Form 10Q
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 27, 2007

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated filer  x    Accelerated filer  ¨    Non-Accelerated filer  ¨

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

As of February 9, 2007, 6,040,034,409 shares of the registrant’s common stock were outstanding.

 



Table of Contents

CISCO SYSTEMS, INC.

FORM 10-Q

FOR THE QUARTER ENDED JANUARY 27, 2007

INDEX

 

               Page
  

Part I.

  

Financial Information

  
  

Item 1.

  

Financial Statements (Unaudited)

  
     

Consolidated Statements of Operations for the three and six months ended January 27, 2007 and January 28, 2006

   3
     

Consolidated Balance Sheets at January 27, 2007 and July 29, 2006

   4
     

Consolidated Statements of Cash Flows for the six months ended January 27, 2007 and January 28, 2006

   5
     

Consolidated Statements of Shareholders’ Equity for the six months ended January 27, 2007 and January 28, 2006

   6
     

Notes to Consolidated Financial Statements

   7
  

Item 2.

  

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

   29
  

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   48
  

Item 4.

  

Controls and Procedures

   50
  

Part II.

  

Other Information

  
  

Item 1.

  

Legal Proceedings

   51
  

Item 1A.

  

Risk Factors

   52
  

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   65
  

Item 3.

  

Defaults Upon Senior Securities

   65
  

Item 4.

  

Submission of Matters to a Vote of Security Holders

   65
  

Item 5.

  

Other Information

   66
  

Item 6.

  

Exhibits

   66
     

Signature

   67

 

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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 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

NET SALES:

           

Product

   $ 7,099    $ 5,537    $ 14,039    $ 11,028

Service

     1,340      1,091      2,584      2,150
                           

Total net sales

     8,439      6,628      16,623      13,178
                           

COST OF SALES:

           

Product

     2,544      1,774      5,043      3,525

Service

     507      388      959      777
                           

Total cost of sales

     3,051      2,162      6,002      4,302
                           

GROSS MARGIN

     5,388      4,466      10,621      8,876

OPERATING EXPENSES:

           

Research and development

     1,094      966      2,177      1,962

Sales and marketing

     1,726      1,431      3,412      2,884

General and administrative

     340      282      704      560

Amortization of purchased intangible assets

     96      56      201      115

In-process research and development

     2      —        6      2
                           

Total operating expenses

     3,258      2,735      6,500      5,523
                           

OPERATING INCOME

     2,130      1,731      4,121      3,353

Interest income, net

     172      168      329      322

Other income, net

     33      17      61      —  
                           

Interest and other income, net

     205      185      390      322
                           

INCOME BEFORE PROVISION FOR INCOME TAXES

     2,335      1,916      4,511      3,675

Provision for income taxes

     414      541      982      1,039
                           

NET INCOME

   $ 1,921    $ 1,375    $ 3,529    $ 2,636
                           

Net income per share — basic

   $ 0.32    $ 0.22    $ 0.58    $ 0.43
                           

Net income per share — diluted

   $ 0.31    $ 0.22    $ 0.56    $ 0.42
                           

Shares used in per-share calculation — basic

     6,057      6,146      6,060      6,195
                           

Shares used in per-share calculation — diluted

     6,291      6,248      6,255      6,301
                           

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 27,
2007
    July 29,
2006
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 2,434     $ 3,297  

Investments

     18,247       14,517  

Accounts receivable, net of allowance for doubtful accounts of $169 at January 27, 2007 and $175 at July 29, 2006

     2,908       3,303  

Inventories

     1,642       1,371  

Deferred tax assets

     1,673       1,604  

Prepaid expenses and other current assets

     1,612       1,584  
                

Total current assets

     28,516       25,676  

Property and equipment, net

     3,539       3,440  

Goodwill

     9,318       9,227  

Purchased intangible assets, net

     1,960       2,161  

Other assets

     2,921       2,811  
                

TOTAL ASSETS

   $ 46,254     $     43,315  
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 931     $ 880  

Income taxes payable

     1,330       1,744  

Accrued compensation

     1,589       1,516  

Deferred revenue

     4,718       4,408  

Other accrued liabilities

     2,923       2,765  
                

Total current liabilities

     11,491       11,313  

Long-term debt

     6,416       6,332  

Deferred revenue

     1,343       1,241  

Other long-term liabilities

     414       511  
                

Total liabilities

     19,664       19,397  
                

Minority interest

     8       6  

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; 6,048 and 6,059 shares issued and outstanding at January 27, 2007 and July 29, 2006, respectively

     27,245       24,257  

Accumulated deficit

     (1,083 )     (617 )

Accumulated other comprehensive income

     420       272  
                

Total shareholders’ equity

     26,582       23,912  
                

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 46,254     $ 43,315  
                

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

(Unaudited)

 

     Six Months Ended  
     January 27,
2007
    January 28,
2006
 

Cash flows from operating activities:

    

Net income

   $ 3,529     $ 2,636  

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

    

Depreciation and amortization

     690       512  

Employee share-based compensation expense

     472       578  

Share-based compensation expense related to acquisitions and investments

     19       52  

Provision for doubtful accounts

     —         10  

Provision for inventory

     116       70  

Deferred income taxes

     (66 )     1  

Excess tax benefits from share-based compensation

     (428 )     (125 )

In-process research and development

     6       2  

Net gains and impairment charges on investments

     (99 )     (21 )

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

    

Accounts receivable

     395       (329 )

Inventories

     (387 )     (115 )

Prepaid expenses and other current assets

     (39 )     (47 )

Lease receivables, net

     (66 )     (60 )

Accounts payable

     51       (51 )

Income taxes payable

     104       63  

Accrued compensation

     73       (97 )

Deferred revenue

     412       59  

Other liabilities

     147       129  
                

Net cash provided by operating activities

     4,929       3,267  
                

Cash flows from investing activities:

    

Purchases of investments

     (11,184 )     (10,467 )

Proceeds from sales and maturities of investments

     7,762       11,886  

Acquisition of property and equipment

     (548 )     (394 )

Acquisition of businesses, net of cash and cash equivalents acquired

     (166 )     (150 )

Change in investments in privately held companies

     (76 )     (90 )

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

     —         (25 )

Other

     (27 )     (84 )
                

Net cash (used in) provided by investing activities

     (4,239 )     676  
                

Cash flows from financing activities:

    

Issuance of common stock

     2,779       563  

Repurchase of common stock

     (4,781 )     (4,248 )

Excess tax benefits from share-based compensation

     428       125  

Other

     21       26  
                

Net cash used in financing activities

     (1,553 )     (3,534 )
                

Net (decrease) increase in cash and cash equivalents

     (863 )     409  

Cash and cash equivalents, beginning of period

     3,297       4,742  
                

Cash and cash equivalents, end of period

   $ 2,434     $ 5,151  
                

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in millions)

(Unaudited)

 

Six Months Ended January 28, 2006

  

Shares

of
Common
Stock

   

Common Stock

and Additional

Paid-In
Capital

    Retained
Earnings
(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Income
   Total
Shareholders’
Equity
 

BALANCE AT JULY 30, 2005

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

Net income

   —         —         2,636       —        2,636  

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

   —         —         —         11      11  

Other

   —         —         —         40      40  
                 

Comprehensive income

              2,687  
                 

Issuance of common stock

   56       563       —         —        563  

Repurchase of common stock

   (236 )     (838 )     (3,410 )     —        (4,248 )

Tax benefits from employee stock incentive plans

   —         140       —         —        140  

Purchase acquisitions

   1       24       —         —        24  

Employee share-based compensation expense

   —         572       —         —        572  

Share-based compensation expense related to acquisitions and investments

   —         52       —         —        52  
                                     

BALANCE AT JANUARY 28, 2006

   6,152     $ 22,907     $ (268 )   $ 325    $ 22,964  
                                     

Six Months Ended January 27, 2007

   Shares
of
Common
Stock
   

Common Stock

and Additional

Paid-In
Capital

    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
   Total
Shareholders’
Equity
 

BALANCE AT JULY 29, 2006

   6,059     $ 24,257     $ (617 )   $ 272    $ 23,912  

Net income

   —         —         3,529       —        3,529  

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

   —         —         —         107      107  

Other

   —         —         —         41      41  
                 

Comprehensive income

              3,677  
                 

Issuance of common stock

   176       2,779       —         —        2,779  

Repurchase of common stock

   (187 )     (786 )     (3,995 )     —        (4,781 )

Tax benefits from employee stock incentive plans

   —         503       —         —        503  

Purchase acquisitions

   —         3       —         —        3  

Employee share-based compensation expense

   —         470       —         —        470  

Share-based compensation expense related to acquisitions and investments

   —         19       —         —        19  
                                     

BALANCE AT JANUARY 27, 2007

   6,048     $ 27,245     $ (1,083 )   $ 420    $ 26,582  
                                     

Supplemental Information

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of January 27, 2007, the Company’s Board of Directors had authorized an aggregate repurchase of up to $47 billion of common stock under this program, which includes the November 15, 2006 authorization to repurchase up to an additional $7 billion of the Company’s common stock 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 (i) a reduction to retained earnings until retained earnings were zero and then as an increase to accumulated deficit and (ii) a reduction of common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock incentive plans are recorded in shareholders’ equity as an increase to common stock and additional paid-in capital. The stock repurchases since the inception of this program are summarized in the table below (in millions):

 

     Shares
of
Common
Stock
  

Common Stock

and Additional

Paid-In
Capital

   Retained
Earnings
(Accumulated
Deficit)
   Accumulated
Other
Comprehensive
Income
   Total
Shareholders’
Equity

Repurchases of common stock

   2,118    $ 7,080    $ 33,149    $ —      $ 40,229

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”) designs, manufactures, and sells networking and other products related to the communications and information technology industry and provides services associated with these products and their use. The Company’s products are installed at corporations, public institutions, telecommunications companies, commercial businesses and personal residences. Cisco provides a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world.

The Company conducts business globally and is primarily managed on a geographic basis in the following theaters: United States and Canada; European Markets; Emerging Markets; Asia Pacific; and Japan. The Emerging Markets theater consists of Eastern Europe, Latin America, the Middle East and Africa, and Russia and the Commonwealth of Independent States (CIS).

On February 24, 2006, the Company completed the acquisition of Scientific-Atlanta, Inc. (“Scientific-Atlanta”), a provider of set-top boxes, end-to-end video distribution networks, and video system integration. With this acquisition, the Company has enhanced its video capabilities to help enable the convergence of data, voice and video technologies. The Company seeks to have further strategic business relationships with key service provider customers, and to reach a broad range of consumers with its enhanced product line following the acquisition.

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 2007 and fiscal 2006 are 52-week fiscal years.

Basis of Presentation

The accompanying financial data as of January 27, 2007 and for the three and six months ended January 27, 2007 and January 28, 2006 has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. The July 29, 2006 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 29, 2006.

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 27, 2007, results of operations for the three and six months ended January 27, 2007 and January 28, 2006, cash flows, and shareholders’ equity for the six months ended January 27, 2007 and January 28, 2006, as applicable, have been made. The results of operations for the three and six months ended January 27, 2007 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

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, restricted common stock and restricted stock units.

Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires that employee equity share options, nonvested shares, and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect 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,

 

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Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares.

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2008. The Company is currently evaluating the impact of FIN 48 on its Consolidated Financial Statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides interpretative guidance on the process of quantifying financial statement misstatements and is effective for fiscal years ending after November 15, 2006. The Company applied the provisions of SAB 108 beginning in the first quarter of fiscal 2007 and there was no impact to the Consolidated Financial Statements.

Reclassifications

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

3. Business Combinations

Purchase Acquisitions

A summary of the purchase acquisitions and asset purchases for the six months ended January 27, 2007 is as follows (in millions):

 

     Purchase
Consideration
   Liabilities
Assumed
   In-Process
R&D
Expense
   Purchased
Intangible
Assets
   Goodwill

Arroyo Video Solutions, Inc.

