relating to purchase acquisitions to in-process R&D is determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D expense in the first six months of fiscal 2005 and fiscal 2004 was $14 million and $1 million, respectively. See Note 3 to the Consolidated Financial Statements for additional information regarding the acquisitions completed in the first six months of fiscal 2005 and the in-process R&D recorded for each acquisition. In-process R&D was expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed.

 

The fair value of the existing purchased technology and patents, as well as the technology under development, is determined using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations are typically derived from a weighted-average cost of capital analysis and venture capital surveys, adjusted upward to reflect additional risks inherent in the development lifecycle. We consider the pricing model for products related to these acquisitions to be standard within the high-technology communications equipment industry. However, we do not expect to achieve a material amount of expense reductions as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include significant anticipated cost savings.

 

For purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical viability, rapidly changing customer markets, uncertain standards for

 

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new products, and significant competitive threats from several companies. The nature of the efforts to develop these technologies into commercially viable products consists primarily of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets and could have a material adverse impact on our business and operating results.

 

Interest and Other Income, Net

 

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

 

     Three Months Ended

    Six Months Ended

 
    

January 29,

2005


  

January 24,

2004


  

Variance

in

dollars


   

January 29,

2005


  

January 24,

2004


  

Variance

in

dollars


 

Interest income

   $ 127    $ 124    $ 3     $ 257    $ 261    $ (4 )

Other income, net

     17      136      (119 )     57      137      (80 )
    

  

  


 

  

  


Total

   $ 144    $ 260    $ (116 )   $ 314    $ 398    $ (84 )
    

  

  


 

  

  


 

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

 

     Three Months Ended

    Six Months Ended

 
    

January 29,

2005


   

January 24,

2004


   

January 29,

2005


   

January 24,

2004


 

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

   $ 22     $ 151     $ 80     $ 191  

Impairment charges on publicly traded equity securities

     (5 )     —         (5 )     —    

Net gains on investments in privately held companies

     18       15       22       15  

Impairment charges on investments in privately held companies

     (5 )     (44 )     (23 )     (85 )
    


 


 


 


Net gains and impairment charges on investments

     30       122       74       121  

Other

     (13 )     14       (17 )     16  
    


 


 


 


Total

   $ 17     $ 136     $ 57     $ 137  
    


 


 


 


 

Provision for Income Taxes

 

The effective tax rate was 28.5% for the second quarter of fiscal 2005 and 28.6% for the first six months of fiscal 2005. The effective tax rate was 28.6% in the second quarter of fiscal 2004 and 28.7% for the first six months of fiscal 2004. The effective tax rate differs from the statutory rate primarily due to acquisition-related costs, research and experimentation tax credits, state taxes, and the tax impact of foreign operations.

 

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

 

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On October 22, 2004, the American Jobs Creation Act of 2004 (the “Jobs Creation Act”) was signed into law. The Jobs Creation Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and, as of today, uncertainty remains as to how to interpret numerous provisions of the Jobs Creation Act. Based on our analysis of the Jobs Creation Act, although not yet finalized, it is reasonably possible that under the repatriation provisions of the Jobs Creation Act, we may repatriate some amount of earnings between $0 and $1.5 billion, with the respective tax liability between $0 and $150 million. We expect to be in a position to finalize our assessment by July 30, 2005.

 

Recent Accounting Pronouncement

 

In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all stock-based payments. SFAS 123R is effective for all interim and annual periods beginning after June 15, 2005. We are currently evaluating the impact of SFAS 123(R) on our operating results and financial condition. See Note 10 to the Consolidated Financial Statements for pro forma information required under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”.

 

Liquidity and Capital Resources

 

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

 

Balance Sheet and Cash Flows

 

Cash and Cash Equivalents and Total Investments

 

The following table summarizes our cash and cash equivalents and total investments (in millions):

 

    

January 29,

2005


   July 31,
2004


  

Increase

(Decrease)


 

Cash and cash equivalents

   $ 2,473    $ 3,722    $ (1,249 )

Fixed income securities

     13,021      14,411      (1,390 )

Publicly traded equity securities

     1,031      1,134      (103 )
    

  

  


Total

   $ 16,525    $ 19,267    $ (2,742 )
    

  

  


 

For the six months ended January 29, 2005, the decrease in cash and cash equivalents and total investments was primarily a result of cash used for the repurchase of common stock of $5.7 billion, acquisitions of businesses of $553 million, and capital expenditures of $290 million, partially offset by cash provided by operating activities of $3.2 billion and cash provided by the issuance of common stock of $433 million related to employee stock option exercises and employee stock purchases.

 

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

 

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Accounts Receivable, Net

 

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

 

    

January 29,

2005


  

July 31,

2004


  

Increase

(Decrease)


Accounts receivable, net

   $ 2,278    $ 1,825    $ 453

 

Days sales outstanding (“DSO”) in accounts receivables as of January 29, 2005 and July 31, 2004 were 34 days and 28 days, respectively. The increase in DSO was due to more billings occurring later in the second quarter of fiscal 2005, primarily due to typical seasonality of renewals of a large number of calendar year-end technical support service contracts that occurred in January 2005.

 

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

 

Inventories

 

The following table summarizes our inventories (in millions):

 

    

January 29,

2005


  

July 31,

2004


  

Increase

(Decrease)


 

Raw materials

   $ 68    $ 58    $ 10  

Work in process

     415      416      (1 )

Finished goods:

                      

Distributor inventory and deferred cost of sales

     379      316      63  

Manufacturing finished goods

     175      206      (31 )
    

  

  


Total finished goods

     554      522      32  

Service-related spares

     188      177      11  

Demonstration systems

     30      34      (4 )
    

  

  


Total

   $ 1,255    $ 1,207    $ 48  
    

  

  


 

Annualized inventory turns were 6.5 in the second quarter of fiscal 2005, compared with 6.4 in the fourth quarter of fiscal 2004. Distributor inventory and deferred cost of sales are related to unrecognized revenue on shipments to distributors and retail partners and shipments to enterprise and service provider customers. Manufacturing finished goods consist primarily of build-to-order and build-to-stock products, including home networking products. Service-related spares consist of reusable equipment related to our technical support and warranty activities. All inventories are accounted for at the lower of cost or market.

 

Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times against the risk of inventory obsolescence because of rapidly changing technology and customer requirements. We may continue to see these higher levels of inventories in the short-term due to the expansion of our product lines and continued need for higher inventory levels of certain high-demand products in order to manage customer lead times.

 

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Deferred Revenue

 

The breakdown of deferred revenue at January 29, 2005 and July 31, 2004 was as follows (in millions):

 

    

January 29,

2005


  

July 31,

2004


  

Increase

(Decrease)


Deferred revenue:

                    

Service

   $ 3,097    $ 3,047    $ 50

Product

     1,550      1,455      95
    

  

  

Total

   $ 4,647    $ 4,502    $ 145
    

  

  

Reported as:

                    

Current

   $ 3,657    $ 3,527    $ 130

Noncurrent

     990      975      15
    

  

  

Total

   $ 4,647    $ 4,502    $ 145
    

  

  

 

The increase in deferred service revenue for the six months ended January 29, 2005 reflects a seasonal increase in the volume of technical support contract initiations and renewals, partially offset by the ongoing amortization of deferred service revenue. For the three months ended January 29, 2005, deferred service revenue increased by $212 million due to typical seasonality in renewal of calendar year-end contracts. The increase in deferred product revenue was related to an increase in sales with acceptance criteria as specified by the customer, and the timing of cash collections from our distributors and retail partners.

 

Contractual Obligations