   $ 86    $ 1    $ 3    $ 25    $ 57

Other

     86      6      3      42      41
                                  

Total

   $ 172    $ 7    $ 6    $ 67    $ 98
                                  

The Company acquired Arroyo Video Solutions, Inc. to enable carriers to accelerate the creation and distribution of network-delivered entertainment, interactive media and advertising services across the growing portfolio of televisions, personal computers, and mobile handsets.

Under the terms of the definitive agreements related to the acquisitions and asset purchases, the purchase consideration consisted of cash and stock options assumed. The purchase consideration for the Company’s acquisitions and asset purchases is also allocated to tangible assets acquired. The Consolidated Financial Statements include the operating results of each business from the date of acquisition. Pro forma results of operations for the acquisitions completed during the six months ended January 27, 2007 have not been presented because the effects of the acquisitions, individually or in the aggregate, were not material to the Company’s financial results.

Pro Forma Financial Information Relating to the Acquisition of Scientific-Atlanta, Inc.

The financial information in the table below summarizes the combined results of operations of Cisco and Scientific-Atlanta, on a pro forma basis, as though the companies had been combined at the beginning of each period presented. The pro forma financial

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

information for the three and six months ended January 28, 2006 combines the historical results of operations of Cisco for the three and six months ended January 28, 2006, with the historical results of operations of Scientific-Atlanta for the three and six months ended December 30, 2005.

The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition of Scientific-Atlanta and issuance of $6.5 billion of debt (see Note 7) had taken place at the beginning of each period presented. The debt was issued to finance the acquisition of Scientific-Atlanta as well as for general corporate purposes. For the purposes of this pro forma financial information, the interest expense on the entire debt, including the effects of hedging, was included in the pro forma financial adjustments. The pro forma financial information for the three and six months ended January 28, 2006 also includes the purchase accounting adjustments on historical Scientific-Atlanta inventory, adjustments to depreciation on acquired property and equipment, a charge for in-process research and development, amortization charges from acquired intangible assets, adjustments to interest income, and related tax effects.

 

The following table summarizes the pro forma financial information (in millions, except per-share amounts):

 

     Three Months
Ended
January 28,
2006
   Six Months
Ended
January 28,
2006

Net sales

   $ 7,123    $ 14,163

Net income

   $ 1,211    $ 2,420

Net income per share—basic

   $ 0.20    $ 0.39

Net income per share—diluted

   $ 0.19    $ 0.38

Purchased Intangible Assets and In-Process Research and Development

The following table presents the amortization of purchased intangible assets and in-process research and development (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Amortization of purchased intangible assets

   $ 132    $ 56    $ 273    $ 115

In-process research and development

   $ 2    $ —      $ 6    $ 2

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-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist.

The following table presents details of the purchased intangible assets acquired during the six months ended January 27, 2007 (in millions, except years):

 

     Technology   

Customer

Relationships

   Total
    

Weighted

Average

Useful Life

(in Years)

   Amount   

Weighted

Average

Useful Life

(in Years)

   Amount    Amount

Arroyo Video Solutions, Inc.

   5.0    $ 14    7.0    $ 11    $ 25

Other

   4.2      35    4.5      7      42
                          
      $ 49       $ 18    $ 67
                          

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

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

 

January 27, 2007

   Gross   

Accumulated

Amortization

    Net

Technology

   $     1,028    $ (359 )   $ 669

Customer relationships

     1,558      (296 )     1,262

Other

     140      (111 )     29
                     

Total

   $ 2,726    $ (766 )   $     1,960
                     

July 29, 2006

   Gross   

Accumulated

Amortization

    Net

Technology

   $ 1,052    $ (302 )   $ 750

Customer relationships

     1,535      (175 )     1,360

Other

     164      (113 )     51
                     

Total

   $ 2,751    $ (590 )   $ 2,161
                     

The estimated future amortization expense of purchased intangible assets as of January 27, 2007 is as follows (in millions):

 

Fiscal Year

   Amount

2007 (remaining six months)

   $ 263

2008

     482

2009

     397

2010

     289

2011

     217

Thereafter

     312
      

Total

   $ 1,960
      

Goodwill

The following table presents the changes in goodwill allocated to the Company’s reportable segments during the six months ended January 27, 2007 (in millions):

 

    

Balance at

July 29,

2006

   Acquisitions    Other    

Balance at
January 27,

2007

United States and Canada

   $     6,778    $     63    $ (15 )   $     6,826

European Markets

     1,127      18      10       1,155

Emerging Markets

     292      4      (2 )     294

Asia Pacific

     277      9          —         286

Japan

     753      4      —         757
                            

Total

   $ 9,227    $ 98    $ (7 )   $ 9,318
                            

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Compensation Expense Related to Acquisitions and Investments

The following table presents the compensation expense related to acquisitions and investments (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
  

January 28,

2006

  

January 27,

2007

  

January 28,

2006

Share-based compensation expense

   $ 9    $ 24    $ 19    $ 52

Cash compensation expense

     18      6      29      18
                           

Total

   $ 27    $ 30    $ 48    $ 70
                           

Share-Based Compensation Expense

Beginning in fiscal 2006, share-based compensation related to acquisitions and investments is measured under Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) and includes deferred share-based compensation relating to acquisitions completed prior to fiscal 2006. As of January 27, 2007, the remaining balance of share-based compensation related to acquisitions and investments to be recognized over the vesting periods was approximately $58 million.

Cash Compensation Expense

In connection with the Company’s purchase acquisitions, asset purchases, and acquisitions of variable interest entities, the Company has agreed to pay certain additional amounts in cash contingent upon achieving certain agreed-upon technology, development, product, or other milestones or continued employment of certain employees with the Company. In each case, any additional amounts paid will be recorded as compensation expense. As of January 27, 2007 and July 29, 2006, the Company had remaining commitments of $194 million and $223 million, respectively, pursuant to these agreements.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

4. Balance Sheet Details

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

 

     January 27,
2007
    July 29,
2006
 

Inventories:

    

Raw materials

   $ 178     $ 131  

Work in process

     440       377  

Finished goods:

    

Distributor inventory and deferred cost of sales

     456       423  

Manufacturing finished goods

     339       236  
                

Total finished goods

     795       659  
                

Service-related spares

     193       170  

Demonstration systems

     36       34  
                

Total

   $ 1,642     $ 1,371  
                

Property and equipment, net:

    

Land, buildings, and leasehold improvements

   $ 3,736     $ 3,647  

Computer equipment and related software

     1,446       1,352  

Production, engineering, and other equipment

     3,995       3,678  

Operating lease assets

     158       153  

Furniture and fixtures

     370       363  
                
     9,705       9,193  

Less accumulated depreciation and amortization

     (6,166 )     (5,753 )
                

Total

   $ 3,539     $ 3,440  
                

Other assets:

    

Deferred tax assets

   $ 972     $ 983  

Investments in privately held companies

     636       574  

Income tax receivable

     277       279  

Lease receivables, net

     479       464  

Other

     557       511  
                

Total

   $ 2,921     $ 2,811  
                

Deferred revenue:

    

Service

   $ 4,229     $ 4,088  

Product:

    

Unrecognized revenue on product shipments and other deferred revenue

     1,380       1,156  

Cash receipts related to unrecognized revenue from two-tier distributors

     452       405  
                

Total product deferred revenue

     1,832       1,561  
                

Total

   $ 6,061     $ 5,649  
                

Reported as:

    

Current

   $ 4,718     $ 4,408  

Noncurrent

     1,343       1,241  
                

Total

   $ 6,061     $ 5,649  
                

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

5. Lease Receivables, Net

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

 

     January 27,
2007
    July 29,
2006
 

Gross lease receivables

   $ 1,035     $ 960  

Unearned income and other allowances

     (197 )     (188 )
                

Total

   $ 838     $ 772  
                

Reported as:

    

Current

   $ 359     $ 308  

Noncurrent

     479       464  
                

Total

   $ 838     $ 772  
                

Contractual maturities of the gross lease receivables at January 27, 2007 were as follows (in millions):

 

Fiscal Year

   Amount

2007 (remaining six months)

   $ 245

2008

     368

2009

     238

2010

     118

2011

     48

Thereafter

     18
      

Total

   $ 1,035
      

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

6. Investments

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

 

January 27, 2007

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value

Fixed income securities:

          

U.S. government notes and bonds

   $ 7,023    $ 4    $ (28 )   $ 6,999

Corporate notes, bonds, and asset-backed securities

     8,881      7      (58 )     8,830

Municipal notes and bonds

     1,367      —        (2 )     1,365
                            

Total fixed income securities

     17,271      11      (88 )     17,194

Publicly traded equity securities

     694      363      (4 )     1,053
                            

Total

   $ 17,965    $ 374    $ (92 )   $ 18,247
                            

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

July 29, 2006

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

Fixed income securities:

          

U.S. government notes and bonds

   $ 5,179    $ 3    $ (47 )   $ 5,135

Corporate notes, bonds, and asset-backed securities

     7,950      2      (88 )     7,864

Municipal notes and bonds

     809      —        (3 )     806
                            

Total fixed income securities

     13,938      5      (138 )     13,805

Publicly traded equity securities

     467      252      (7 )     712
                            

Total

   $     14,405    $     257    $ (145 )   $     14,517
                            

The following table summarizes the maturities of the Company’s fixed income securities at January 27, 2007 (in millions):

 

     Amortized
Cost
   Fair Value

Less than 1 year

   $ 4,897    $ 4,888

Due in 1 to 2 years

     4,995      4,973

Due in 2 to 5 years

     5,460      5,414

Due after 5 years

     1,919      1,919
             

Total

   $     17,271    $     17,194
             

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

7. Long-Term Debt

In February 2006, the Company issued $500 million of senior floating interest rate notes due 2009 (the “2009 Notes”), $3.0 billion of 5.25% senior notes due 2011 (the “2011 Notes”) and $3.0 billion of 5.50% senior notes due 2016 (the “2016 Notes”), for an aggregate principal amount of $6.5 billion. The following table summarizes the Company’s long-term debt (in millions, except percentages):

 

     January 27, 2007     July 29, 2006  
     Amount     Effective
Rate(1)
    Amount     Effective
Rate(1)
 

Senior notes:

        

Floating-rate notes, due 2009

   $ 500     5.45 %   $ 500     5.27 %

5.25% fixed-rate notes, due 2011

     3,000     5.57 %     3,000     5.39 %

5.50% fixed-rate notes, due 2016

     3,000     5.80 %     3,000     5.62 %
                    

Total senior notes

     6,500         6,500    

Other notes

     5         5    

Unamortized discount

     (17 )       (18 )  

Fair value adjustment

     (72 )       (155 )  
                    

Total

   $     6,416       $     6,332    
                    

(1)

The effective rates for the 2011 Notes and the 2016 Notes reflect the variable rate in effect as of the period end on the interest rate swaps designated as fair value hedges of those notes, including the amortization of the discount.

The 2011 Notes and the 2016 Notes are redeemable by the Company at any time, subject to a make-whole premium. To achieve its interest rate objectives, the Company entered into $6.0 billion notional amount of interest rate swaps. In effect, these swaps convert the fixed interest rates of the 2011 Notes and the 2016 Notes to floating interest rates based on the London Interbank Offered Rate (LIBOR). Gains and losses in the fair value of the interest rate swaps offset changes in the fair value of the underlying debt. The Company was in compliance with all debt covenants as of January 27, 2007.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Interest is payable quarterly on the 2009 Notes and semi-annually on the 2011 Notes and 2016 Notes. Interest expense, net of the effect of hedging, included in interest income, net, in the Consolidated Statements of Operations and cash paid for interest are summarized as follows (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Interest expense

   $ 95    $ —      $ 189    $ —  

Cash paid for interest

   $ 7    $ —      $ 173    $ —  

8. Commitments and Contingencies

Operating Leases

The Company leases office space in several U.S. locations. Outside the United States, larger sites include Australia, Belgium, Canada, China, France, Germany, India, Italy, Japan, and the United Kingdom. Future annual minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of January 27, 2007 are as follows (in millions):

 

Fiscal Year

   Amount

2007 (remaining six months)

   $ 150

2008

     200

2009

     163

2010

     140

2011

     124

Thereafter

     654
      

Total

   $ 1,431
      

Purchase Commitments with Contract Manufacturers and Suppliers

The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the Company’s requirements. 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 27, 2007, the Company had total purchase commitments for inventory of $2.5 billion, compared with $2.0 billion as of July 29, 2006.

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 valuation of the Company’s inventory. As of January 27, 2007, the liability for these purchase commitments was $140 million, compared with $148 million as of July 29, 2006, and was included in other accrued liabilities.

Nuova Systems, Inc.

In the first quarter of fiscal 2007, the Company made an investment in Nuova Systems, Inc. (“Nuova Systems”), which conducts research and development on data center-related products. As a result of this investment, the Company owns approximately 80% of Nuova Systems and has consolidated the results of Nuova Systems in the Company’s Consolidated Financial Statements beginning in the first quarter of fiscal 2007. This investment includes $50 million of funding and a license to certain of the Company’s technology. In addition, upon the occurrence of certain events, the Company has committed up to $42 million of additional funding to Nuova Systems.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

In connection with this investment, the Company and Nuova Systems have entered into a call option agreement that provides the Company with the right to purchase the remaining interests of approximately 20% in Nuova Systems. If exercised by the Company, the call option provides that the minority interest holders would be eligible to receive two milestone payments based on a formula set forth in the call option agreement. The amounts due under the milestone payments will be recognized by the Company when it is determined that the exercise of the call option is probable. These amounts will be recorded as compensation expense based on an estimate of the fair value of the amounts earned by the minority interest holders pursuant to a vesting schedule. Subsequent changes to the fair value of the amounts probable of being earned and the continued vesting will result in adjustments to the recorded compensation expense. If the Company exercises the call option, the potential amount recorded as compensation expense would be up to a maximum of $578 million.

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 the senior debt is contingent upon the achievement of certain agreed-upon milestones. As of January 27, 2007, the Company had invested $606 million in the venture funds pursuant to the commitment, compared with $523 million as of July 29, 2006. In addition, as of January 27, 2007 and July 29, 2006, the Company had invested $49 million in the senior debt pursuant to the commitment, all of which has been repaid.

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 $23 million as of January 27, 2007, compared with approximately $34 million as of July 29, 2006.

Variable Interest Entities

In the ordinary course of business, the Company has investments in privately held companies and provides 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 customer financings and determined that there were no significant unconsolidated variable interest entities as of January 27, 2007.

Guarantees and Product Warranties

The Company’s guarantees issued that are subject to recognition and disclosure requirements as of January 27, 2007 and July 29, 2006 were not material. The following table summarizes the activity related to the product warranty liability during the six months ended January 27, 2007 and January 28, 2006 (in millions):

 

     Six Months Ended  
     January 27,
2007
    January 28,
2006
 

Balance at beginning of period

   $ 309     $ 259  

Provision for warranties issued

     242       190  

Payments

     (222 )     (191 )
                

Balance at end of period

   $ 329     $ 258  
                

The Company accrues for warranty costs as part of its cost of sales based on associated material product costs, labor costs for technical support staff, and associated overhead. The 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, 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.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

In addition, the Company has entered into indemnification agreements with its officers and directors, and the Company’s bylaws contain similar indemnification obligations to the Company’s agents.

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

Derivative Instruments

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

Foreign Currency Derivatives

The Company’s foreign exchange forward and option contracts are summarized as follows (in millions):

 

     January 27, 2007     July 29, 2006  
      Notional
Amount
   Fair
Value
    Notional
Amount
  

Fair

Value

 

Forward contracts:

          

Purchased

   $     1,363    $ 1     $     1,376    $ (2 )

Sold

   $ 534    $ (7 )   $ 554    $ (3 )

Option contracts:

          

Purchased

   $ 390    $ 18     $ 591    $     20  

Sold

   $ 362    $ (1 )   $ 573    $ (2 )

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

The Company enters into foreign exchange forward contracts to reduce the short-term effects of foreign currency fluctuations on foreign currency receivables, investments, and payables. The gains and losses on the foreign exchange forward contracts offset the transaction gains and losses on foreign currency receivables, investments, and payables recognized in earnings. Gains and losses on the contracts are included in other income, net, in the Consolidated Statements of Operations and offset foreign exchange gains and losses from the revaluation of intercompany balances or other current assets, investments, or 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 forward 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 and forward contracts. 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, if any, of the gain or loss is reported in earnings immediately. These currency option contracts and forward contracts generally have maturities of less than 18 months.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Interest Rate Derivatives

The Company’s interest rate derivatives are summarized as follows (in millions):

 

     January 27, 2007     July 29, 2006  
      Notional
Amount
   Fair
Value
    Notional
Amount
   Fair
Value
 

Interest rate derivatives:

          

Interest rate swaps—investments

   $     1,000    $     35     $     1,000    $     45  

Interest rate swaps—long-term debt

   $ 6,000    $ (72 )   $ 6,000    $ (155 )

The Company’s primary objective for holding fixed income securities is to achieve an appropriate investment return consistent with preserving principal and managing risk. To realize these objectives, the Company may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. The Company has entered into $1.0 billion of interest rate swaps designated as fair value hedges of its investment portfolio. Under these interest rate swap contracts, the Company makes fixed-rate interest payments and receives interest payments based on LIBOR. The effect of these swaps is to convert fixed-rate returns to floating-rate returns based on LIBOR for 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. The fair values of the interest rate swaps designated as hedges of the Company’s investments were reflected in prepaid expenses and other current assets in the Consolidated Balance Sheets.

In conjunction with its issuance of fixed-rate senior notes in February 2006, the Company entered into $6.0 billion of interest rate swaps designated as fair value hedges of the fixed-rate debt. Under these interest rate swap contracts, the Company receives fixed-rate interest payments and makes interest payments based on LIBOR. The effect of these swaps is to convert fixed-rate interest expense to floating-rate interest expense based on LIBOR. 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 debt. The fair values of the interest rate swaps designated as hedges of the Company’s debt were reflected in other long-term liabilities in the Consolidated Balance Sheets.

Equity Derivatives

The Company’s equity derivatives are summarized as follows (in millions):

 

     January 27, 2007    July 29, 2006
      Notional
Amount
   Fair
Value
   Notional
Amount
   Fair
Value

Equity derivatives:

           

Forward sale and option agreements

   $     244    $     39    $     164    $     93

The Company maintains a portfolio of publicly traded equity securities which are subject to price risk. The Company may hold equity securities for strategic purposes or to diversify the Company’s overall investment portfolio. To manage its exposure to changes in the fair value of certain equity securities, the Company may, from time to time, enter into equity derivative contracts. As of January 27, 2007, the Company had entered into forward sale and option agreements on certain publicly traded equity securities designated as fair value hedges. The gains and losses due to changes in the value of the hedging instruments are included in other income, net, in the Consolidated Statements of Operations and offset the change in the fair value of the underlying hedged investment. The fair values of the equity derivatives were reflected in prepaid expenses and other current assets and other accrued liabilities in the Consolidated Balance Sheets.

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 the Company and certain of its officers and directors. The lawsuits were consolidated, and the consolidated action was purportedly brought on behalf of those who purchased the Company’s publicly traded securities during an alleged class period of November 10, 1999 through February 6, 2001. On August 18, 2006, the Company

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

announced an agreement to resolve the litigation. Pursuant to that agreement, liability insurers paid $91.75 million to the plaintiffs in resolution of all claims against the Company and its officers and directors. The settlement was approved by the Court on December 5, 2006. Plaintiffs had alleged that defendants made false and misleading statements, purported to assert claims for violations of the federal securities laws, and sought unspecified compensatory damages and other relief. The Company and the individual defendants continue to deny all allegations in the lawsuit.

On February 16, 2005, a purported shareholder derivative lawsuit was filed in the Superior Court of California, County of Santa Clara, against various of the Company’s officers and directors and naming the Company as a nominal defendant. In July 2006, the Superior Court dismissed all claims and gave plaintiff until October 2006 in which to file an amended complaint, if plaintiff chose to do so. Pursuant to agreement between the parties, plaintiff has elected not to amend its complaint or file an appeal challenging the Superior Court’s order. The lawsuit had included derivative and class claims for breach of fiduciary duty, unjust enrichment, constructive trust and violations of the California Corporations Code, was 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 sought unspecified compensation and other damages, rescission of options and other relief.

The Company and other defendants are subject to patent claims asserted by QPSX Developments 5 Pty Ltd (“QPSX” now known as Ipernica Ltd) against the Company and such other defendants on June 21, 2005 in the United States District Court for the Eastern District of Texas. QPSX alleges that various Cisco switches and routers infringe United States Patent No. 5,689,499 and seeks damages and injunctive relief. Trial is scheduled to begin in April 2007. The Company believes that it has strong arguments at trial with respect to both non-infringement and invalidity, and believes that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, the Company is unable to reasonably estimate the ultimate outcome of this litigation at this time.

The Company and other defendants are also subject to patent claims asserted by Telcordia Technologies Inc. (“Telcordia”) against the Company and such other defendants on July 16, 2004 in the Federal District Court for the District of Delaware. Telcordia alleges that various Cisco routers, switches and optical products infringe United States Patent Nos. 4,893,306, 4,835,763 and Re 36,633, and seeks damages and injunctive relief. Based on the Court’s claim construction order, Telcordia has agreed that the Company does not infringe Patent No. 4,893,306 but has reserved its right to appeal the Court’s decision. Trial on the remaining claims is scheduled to begin in April 2007. The Company believes that it has strong arguments at trial with respect to both non-infringement and invalidity, and believes that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, the Company is unable to reasonably estimate the ultimate outcome of this litigation at this time.

In September 2005, Scientific-Atlanta, Inc. (which subsequently was acquired by the Company) and another plaintiff filed a declaratory judgment action against Forgent Networks (“Forgent”) in the United States District Court for the Eastern District of Texas after Forgent sued various Scientific-Atlanta customers. In the action, Scientific-Atlanta asserted that its products did not infringe Forgent’s United States Patent No. 6,285,746 and that the patent was invalid. On October 20, 2005, Forgent responded to the complaint by alleging that various Scientific-Atlanta digital video recorders infringe the patent and by seeking damages and injunctive relief. Subsequent to that, another declaratory judgment plaintiff moved to intervene and the cases have been combined. Trial is scheduled to begin in May 2007. The Company believes that it has strong arguments at trial with respect to both non-infringement and invalidity, and believes that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, the Company is unable to reasonably estimate the ultimate outcome of this litigation at this time.

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

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

9. Shareholders’ Equity

Stock Repurchase Program

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of January 27, 2007, the Company’s Board of Directors had authorized an aggregate repurchase of up to $47 billion of common stock under this program. The stock repurchase activity under the stock repurchase program during the first six months of fiscal 2007 is summarized as follows (in millions, except per-share amounts):

 

     Shares
Repurchased
   Price per
Share
   Remaining
Amount
Authorized
 

Balance at July 29, 2006

   1,931    $     18.36    $ 4,552  

Additional authorization on November 15, 2006

   —        —        7,000  

Repurchase of common stock

   187      25.55      (4,781 )
                

Balance at January 27, 2007

   2,118    $ 19.00    $ 6,771  
                

The purchase price for the shares of the Company’s stock repurchased was reflected as a reduction to shareholders’ equity. In accordance with Accounting Principles Board Opinion No. 6, “Status of Accounting Research Bulletins,” the Company is required to allocate the purchase price of the repurchased shares as (i) a reduction to retained earnings until retained earnings are zero and then as an increase to accumulated deficit and (ii) a reduction of common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock incentive plans are recorded as an increase to common stock and additional paid-in capital.

Comprehensive Income

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

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
  

January 27,

2007

    January 28,
2006

Net income

   $     1,921    $     1,375    $     3,529     $     2,636

Other comprehensive income:

          

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

     30      78      109       8

Other (1)

     41      25      41       40
                            

Comprehensive income before minority interest

     1,992      1,478      3,679       2,684

Change in minority interest (2)

     6      —        (2 )     3
                            

Total

   $ 1,998    $ 1,478    $ 3,677     $ 2,687
                            

(1) Includes changes in currency translation
(2) The Company consolidates its investment in a venture fund managed by SOFTBANK as it is the primary beneficiary as defined under FIN 46(R). As a result, SOFTBANK’s interest in the change in the unrealized gains and losses on the investments in the venture fund is recorded as a component of accumulated other comprehensive income, and is reflected as a change in minority interest.

10. Employee 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 stock have been reserved for issuance. Eligible employees may purchase a limited number of shares of the Company’s stock at a discount of up to 15% of the lesser of the market value on the subscription date or the purchase date, which is approximately six months after the subscription date. The Purchase Plan terminates on January 3, 2010. The Company issued 10 million shares under the Purchase Plan during the three and six months ended January 27, 2007, and 11 million shares under the Purchase Plan during the three and six months ended January 28, 2006. As of January 27, 2007, 89 million shares were available for issuance under the Purchase Plan.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Employee Stock Incentive Plans

Stock Incentive Plan Program Description

As of January 27, 2007, the Company had four stock incentive plans: the 2005 Stock Incentive Plan (the “2005 Plan”), the 1996 Stock Incentive Plan (the “1996 Plan”), the 1997 Supplemental Stock Incentive Plan (the “Supplemental Plan”), and the Cisco Systems, Inc. SA Acquisition Long-Term Incentive Plan (the “Acquisition Plan”). In addition, the Company has, in connection with the acquisitions of various companies, assumed the stock incentive plans of the acquired companies or issued replacement share-based awards. Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, and government regulations. Since the inception of the stock incentive plans, the Company has granted stock options to virtually all employees, and the majority has been granted to employees below the vice president level. The Company’s stock incentive plans are summarized as follows:

2005 Plan

 

   

The maximum number of shares issuable over the term of the 2005 Plan is limited to 350 million shares. The 2005 Plan permits the granting of stock options, stock grants, stock units, and stock appreciation rights to employees (including employee directors and officers) and consultants of the Company and its subsidiaries and affiliates, and nonemployee directors of the Company. Stock options granted under the 2005 Plan have an exercise price of at least 100% of the fair market value of the underlying stock on the grant date and expire no later than nine years from the grant date. The stock options will generally become exercisable for 20% of the option shares one year from the date of grant and then ratably over the following 48 months. Stock grants and stock units will generally vest with respect to 20% of the shares covered by the grant on each of the first through fifth anniversaries of the date of the grant. The Compensation and Management Development Committee of the Board of Directors has the discretion to use a different vesting schedule. Stock appreciation rights may be awarded in combination with stock options or stock grants and such awards shall provide that the stock appreciation rights will not be exercisable unless the related stock options or stock grants are forfeited. Stock grants may be awarded in combination with nonstatutory stock options, and such awards may provide that the stock grants will be forfeited in the event that the related nonstatutory stock options are exercised.

1996 Plan

 

   

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

Supplemental Plan

 

   

In 1997, the Company adopted the Supplemental Plan, under which stock options can be granted or shares can be directly issued to eligible employees. Officers and members of the Company’s Board of Directors are not eligible to participate in the Supplemental Plan. Nine million shares have been reserved for issuance under the Supplemental Plan. All stock option grants have an exercise price equal to the fair market value of the underlying stock on the grant date. The Company no longer makes stock option grants or direct share issuances under the Supplemental Plan.

Acquisition Plan

 

   

Effective upon completion of the Company’s acquisition of Scientific-Atlanta, the Company adopted the Acquisition Plan. The Acquisition Plan constitutes an assumption, amendment, restatement and renaming of the 2003 Long-Term Incentive Plan of Scientific-Atlanta. The Acquisition Plan permits the grant of stock options, stock grants, stock units, and stock appreciation rights to certain employees of the Company and its subsidiaries and affiliates who had been employed by Scientific-Atlanta or its subsidiaries. An aggregate of 14.8 million shares of the Company’s common stock has been reserved for issuance under the Acquisition Plan on a discretionary basis, subject to limitations set forth in the Acquisition Plan.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Distribution and Dilutive Effect of Stock Options

The following table illustrates grant dilution based on net options granted as a percentage of shares of common stock outstanding at period end (in millions, except percentages):

 

     Six Months Ended  
     January 27,
2007
    January 28,
2006
 

Shares of common stock outstanding

   6,048     6,152  
            

Granted and assumed

   164     167  

Canceled/forfeited/expired

   (28 )   (44 )
            

Net stock options granted

   136     123  
            

Grant dilution

   2.2 %   2.0 %
            

Weighted-average basic and diluted shares outstanding for the six months ended January 27, 2007 were 6.1 billion shares and 6.3 billion shares, respectively. For the six months ended January 27, 2007, the dilutive effect of in-the-money employee stock options was approximately 194 million shares or 3.2% of the basic shares outstanding based on the Company’s average share price of $24.24.

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 years ended July 29, 2006 and July 30, 2005 were in excess of $100,000. The following table summarizes the options granted to the Named Executive Officers during the periods indicated (in millions, except percentages):

 

     Six Months Ended  
    

January 27,

2007

    January 28,
2006
 

Stock options granted to the Named Executive Officers

   2.9     2.9  
            

Stock options granted to the Named Executive Officers as a percentage of net stock options granted

   2.1 %   2.4 %
            

Stock options granted to the Named Executive Officers as a percentage of outstanding shares

   0.05 %   0.05 %
            

Cumulative stock options held by Named Executive Officers as a percentage of total stock options outstanding

   3.2 %   3.5 %
            

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

General Share-Based Award Information

A summary of share-based award activity is as follows (in millions, except per-share amounts):

 

           Stock Options Outstanding
     Share-
Based
Awards
Available
for Grant
    Number
Outstanding
    Weighted-
Average
Exercise Price
per Share

Balance at July 30, 2005

   223     1,436     $ 25.02

Granted and assumed

   (230 )   230       18.21

Exercised

   —       (136 )     10.08

Canceled/forfeited/expired

   79     (84 )     29.53

Restricted stock and restricted stock units granted

   (6 )   —         —  

Additional shares reserved

   398     —         —  
              

Balance at July 29, 2006

   464     1,446       25.08

Granted and assumed

   (164 )   164       23.20

Exercised (1)

   —       (167 )     15.64

Canceled/forfeited/expired

   16     (28 )     31.21

Restricted stock and restricted stock units granted

   (5 )   —         —  
              

Balance at January 27, 2007

   311     1,415     $ 25.85
              

(1) The total pretax intrinsic value of stock options exercised during the six months ended January 27, 2007 was $1.5 billion.

The following table summarizes significant ranges of outstanding and exercisable options as of January 27, 2007 (in millions, except years and per-share amounts):

 

     Stock Options Outstanding    Stock Options Exercisable

Range of Exercise Prices

   Number
Outstanding
  

Weighted-

Average

Remaining

Contractual

Life (in Years)

   Weighted-
Average
Exercise
Price per
Share
   Aggregate
Intrinsic
Value
   Number
Exercisable
   Weighted-
Average
Exercise
Price per
Share
   Aggregate
Intrinsic
Value

$0.01 –15.00

   159    4.08    $ 11.32    $ 2,382    124    $ 11.34    $ 1,855

15.01 –18.00

   268    6.07      17.15      2,464    137      16.59      1,341

18.01 –20.00

   340    5.94      19.21      2,427    182      19.16      1,303

20.01 –22.50

   90    5.27      20.84      495    61      20.71      346

22.51 –25.00

   174    8.15      23.10      567    17      23.73      44

25.01 –35.00

   107    2.13      27.30      7    97      27.33      7

35.01 – 72.56

   277    2.35      53.55      —      277      53.48      —  
                                

Total

   1,415    4.99    $ 25.85    $ 8,342    895    $ 29.38    $ 4,896
                                

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value based on the Company’s closing stock price of $26.35 as of January 26, 2007, which would have been received by the option holders had those option holders exercised their options as of that date. The total number of in-the-money stock options exercisable as of January 27, 2007 was 528 million. As of July 29, 2006, 969 million outstanding stock options were exercisable and the weighted-average exercise price was $28.53.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The following table presents the option exercises for the six months ended January 27, 2007, 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 27, 2007
   Intrinsic Value of
Unexercised in-the-Money
Options at January 27, 2007
           Exercisable    Unexercisable    Exercisable    Unexercisable

Named Executive Officers

   6    $ 68    36    10    $  154    $ 72

Valuation and Expense Information Under SFAS 123(R)

On July 31, 2005, the Company adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to the Company’s employees and directors including employee stock options, employee stock purchases related to the Employee Stock Purchase Plan (“employee stock purchases”), employee restricted stock and restricted stock units, based on estimated fair values. Employee share-based compensation expense under SFAS 123(R) was as follows (in millions):

 

      Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Cost of sales—product

   $ 12    $ 11    $ 23    $ 30

Cost of sales—service

     30      28      54      62
                           

Employee share-based compensation expense in cost of sales

     42      39      77      92
                           

Research and development

     74      90      148      193

Sales and marketing

     99      106      193      233

General and administrative

     32      26      54      60
                           

Employee share-based compensation expense in operating expenses

     205      222      395      486
                           

Total employee share-based compensation expense(1)

   $ 247    $ 261    $ 472    $ 578
                           

(1) Share-based compensation expense related to acquisitions and investments is disclosed in Note 3 and is not included in the table. As of January 27, 2007, total compensation cost related to nonvested share-based awards not yet recognized was $2.8 billion, including share-based compensation relating to acquisition and investments, which is expected to be recognized over the next 45 months on a weighted-average basis.

The income tax benefit for employee share-based compensation expense was $105 million and $163 million for the three and six months ended January 27, 2007, respectively, and $73 million and $162 million for the three and six months ended January 28, 2006, respectively. The income tax benefit has been determined using the applicable tax rates in jurisdictions to which this expense relates and for fiscal 2007 includes the tax effects resulting from the reinstatement of the U.S. federal research and development (R&D) tax credit during the three months ended January 27, 2007 (see Note 11). The tax benefit for fiscal 2006 includes the effect of U.S. tax regulations that require intercompany reimbursement of certain share-based compensation expenses.

Lattice-Binomial Model

Upon adoption of SFAS 123(R), the Company began estimating the value of employee stock options and employee stock purchases on the date of grant using a lattice-binomial model. Prior to the adoption of SFAS 123(R), the value of each employee stock option and employee stock purchase was estimated on the date of grant using the Black-Scholes model.

 

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CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The Company’s employee stock options have various restrictions including vesting provisions and restrictions on transfer and hedging, among others, and are often exercised prior to their contractual maturity. Lattice-binomial models are more capable of incorporating the features of the Company’s employee stock options than closed-form models such as the Black-Scholes model. The use of a lattice-binomial model requires extensive actual employee exercise behavior data and a number of complex assumptions including expected volatility, risk-free interest rate, expected dividends, kurtosis, and skewness. The weighted-average assumptions, using the lattice-binomial model, the weighted-average expected life and estimated value of employee stock options are summarized as follows:

 

      Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    January 27,
2007
    January 28,
2006
 

Weighted-average assumptions:

        

Expected volatility

     24.5 %     23.7 %     25.8 %     23.7 %

Risk-free interest rate

     4.6 %     4.5 %     4.6 %     4.2 %

Expected dividend

     0.0 %     0.0 %     0.0 %     0.0 %

Kurtosis

     4.6       4.2       4.5       4.3  

Skewness

     (0.80 )     (0.60 )     (0.80 )     (0.60 )

Weighted-average expected life in years

     6.7       6.6       6.7       6.6  

Weighted-average estimated value

   $ 7.93     $ 5.05     $ 6.94     $ 5.01  

The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. The weighted-average assumptions were determined as follows:

 

   

The Company used the implied volatility for two-year traded options on the Company’s stock as the expected volatility assumption required in the lattice-binomial model, consistent with SFAS 123(R) and Staff Accounting Bulletin No. 107 (“SAB 107”). The selection of the implied volatility approach was based upon the availability of actively traded options on the Company’s stock and the Company’s assessment that implied volatility is more representative of future stock price trends than historical volatility.

 

   

The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of the Company’s employee stock options.

 

   

The dividend yield assumption is based on the history and expectation of dividend payouts.

 

   

The estimated kurtosis and skewness are technical measures of the distribution of stock price returns, which affect expected employee exercise behaviors that are based on the Company’s stock price return history as well as consideration of various academic analyses.

The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. The expected life of employee stock options is impacted by all of the underlying assumptions and calibration of the Company’s model. The lattice-binomial model assumes that employees’ exercise behavior is a function of the option’s remaining vested life and the extent to which the option is in-the-money. The lattice-binomial model estimates the probability of exercise as a function of these two variables based on the entire history of exercises and cancellations on all past option grants made by the Company.

Because share-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience and the Company estimated forfeitures to be 3% annually for the three and six months ended January 27, 2007 and January 28, 2006.

 

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Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

Accuracy of Fair Value Estimates

The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, its lattice-binomial model. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based payment awards.

 

The Company’s determination of fair value of share-based payment awards is affected by the assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because the Company’s employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models may not provide an accurate measure of the fair value of the Company’s employee stock options. Although the fair value of employee stock options is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

11. Income Taxes

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

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    January 27,
2007
    January 28,
2006
 

Effective tax rate

     17.7 %     28.2 %     21.8 %     28.3 %

Cash paid for income taxes

   $ 487     $ 605     $ 959     $ 974  

During the three months ended January 27, 2007, the Tax Relief and Health Care Act of 2006 reinstated the U.S. federal R&D tax credit, retroactive to January 1, 2006. As a result, the tax provision rate for the three and six months ended January 27, 2007 included a $120 million tax benefit from the U.S. R&D tax credit, including $60 million related to fiscal 2006 R&D expenses and $30 million related to the first quarter of fiscal 2007 R&D expenses. The effective tax rate for the three and six months ended January 27, 2007 also reflects a benefit from an increase in foreign income taxed at other than U.S. rates.

The Company’s income taxes currently payable have been reduced by the tax benefits from employee stock incentive plans. These benefits totaled $503 million and $140 million for the six months ended January 27, 2007 and January 28, 2006, respectively, and were reflected as an increase to additional paid-in capital in the Consolidated Statements of Shareholders’ Equity. The Company includes only the direct tax effects of employee stock incentive plans in calculating this increase to additional paid-in capital.

The Company’s federal income tax returns for fiscal years ended July 27, 2002 through July 31, 2004 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 created a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. In the first quarter of fiscal 2006, the Company distributed cash from its foreign subsidiaries and will report an extraordinary dividend (as defined in the Jobs Creation Act) of $1.2 billion and a related tax liability of approximately $63 million in its fiscal 2006 federal income tax return. This amount was previously provided for in the provision for income taxes and is included in income taxes payable. This distribution does not change the Company’s intention to indefinitely reinvest undistributed earnings of certain of its foreign subsidiaries in operations outside the United States.

 

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Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

12. Segment Information and Major Customers

The Company’s operations involve the design, development, manufacturing, marketing, and technical support of networking and other products and services related to the communications and information technology industry. Cisco products include routers, switches, advanced technologies, and other products. These products, primarily integrated by Cisco IOS Software, link geographically dispersed local-area networks (LANs) and wide-area networks (WANs).

The Company conducts business globally and is primarily managed on a geographic basis. 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. Gross margin for each theater includes the amortization of purchased intangible assets and the employee share-based compensation expense related to that theater. 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 use the information to measure the performance of the operating segments.

Summarized financial information by theater based on the Company’s internal management system, is as follows (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Net sales:

           

United States and Canada (1)

   $ 4,556    $ 3,468    $ 9,283    $ 7,120

European Markets

     1,841      1,533      3,444      2,901

Emerging Markets

     890      620      1,642      1,156

Asia Pacific

     847      720      1,602      1,355

Japan

     305      287      652      646
                           

Total

   $ 8,439    $ 6,628    $ 16,623    $ 13,178
                           

Gross margin:

           

United States and Canada

   $ 2,857    $ 2,294    $ 5,823    $ 4,719

European Markets

     1,196      1,051      2,261      1,991

Emerging Markets

     582      437      1,080      814

Asia Pacific

     543      482      1,007      895

Japan

     210      202      450      457
                           

Total

   $ 5,388    $ 4,466    $ 10,621    $ 8,876
                           

(1)

Net sales in the United States were $4.3 billion and $3.3 billion for the three months ended January 27, 2007 and January 28, 2006, respectively. Net sales in the United States were $8.8 billion and $6.7 billion for the six months ended January 27, 2007 and January 28, 2006, respectively.

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

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Net sales:

           

Routers

   $ 1,674    $ 1,420    $ 3,269    $ 2,837

Switches

     3,013      2,665      6,043      5,308

Advanced technologies

     1,930      1,163      3,790      2,296

Other

     482      289      937      587
                           

Product

     7,099      5,537      14,039      11,028

Service

     1,340      1,091      2,584      2,150
                           

Total

   $ 8,439    $ 6,628    $ 16,623    $ 13,178
                           

 

27


Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

 

The Company refers to some of its products and technologies as advanced technologies. As of January 27, 2007, the Company had identified the following advanced technologies for particular focus: application networking services, home networking, hosted small-business systems, security, storage area networking, unified communications, video systems, and wireless technology. The Company continues to 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. Beginning in the first quarter of fiscal 2007, sales of optical networking products, which were previously included in the advanced technologies product category, are included in the other product category, and prior period amounts have been reclassified in order to conform to the current period’s presentation.

The majority of the Company’s assets as of January 27, 2007 and July 29, 2006 were attributable to its U.S. operations. For the three and six months ended January 27, 2007 and January 28, 2006, 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 27,
2007
  

July 29,

2006

Property and equipment, net:

     

United States

   $ 3,189    $ 3,082

International

     350      358
             

Total

   $ 3,539    $ 3,440
             

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 27,

2007

  

January 28,

2006

  

January 27,

2007

  

January 28,

2006

Net income

   $ 1,921    $ 1,375    $ 3,529    $ 2,636
                           

Weighted-average shares—basic

     6,057      6,146      6,060      6,195

Effect of dilutive potential common shares

     234      102      195      106
                           

Weighted-average shares—diluted

     6,291      6,248      6,255      6,301
                           

Net income per share—basic

   $ 0.32    $ 0.22    $ 0.58    $ 0.43
                           

Net income per share—diluted

   $ 0.31    $ 0.22    $ 0.56    $ 0.42
                           

Antidilutive employee stock options

     475      1,099      537      1,055

14. Pending Business Combinations

As of January 27, 2007, the Company announced a definitive agreement to acquire privately held IronPort Systems, Inc., a leading provider of messaging security appliances, focusing on enterprise spam and spyware protection. The aggregate announced purchase price for this acquisition is approximately $830 million in cash, stock, and stock options assumed. The acquisition is expected to close in the third quarter of fiscal 2007 and will be accounted for under the purchase method of accounting.

 

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, under “Part II, Item 1A. Risk Factors” and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.

Overview

Our results for the second quarter and first six months of fiscal 2007 reflected increases in net sales, net income, and net income per share from the corresponding periods of fiscal 2006. In February 2006, we completed the acquisition of Scientific-Atlanta, a provider of set-top boxes, end-to-end video distribution networks, and video integration systems. With this acquisition, we have enhanced our video capabilities and this enables the convergence of data, voice and video technologies. We believe that video applications have the potential to provide accelerating momentum resulting in growth of both bandwidth and set-top boxes, and we believe Scientific-Atlanta may enable us to have further strategic business relationships with key service provider customers and to reach a broad range of consumers with our enhanced product line. The results for the second quarter and first six months of fiscal 2007 include Scientific-Atlanta’s contribution of $639 million and $1.2 billion in net sales, respectively. The results for the second quarter and first six months of fiscal 2006 do not include Scientific-Atlanta.

Revenue

During the second quarter and first six months of fiscal 2007, we continued to achieve a good balance in year-over-year revenue growth from our four largest geographic segments, our customer markets, and our product families. Revenue increased in all of our geographic theaters in the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006. Sales of our advanced technologies, which comprise a larger percentage of our net product sales than routing, increased by approximately 66% and 65% during the second quarter and first six months of fiscal 2007, respectively, over the corresponding periods of fiscal 2006. The increase in sales of advanced technologies during the second quarter and first six months of fiscal 2007 was due in part to the acquisition of Scientific-Atlanta, which increased sales of advanced technologies by 43% and 42% during the respective periods, and also due to strength in sales of our unified communications, security, wireless, and storage products. In the second quarter of fiscal 2007, our routing and switching revenue increased by approximately 18% and 13%, respectively, over the second quarter of fiscal 2006, and by approximately 15% and 14%, respectively, in the first six months of fiscal 2007 compared to the first six months of fiscal 2006.

Operating Margin

For the second quarter and first six months of fiscal 2007, our gross margin percentage decreased compared to the corresponding periods of fiscal 2006. The decrease in gross margin percentage from the corresponding periods of fiscal 2006 was primarily related to the acquisition of Scientific-Atlanta, whose business model has a lower gross margin percentage than the Cisco model. Other factors contributing to the decrease in the gross margin percentage were sales discounts, rebates, product pricing, and sales mix. These factors were partially offset by lower manufacturing costs related to lower component costs and higher shipment volume. Operating expenses increased during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 primarily due to expenses related to increased investments in sales and engineering headcount, but decreased as a percentage of revenue for both periods.

 

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Other Financial Highlights

During the first six months of fiscal 2007, we generated cash flows from operations of $4.9 billion. Our cash and cash equivalents and investments were $20.7 billion at the end of the second quarter of fiscal 2007, compared with $17.8 billion at the end of fiscal 2006. We used $4.8 billion of cash to repurchase 187 million shares of our common stock during the first six months of fiscal 2007. Days sales outstanding in accounts receivable (DSO) at the end of the second quarter of fiscal 2007 improved to 31 days, compared to 38 days at the end of fiscal 2006. Our inventory balance was $1.6 billion at the end of the second quarter of fiscal 2007, compared to $1.4 billion at the end of fiscal 2006. Annualized inventory turns were 7.8 in the second quarter of fiscal 2007 as compared to 8.5 in the fourth quarter of fiscal 2006.

Focus Areas

During the first six months of fiscal 2007, we continued to focus particular attention on the commercial market segment; additional sales coverage; growing and expanding our advanced technologies; evolving our support model; and expanding our presence in the Emerging Markets theater. In addition to these areas, we expect to continue to focus on next-generation service provider network build-outs, strengthening our product offerings in the consumer market, and providing more comprehensive solutions to our customers as they employ Internet solutions. We believe that the network is becoming the platform for all forms of communications and information technology, and that the investments we have made and our architectural approach are creating growth opportunities for us as the role of the network expands. Indicative of the opportunities in our markets, we continue to encounter price-focused competition, including competitors from Asia, and in particular China.

We also have been focusing on expanding our service model. Compared to the corresponding periods in fiscal 2006, our net service revenue increased by approximately 23% and 20% during the second quarter and first six months of fiscal 2007, respectively, with service gross margins of 62.2% and 62.9% during the respective periods. Our service and support strategy seeks to capitalize on increased globalization, and we believe this, along with our architectural approach, has the potential to further differentiate us from competitors.

Critical Accounting Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended July 29, 2006 describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The accounting policies described below are significantly affected by critical accounting estimates. Such accounting policies require significant judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies.

Revenue Recognition

Our products are generally integrated with software that is essential to the functionality of the equipment. Additionally, we provide unspecified software upgrades and enhancements related to the equipment through our maintenance contracts for most of our products. Accordingly, we account for revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. For sales of products where software is incidental to the equipment, we apply the provisions of Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” and Staff Accounting Bulletin No. 104, “Revenue Recognition,” and all related interpretations. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met.

Contracts, Internet commerce agreements, and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history. When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. The amount of product and service revenue recognized is impacted by our judgment as to whether an arrangement includes multiple elements and, if so, whether vendor-specific objective evidence of fair value exists. Changes to the elements in an arrangement and our ability to establish vendor-specific objective evidence for those elements could affect the timing of the revenue recognition. Our total deferred revenue for products was $1.8 billion and $1.6 billion as of January 27, 2007 and July 29, 2006, respectively. Technical support services revenue is deferred and recognized ratably over the

 

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period during which the services are to be performed, which is typically from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our total deferred revenue for services was $4.2 billion and $4.1 billion as of January 27, 2007 and July 29, 2006, respectively.

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

Allowance for Doubtful Accounts and Sales Returns

Our accounts receivable balance, net of allowance for doubtful accounts, was $2.9 billion and $3.3 billion as of January 27, 2007 and July 29, 2006, respectively. The allowance for doubtful accounts was $169 million, or 5.5% of the gross accounts receivable balance, as of January 27, 2007, and $175 million, or 5.0% of the gross accounts receivable balance, as of July 29, 2006. The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customer’s ability to pay.

We had no provision for doubtful accounts for the first six months of fiscal 2007. Our provision for doubtful accounts was $10 million for the first six months of fiscal 2006. 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 27, 2007 and July 29, 2006 was $83 million and $80 million, respectively, and was recorded as a reduction of our accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected.

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

Our inventory balance was $1.6 billion and $1.4 billion as of January 27, 2007 and July 29, 2006, respectively. The valuation of inventory requires us to write down inventory based on excess and obsolete inventories determined primarily by future demand forecasts. Inventory write-downs are measured as the difference between the cost of the inventory and market based upon assumptions about future demand and are charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

Our provision for inventory was $116 million and $70 million for the first six months of fiscal 2007 and 2006, respectively. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory write-downs, and our gross margin could be adversely affected.

In addition, we record a liability for firm, noncancelable, and unconditional purchase commitments with contract manufacturers and suppliers for quantities in excess of our future demand forecasts consistent with the valuation of our inventory. As of January 27, 2007, the liability for these purchase commitments was $140 million, compared to $148 million as of July 29, 2006, and was included in other accrued liabilities. In the third quarter of fiscal 2006, we began the initial implementation of the lean manufacturing model. Lean manufacturing is an industry-standard model that seeks to drive efficiency and flexibility in manufacturing processes and in the broader supply chain. We expect that we will complete our implementation of the lean manufacturing model during fiscal 2008. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times with the risk of inventory obsolescence.

Warranty Costs

The liability for product warranties, included in other accrued liabilities, was $329 million as of January 27, 2007, compared to $309 million as of July 29, 2006. 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

 

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cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities.

The provision for product warranties issued during the first six months of fiscal 2007 and 2006 was $242 million and $190 million, respectively. The increase in the provision for product warranties was due to higher warranty claims related to higher shipment volume of our products. If we 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.

Share-Based Compensation Expense

On July 31, 2005, we adopted SFAS 123(R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors including employee stock options, employee stock purchases, and employee restricted stock and restricted stock units, based on estimated fair values. Share-based compensation expense recognized under SFAS 123(R) was as follows:

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Employee share-based compensation expense

   $ 247    $ 261    $ 472    $ 578

Share-based compensation expense related to acquisitions and investments

     9      24      19      52
                           

Total

   $ 256    $ 285    $ 491    $ 630
                           

See Note 10 to the Consolidated Financial Statements for additional information. Upon adoption of SFAS 123(R), we began estimating the value of employee stock options on the date of grant using a lattice-binomial model. Prior to the adoption of SFAS 123(R), the value of each employee stock option and employee stock purchase was estimated on the date of grant using the Black-Scholes model. The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. The use of a lattice-binomial model requires extensive actual employee exercise behavior data and a number of complex assumptions including expected volatility, risk-free interest rate, expected dividends, kurtosis, and skewness. The weighted-average assumptions, using the lattice-binomial model and the weighted-average estimated value of employee stock options are summarized as follows:

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    January 27,
2007
    January 28,
2006
 

Weighted-average assumptions:

        

Expected volatility

     24.5 %     23.7 %     25.8 %     23.7 %

Risk-free interest rate

     4.6 %     4.5 %     4.6 %     4.2 %

Expected dividend

     0.0 %     0.0 %     0.0 %     0.0 %

Kurtosis

     4.6       4.2       4.5       4.3  

Skewness

     (0.80 )     (0.60 )     (0.80 )     (0.60 )

Weighted-average estimated value

   $ 7.93     $ 5.05     $ 6.94     $ 5.01  

We used the implied volatility for two-year traded options on our stock as the expected volatility assumption required in the lattice-binomial model consistent with SFAS 123(R) and SAB 107. The selection of the implied volatility approach was based upon the availability of actively traded options on our stock and also upon our assessment that implied volatility is more representative of future stock price trends than historical volatility. The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of our employee stock options. The dividend yield assumption is based on the history and expectation of dividend payouts. The estimated kurtosis and skewness are technical measures of the distribution of stock price returns, which affect expected employee exercise behaviors that are based on our stock price return history as well as consideration of various academic analyses. Because share-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated

 

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based on historical experience. If factors change and we employ different assumptions in the application of SFAS 123(R) in future periods, the compensation expense that we record under SFAS 123(R) may differ significantly from what we have recorded in the current period.

Investment Impairments

Our publicly traded equity securities are reflected in the Consolidated Balance Sheets at a fair value of $1.1 billion as of January 27, 2007, compared to $712 million as of July 29, 2006. See Note 6 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, to the extent unhedged, is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Our ongoing consideration of these factors could result in additional impairment charges in the future, which could adversely affect our net income. There were no impairment charges on investments in publicly held companies during the first six months of fiscal 2007 or fiscal 2006.

We also have investments in privately held companies, some of which are in the startup or development stages. As of January 27, 2007, our investments in privately held companies were $636 million, compared to $574 million as of July 29, 2006, and were included in other assets. See Note 4 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 $10 million and $4 million during the second quarter of fiscal 2007 and fiscal 2006, respectively, and were $14 million and $11 million during the first six months of fiscal 2007 and fiscal 2006, respectively.

Goodwill Impairments

Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques. 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 27, 2007 and July 29, 2006 was $9.3 billion and $9.2 billion, respectively. In response to changes in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. There was no impairment of goodwill in the first six months of fiscal 2007 or fiscal 2006.

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 fully 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 or the refinement of an estimate. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.

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

 

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Our effective tax rates differ from the statutory rate primarily due to acquisition-related costs, share-based compensation, R & D tax credits, state taxes, and the tax impact of foreign operations. The effective tax rate was 17.7% in the second quarter of fiscal 2007 and 21.8% for the first six months of fiscal 2007. The effective tax rate was 28.2% in the second quarter of fiscal 2006 and 28.3% for the first six months of fiscal 2006.

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

Loss Contingencies

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

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

Net Sales

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

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
   January 28,
2006
   Variance
in Dollars
   Variance
in Percent
    January 27,
2007
   January 28,
2006
   Variance
in Dollars
   Variance
in Percent
 

Net sales:

                      

Product

   $ 7,099    $ 5,537    $ 1,562    28.2 %   $ 14,039    $ 11,028    $ 3,011    27.3 %

Service

     1,340      1,091      249    22.8 %     2,584      2,150      434    20.2 %
                                              

Total

   $ 8,439    $ 6,628    $ 1,811    27.3 %   $ 16,623    $ 13,178    $ 3,445    26.1 %
                                              

 

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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 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
    January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
 

Net sales:

                  

United States and Canada

   $ 4,556     $ 3,468     $ 1,088    31.4 %   $ 9,283     $ 7,120     $ 2,163    30.4 %

Percentage of net sales

     54.1 %     52.3 %          55.9 %     54.0 %     

European Markets

     1,841       1,533       308    20.1 %     3,444       2,901       543    18.7 %

Percentage of net sales

     21.8 %     23.1 %          20.7 %     22.0 %     

Emerging Markets

     890       620       270    43.5 %     1,642       1,156       486    42.0 %

Percentage of net sales

     10.5 %     9.4 %          9.9 %     8.8 %     

Asia Pacific

     847       720       127    17.6 %     1,602       1,355       247    18.2 %

Percentage of net sales

     10.0 %     10.9 %          9.6 %     10.3 %     

Japan

     305       287       18    6.3 %     652       646       6    0.9 %

Percentage of net sales

     3.6 %     4.3 %          3.9 %     4.9 %     
                                                  

Total

   $ 8,439     $ 6,628     $ 1,811    27.3 %   $ 16,623     $ 13,178     $ 3,445    26.1 %
                                                  

The increase in net product sales primarily occurred across our four largest geographic theaters, as we experienced increased information technology-related capital spending in our service provider, enterprise, commercial, and consumer markets. Our net product sales also benefited from our entry into new markets and development of adjacent product offerings, and the acquisition of Scientific-Atlanta. Scientific-Atlanta’s net product sales for each theater and service revenue are summarized in the following table (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Scientific - Atlanta

           

United States and Canada

   $ 469    $ —      $ 910    $ —  

European Markets

     82      —        146      —  

Emerging Markets

     35      —        66      —  

Asia Pacific

     17      —        34      —  

Japan

     2      —        5      —  
                           

Total product sales

     605      —        1,161      —  

Service

     34      —        62      —  
                           

Total

   $ 639    $ —      $ 1,223    $ —  
                           

 

Net Product Sales by Theater

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

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
    January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
 

Net product sales:

                  

United States and Canada

   $ 3,618     $ 2,707     $ 911    33.7 %   $ 7,469     $ 5,614     $ 1,855    33.0 %

Percentage of net product sales

     51.0 %     48.9 %          53.3 %     50.9 %     

European Markets

     1,645       1,367       278    20.3 %     3,062       2,569       493    19.2 %

Percentage of net product sales

     23.2 %     24.7 %          21.8 %     23.3 %     

Emerging Markets

     818       576       242    42.0 %     1,509       1,073       436    40.6 %

Percentage of net product sales

     11.5 %     10.4 %          10.7 %     9.7 %     

Asia Pacific

     752       641       111    17.3 %     1,423       1,208       215    17.8 %

Percentage of net product sales

     10.6 %     11.6 %          10.1 %     11.0 %     

Japan

     266       246       20    8.1 %     576       564       12    2.1 %

Percentage of net product sales

     3.7 %     4.4 %          4.1 %     5.1 %     
                                                  

Total

   $ 7,099     $ 5,537     $ 1,562    28.2 %   $ 14,039     $ 11,028     $ 3,011    27.3 %
                                                  

 

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United States and Canada

The increase in net product sales in the United States and Canada theater during the second quarter and first six months of fiscal 2007 compared to the corresponding periods in fiscal 2006 was due to an increase in net product sales in the service provider market, including CRS-1 sales, growth in the commercial market and the acquisition of Scientific-Atlanta. However, after experiencing strength in the first quarter of fiscal 2007, the enterprise market in the United States grew at a slower rate in the second quarter of fiscal 2007.

European Markets

The increase in net product sales in the European Markets theater during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was due to balanced improvement in net product sales across all of our customer markets throughout the European Markets theater. During the second quarter and the first six months of fiscal 2007, net product sales in two of the largest countries within the European Markets theater, the United Kingdom and Germany, increased from the corresponding periods in fiscal 2006.

Emerging Markets

Net product sales in the Emerging Markets theater increased during the second quarter and first six months of fiscal 2007 primarily as a result of continued product deployment by service providers and growth in the enterprise and commercial markets as customers continue to adopt our architectural platform, led by strength in the Middle East and Africa, Eastern Europe, and Russia and the Commonwealth of Independent States (CIS).

Asia Pacific

The increase in net product sales in the Asia Pacific theater during the second quarter and first six months of fiscal 2007 was attributable to growth in the commercial, enterprise, and service provider markets. Within the Asia Pacific theater, Australia and India had strong growth during the second quarter and the first six months of fiscal 2007, but China experienced slower growth in the second quarter of fiscal 2007 compared to the second quarter of fiscal 2006, after experiencing solid growth in the first quarter of fiscal 2007.

Japan

Net product sales in the Japan theater improved slightly in the second quarter and first six months of fiscal 2007 compared to the corresponding periods in fiscal 2006.

Net Product Sales by Groups of Similar Products

We classify our net product sales into four primary categories: routers, switches, advanced technologies, and other.

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

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
    January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
 

Net product sales:

                  

Routers

   $ 1,674     $ 1,420     $ 254    17.9 %   $ 3,269     $ 2,837     $ 432    15.2 %

Percentage of net product sales

     23.6 %     25.6 %          23.3 %     25.7 %     

Switches

     3,013       2,665       348    13.1 %     6,043       5,308       735    13.8 %

Percentage of net product sales

     42.4 %     48.1 %          43.0 %     48.1 %     

Advanced technologies

     1,930       1,163       767    66.0 %     3,790       2,296       1,494    65.1 %

Percentage of net product sales

     27.2 %     21.0 %          27.0 %     20.8 %     

Other

     482       289       193    66.8 %     937       587       350    59.6 %

Percentage of net product sales

     6.8 %     5.3 %          6.7 %     5.4 %     
                                                  

Total

   $ 7,099     $ 5,537     $ 1,562    28.2 %   $ 14,039     $ 11,028     $ 3,011    27.3 %
                                                  

 

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Routers

The increase in net product sales related to routers in the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was primarily due to higher sales of our high-end routers, with strength in our CRS-1 products. Our sales of high-end routers, which represent a larger proportion of our total router sales compared to midrange and low-end routers, increased by approximately $215 million and $410 million in the second quarter and first six months of fiscal 2007, respectively, compared to the corresponding periods of fiscal 2006. Our high-end router sales are primarily to service providers, which tend to make large and sporadic purchases. We believe that the increase in high-end router sales is attributable to service providers continuing to scale network capacity to accommodate actual and projected increases in video, voice, and data traffic.

Switches

The increase in net product sales related to switches in the second quarter and first six months of fiscal 2007 was due primarily to higher sales of local-area network (LAN) fixed-configuration switches, which increased during the second quarter and first six months of fiscal 2007 by approximately $270 million and $500 million, respectively, compared to the corresponding periods in fiscal 2006. Sales of LAN modular switches also increased during both periods compared to the corresponding periods in fiscal 2006. The increase in sales of LAN switches was a result of the continued adoption by our customers of new technologies, including Gigabit Ethernet and Power over Ethernet. This has resulted in higher sales of fixed switches, including the Cisco Catalyst 3560 Series and the Cisco Catalyst 3750 Series and our high-end modular switches, the Catalyst 6500 Series, as new technologies are deployed throughout the customers’ networks from the core to the wiring closet. Additionally, growth in advanced technologies such as unified communications and wireless LANs creates demand for LAN fixed and modular switching infrastructure as additional endpoints are added to the network.

Advanced Technologies

The increase in net product sales related to advanced technologies in the second quarter and first six months of fiscal 2007 compared to the corresponding periods in fiscal 2006 was due primarily to:

 

   

Increased sales of video systems, which include solutions and systems designed to enable video-specific systems, including both transmission and subscriber equipment, sold directly to service providers. Net product sales for video systems of approximately $430 million and $820 million during the second quarter and first six months of fiscal 2007, respectively, were related to Scientific-Atlanta.

 

   

Unified communications sales increased by approximately $105 million and $175 million during the second quarter and first six months of fiscal 2007 primarily due to sales of IP phones and associated software as our customers transitioned from an analog-based to an IP-based infrastructure.

 

   

Home networking product sales increased by approximately $80 million and $220 million during the second quarter and first six months of fiscal 2007, respectively, primarily due to the acquisition of Scientific-Atlanta which contributed approximately $75 million and $150 million of home networking product sales during the second quarter and first six months of fiscal 2007, respectively.

 

   

Sales of security products increased by approximately $55 million and $80 million during the second quarter and first six months of fiscal 2007, respectively, primarily due to module and line card sales related to our routers and LAN modular switches as customers continued to emphasize network security.

 

   

Sales of wireless LAN products increased by approximately $50 million and $120 million during the second quarter and first six months of fiscal 2007, respectively, primarily due to new customers and continued deployments with existing customers.

 

   

Sales of storage area networking products increased by approximately $35 million and $50 million during the second quarter and first six months of fiscal 2007, respectively.

 

   

Application networking services and hosted small-business systems, which were identified as advanced technologies in fiscal 2006, did not represent a significant amount of revenue for either the second quarter or first six months of fiscal 2007.

Other Product Revenue

The increase in other product revenue during the second quarter and first six months of fiscal 2007 compared to the respective periods of fiscal 2006 was due primarily to the inclusion of net product sales related to Scientific-Atlanta of approximately $100 million and $190 million during the second quarter and first six months of fiscal 2007, respectively. Optical networking products which increased by approximately $110 million and $190 million during the second quarter and first six months of fiscal 2007,

 

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respectively, compared to the respective periods of fiscal 2006, included approximately $55 million and $105 million of sales during the second quarter and first six months of fiscal 2007, respectively, related to Scientific-Atlanta. Our sales of optical networking products were previously included in our advanced technologies product category and prior period amounts have been reclassified to conform to the current period’s presentation. The increase in other product revenue was also due to the strength in sales of IP-based communications solutions to service providers.

Factors That May Impact Net Product Sales

Net product sales may continue to be affected by changes in the geopolitical environment and global economic conditions; competition, including price-focused competitors from Asia, especially China; new product introductions; sales cycles and product implementation cycles; changes in the mix of our customers between service provider and enterprise markets; changes in the mix of direct sales and indirect sales; variations in sales channels; and final acceptance criteria of the product, system, or solution as specified by the customer. In addition, sales to the service provider market have been characterized by large and often sporadic purchases, especially relating to our router sales and sales of certain advanced technologies. In addition, service provider customers typically have longer implementation cycles, require a broader range of services, including network design services, and often have acceptance provisions that can lead to a delay in revenue recognition. To improve customer satisfaction, we continue to focus on managing our manufacturing lead-time performance, which may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less predictability in our quarter-to-quarter net sales and operating results.

Net product sales may also be adversely affected by fluctuations in demand for our products, especially with respect to Internet businesses and telecommunications service providers, price and product competition in the communications and information technology industry, 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, including those caused by any possible disruption related to lean manufacturing, 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. For additional factors that may impact net product sales, see “Part II, Item 1A. Risk Factors.”

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 for sales 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 during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was primarily due to increased technical support service contract initiations and renewals associated with higher product sales, which have resulted in a larger installed base of equipment being serviced, and revenue from advanced services, which relates to consulting support services for our technologies for specific networking needs.

Gross Margin

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

 

     Three Months Ended     Six Months Ended  
     Amount    Percentage     Amount    Percentage  
     January 27,
2007
  

January 28,

2006

   January 27,
2007
    January 28,
2006
    January 27,
2007
  

January 28,

2006

   January 27,
2007
    January 28,
2006
 

Gross margin:

                    

Product

   $ 4,555    $ 3,763    64.2 %   68.0 %   $ 8,996    $ 7,503    64.1 %   68.0 %

Service

     833      703    62.2 %   64.4 %     1,625      1,373    62.9 %   63.9 %
                                    

Total

   $ 5,388    $ 4,466    63.8 %   67.4 %   $ 10,621    $ 8,876    63.9 %   67.4 %
                                    

 

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

 

     Three Months Ended     Six Months Ended  
     Amount    Percentage     Amount    Percentage  
     January 27,
2007
   January 28,
2006
   January 27,
2007
    January 28,
2006
    January 27,
2007
   January 28,
2006
   January 27,
2007
    January 28,
2006
 

Gross margin:

                    

United States and Canada

   $ 2,857    $ 2,294    62.7 %   66.1 %   $ 5,823    $ 4,719    62.7 %   66.3 %

European Markets

     1,196      1,051    65.0 %   68.6 %     2,261      1,991    65.7 %   68.6 %

Emerging Markets

     582      437    65.4 %   70.5 %     1,080      814    65.8 %   70.4 %

Asia Pacific

     543      482    64.1 %   66.9 %     1,007      895    62.9 %   66.1 %

Japan

     210      202    68.9 %   70.4 %     450      457    69.0 %   70.7 %
                                    

Total

   $ 5,388    $ 4,466    63.8 %   67.4 %   $ 10,621    $ 8,876    63.9 %   67.4 %
                                    

The decrease in gross margin percentage during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was primarily related to the acquisition of Scientific-Atlanta. The gross margin for the second quarter and first six months of fiscal 2006 does not include Scientific-Atlanta. The gross margin for each theater is derived from information from our internal management system. The gross margin percentage for a particular theater may fluctuate and period-to-period changes in such margin percentages may not be indicative of a trend for that theater.

Product Gross Margin

The decrease in product gross margin percentage during the second quarter of fiscal 2007 compared to the second quarter of fiscal 2006 was due to the following factors:

 

   

Changes in the mix of products sold decreased product gross margin percentage by 3.3%, with 2.7% of this decrease related to the inclusion of net product sales from Scientific-Atlanta and the remainder being due to sales of certain routing products.

 

   

Sales discounts, rebates, and product pricing decreased product gross margin percentage by 2.1%.

 

   

Lower overall manufacturing costs related to lower component costs, value engineering and other manufacturing-related costs increased product gross margin percentage by 0.8%. Value engineering is the process by which production costs are reduced through component redesign, board configuration, test processes, and transformation processes.

 

   

Higher shipment volume, net of certain variable costs, also increased product gross margin percentage by 0.8%.

The decrease in product gross margin percentage during the first six months of fiscal 2007 compared to the first six months of fiscal 2006 was due to the following factors:

 

   

Changes in the mix of products sold decreased product gross margin percentage by 3.3%, with 2.6% of this decrease related to the inclusion of net product sales from Scientific-Atlanta and the remainder being due to sales of certain switching and routing products.

 

   

Sales discounts, rebates, and product pricing decreased product gross margin percentage by 2.4%.

 

   

Lower overall manufacturing costs related to lower component costs, value engineering and other manufacturing-related costs increased product gross margin percentage by 0.9%.

 

   

Higher shipment volume, net of certain variable costs, increased product gross margin percentage by 0.9%.

Product gross margin also includes the amortization of purchased intangible assets and share-based compensation expense and recorded as other manufacturing-related costs.

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

 

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Service Gross Margin

Our service gross margin percentage in the second quarter and first six months of fiscal 2007 decreased from the corresponding periods of fiscal 2006, primarily due to strategic investments in headcount as well as advanced services representing a higher proportion of service revenue in the second quarter and first six months of fiscal 2007 compared with the corresponding periods of fiscal 2006. Additionally, we have continued to invest in building out our technical support and advance services capabilities in the Emerging Markets theater.

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 service gross margin from technical support services is higher than the service gross margin from our advanced services and our revenue from advanced services may continue to increase to a higher proportion of total service revenue due to our continued focus on providing comprehensive support to our customers’ networking devices, applications, and infrastructures.

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

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 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
    January 27,
2007
    January 28,
2006
    Variance
in Dollars
   Variance
in Percent
 

Research and development

   $ 1,094     $ 966     $ 128    13.3 %   $ 2,177     $ 1,962     $ 215    11.0 %

Percentage of net sales

     13.0 %     14.6 %          13.1 %     14.9 %     

Sales and marketing

     1,726       1,431       295    20.6 %     3,412       2,884       528    18.3 %

Percentage of net sales

     20.5 %     21.6 %          20.5 %     21.9 %     

General and administrative

     340       282       58    20.6 %     704       560       144    25.7 %

Percentage of net sales

     4.0 %     4.3 %          4.2 %     4.2 %     
                                                  

Total

   $ 3,160     $ 2,679     $ 481    18.0 %   $ 6,293     $ 5,406     $ 887    16.4 %
                                                  

Percentage of net sales

     37.4 %     40.4 %          37.9 %     41.0 %     

R&D Expenses

R&D expenses increased for the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 primarily due to the acquisition of Scientific-Atlanta, which contributed $55 million and $113 million, respectively, of additional R&D expenses. The increase in both periods was also due to higher headcount-related expenses reflecting our continued investment in R&D efforts in routers, switches, advanced technologies and other product technologies. R&D expenses included the effect of employee share-based compensation expense which decreased by $16 million and $45 million compared to the second quarter and first six months of fiscal 2006, respectively. 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.

Sales and Marketing Expenses

Sales and marketing expenses for the second quarter and first six months of fiscal 2007 increased compared to the corresponding periods of fiscal 2006 primarily due to an increase in sales expenses of approximately $230 million and $430 million, respectively. Sales expenses increased primarily due to an increase in headcount-related expenses. The acquisition of Scientific-Atlanta added $21 million of sales expenses and $14 million of marketing expenses during the second quarter of fiscal 2007, and $40 million of sales expenses and $28 million of marketing expenses during the first six months of fiscal 2007. Sales and marketing expenses for the second quarter and first six months of fiscal 2007 included the effect of employee share-based compensation expense which decreased by $7 million and $40 million, respectively, compared to the corresponding periods of fiscal 2006.

G&A Expenses

G&A expenses for the second quarter of fiscal 2007 increased compared to the second quarter of fiscal 2006 primarily due to the acquisition of Scientific-Atlanta, which contributed $25 million of G&A expenses during the period. G&A expenses for the first six months of fiscal 2007 increased compared to the first six months of fiscal 2006 primarily due to approximately $60 million of real-estate related charges and Scientific-Atlanta contributed $48 million of G&A expenses.

 

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Headcount

Our headcount increased by 4,637 employees during the first six months of fiscal 2007, reflecting the investment in sales and R&D described above and also reflecting increases in investments in our service business and our Juarez manufacturing facility. Our headcount is expected to increase, as we continue to focus on the commercial market segment; additional sales coverage; growing and expanding our advanced technologies; our evolving support model; expanding our presence in the Emerging Markets theater; next-generation service provider network build-outs; strengthening our product offerings in the consumer market; and providing more comprehensive solutions to our customers as they employ Internet solutions. As a result, if we do not achieve the benefits anticipated from these investments, our operating results may be adversely affected.

Employee Share-Based Compensation Expense

Employee share-based compensation expense under SFAS 123(R) was as follows (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Cost of sales—product

   $ 12    $ 11    $ 23    $ 30

Cost of sales—service

     30      28      54      62
                           

Employee share-based compensation expense in cost of sales

     42      39      77      92
                           

Research and development

     74      90      148      193

Sales and marketing

     99      106      193      233

General and administrative

     32      26      54      60
                           

Employee share-based compensation expense in operating expenses

     205      222      395      486
                           

Total employee share-based compensation expense

   $ 247    $ 261    $ 472    $ 578
                           

Share-based compensation expense included compensation expense for share-based payment awards granted prior to, but not yet vested, as of July 30, 2005 based on the grant date fair value using the Black-Scholes model, and compensation expense for share-based payment awards granted subsequent to July 30, 2005 based on the grant date fair value using the lattice-binomial model. In conjunction with the adoption of SFAS 123(R), we changed our method of attributing the value of share-based compensation to expense from the accelerated multiple-option approach to the straight-line single-option method. Compensation expense for all share-based payment awards granted on or prior to July 30, 2005 is recognized using the accelerated multiple-option approach while compensation expense for all share-based payment awards granted subsequent to July 30, 2005 is recognized using the straight-line single-option method. The decrease in employee share-based compensation expense during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was consistent with the change in the attribution method upon the adoption of SFAS 123(R).

Amortization of Purchased Intangible Assets and In-Process Research and Development

The following table presents the amortization of purchased intangible assets and in-process research and development (in millions):

 

     Three Months Ended    Six Months Ended
     January 27,
2007
   January 28,
2006
   January 27,
2007
   January 28,
2006

Amortization of purchased intangible assets included in operating expenses

   $ 96    $ 56    $ 201    $ 115

In-process research and development

   $ 2    $ —      $ 6    $ 2

 

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The increase in amortization of purchased intangible assets over the corresponding periods of fiscal 2006 was primarily due to the acquisition of Scientific-Atlanta. For additional information regarding purchased intangibles, see Note 3 to the Consolidated Financial Statements. Our methodology for allocating the purchase price, relating to purchase acquisitions, to in-process R&D is determined through established valuation techniques. See Note 3 to the Consolidated Financial Statements for additional information regarding the acquisitions completed in the first six months of fiscal 2007 and the in-process R&D recorded for these acquisitions. 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 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 technological feasibility, rapidly changing customer markets, uncertain standards for new products, and significant competitive threats. The nature of the efforts to develop these technologies into commercially viable products consists primarily of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets and could have a material adverse impact on our business and operating results.

The following table summarizes the key assumptions underlying the valuation for our purchase acquisitions completed in the first six months of fiscal 2007 for which in-process R&D was recorded (in millions, except percentages):

 

     In-Process
R&D Expense
   Estimated Cost to
Complete Technology
at Time of Acquisition
   Risk-Adjusted
Discount Rate for
In-Process R&D
 

Arroyo Video Solutions, Inc.

   $ 3    $ 5    30.0 %

Other

     3      1    36.0 %
                

Total

   $ 6    $ 6   
                

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

Interest Income, Net

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

 

     Three Months Ended    Six Months Ended
     January 27,
2007
    January 28,
2006
   January 27,
2007
    January 28,
2006

Interest income

   $ 267     $ 168    $ 518     $ 322

Interest expense

     (95 )     —        (189 )     —  
                             

Total

   $ 172     $ 168    $ 329     $ 322
                             

The increase in interest income during the second quarter and first six months of fiscal 2007 compared to the corresponding periods of fiscal 2006 was primarily due to higher average interest rates on our portfolio of cash and cash equivalents and fixed income securities, and higher average balances. The interest expense was attributable to the issuance of $6.5 billion in senior unsecured notes in February 2006, and includes the effect of $6.0 billion of interest rate swaps. The effect of the interest rate swaps is to convert fixed-rate interest expense to floating-rate interest expense based on LIBOR.

 

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Other Income, Net

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

 

     Three Months Ended     Six Months Ended  
     January 27,
2007
    January 28,
2006
    January 27,
2007
    January 28,
2006
 

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

   $ 61     $ (4 )   $ 127     $ (14 )

Net (losses) gains on investments in privately held companies

     —         40       (14 )     46  

Impairment charges on investments in privately held companies

     (10 )     (4 )     (14 )     (11 )
                                

Net gains and impairment charges on investments

     51       32       99       21  

Other

     (18 )     (15 )     (38 )     (21 )
                                

Total

   $ 33     $ 17     $ 61     $ —    
                                

The other expenses consisted primarily of contributions of publicly traded equity securities and products to charitable organizations.

Provision for Income Taxes

The effective tax rate was 17.7% for the second quarter of fiscal 2007, compared to 28.2% for the second quarter of fiscal 2006, and 21.8% for the first six months of fiscal 2007, compared to 28.3% for the first six months of fiscal 2006.

In the second quarter of fiscal 2007, the Tax Relief and Health Care Act of 2006 reinstated the U.S. federal R&D tax credit, retroactive to January 1, 2006. The tax provision rates for the second quarter and the first six months of fiscal 2007 included a $120 million tax benefit relating to the reinstatement of the U.S. federal R&D tax credit, including $60 million related to fiscal 2006 R&D expenses and $30 million related to the first quarter of fiscal 2007 R&D expenses. The decrease in the effective rate also reflects a benefit from an increase in foreign income taxed at other than U.S. rates. The effective tax rate differs from the statutory rate primarily due to acquisition-related costs, share-based compensation, R&D 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 by changes in tax laws, regulations, accounting principles, or interpretations thereof. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes.

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

Recent Accounting Pronouncements

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim-period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for us in the first quarter of fiscal 2008. We are currently evaluating the impact of FIN 48 on our Consolidated Financial Statements.

 

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In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides interpretative guidance on the process of quantifying financial statement misstatements and is effective for fiscal years ending after November 15, 2006. We applied the provisions of SAB 108 beginning in the first quarter of fiscal 2007 and there was no impact to the Consolidated Financial Statements.

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 Investments

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

 

     January 27,
2007
   July 29,
2006
   Increase
(Decrease)
 

Cash and cash equivalents

   $ 2,434    $ 3,297    $ (863 )

Fixed income securities

     17,194      13,805      3,389  

Publicly traded equity securities

     1,053      712      341  
                      

Total

   $     20,681    $     17,814    $     2,867  
                      

The increase in cash and cash equivalents and investments was primarily a result of cash provided by operating activities of $4.9 billion, cash provided by the issuance of common stock of $2.8 billion related to employee stock option exercises and employee stock purchases, and excess tax benefits from share-based compensation of $428 million, partially offset by cash used for the repurchase of common stock of $4.8 billion and capital expenditures of $548 million.

As of January 27, 2007, approximately $5.5 billion of our cash and cash equivalents and investments was held in the United States. The remainder of our cash and cash equivalents and investments was held outside of the United States in various foreign subsidiaries. If these cash and cash equivalents and investments were distributed to the United States in the form of dividends or otherwise, we would be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes.

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, excess tax benefits from share-based compensation, and the timing and amount of tax and other payments. For additional discussion, see “Part II, Item 1A. Risk Factors” below.

Accounts Receivable, Net

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

 

     January 27,
2007
   July 29,
2006
   Increase
(Decrease)
 

Accounts receivable, net

   $     2,908    $     3,303    $ (395 )

DSO

     31      38      (7 )

The decrease in DSO was a result of improved shipment linearity. The rate at which products are shipped during a quarter, which we refer to as shipment linearity, and the rate at which we collect payments, affect our DSO.

 

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Inventories

The following table summarizes our inventories (in millions, except annualized inventory turns):

 

     January 27,
2007
   July 29,
2006
   Increase
(Decrease)
 

Raw materials

   $ 178    $ 131    $ 47  

Work in process

     440      377      63  

Finished goods:

        

Distributor inventory and deferred cost of sales

     456      423      33  

Manufacturing finished goods

     339      236      103  
                      

Total finished goods

     795      659      136  

Service-related spares

     193      170      23  

Demonstration systems

     36      34      2  
                      

Total

   $     1,642    $     1,371    $     271  
                      

Annualized inventory turns

     7.8      8.5      (0.7 )

Inventories increased as a result of increased sales, our expectations of higher shipments at the beginning of the third quarter, and an increase in raw materials related to Scientific-Atlanta. Our finished goods consist of distributor inventory and deferred cost of sales and manufacturing finished goods. Distributor inventory and deferred cost of sales are related to unrecognized revenue on shipments to distributors and retail partners and shipments to enterprise and service provider customers. Manufacturing finished goods consist primarily of build-to-order and build-to-stock products. 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.

In the third quarter of fiscal 2006, we began the initial implementation of the lean manufacturing model. Over time, consistent with what we have experienced thus far, we expect this process will result in incremental increases in purchase commitments with contract manufacturers and suppliers and corresponding increases in inventory turns. We expect that we will complete our implementation of the lean manufacturing model during fiscal 2008. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times with the risk of inventory obsolescence because of rapidly changing technology and customer requirements. We believe the amount of our inventory is appropriate for our revenue levels.

Long-Term Debt

The following table summarizes our long-term debt (in millions):

 

     January 27,
2007
    July 29,
2006
    Increase
(Decrease)

Senior notes:

      

Floating-rate notes, due 2009

   $ 500     $ 500     $ —  

5.25% fixed-rate notes, due 2011

     3,000       3,000       —  

5.50% fixed-rate notes, due 2016

     3,000       3,000       —  
                      

Total senior notes

     6,500       6,500       —  

Other notes

     5       5       —  

Unamortized discount

     (17 )     (18 )     1

Fair value adjustment

     (72 )     (155 )     83
                      

Total

   $     6,416     $     6,332     $ 84
                      

In February 2006, we issued $500 million of senior floating interest rate notes due 2009 (the “2009 Notes”), $3.0 billion of 5.25% senior notes due 2011 (the “2011 Notes”) and $3.0 billion of 5.50% senior notes due 2016 (the “2016 Notes”), for an aggregate principal amount of $6.5 billion. The debt issuance was used to fund the acquisition of Scientific-Atlanta and for general corporate purposes. The 2011 Notes and the 2016 Notes are redeemable by us at any time, subject to a make-whole premium. To achieve our interest rate objectives, we entered into $6.0 billion notional amount of interest rate swaps. In effect, these swaps convert the fixed interest rates of the 2011 Notes and the 2016 Notes to floating interest rates based on LIBOR. Gains and losses in the fair value of the interest rate swaps offset changes in the fair value of the underlying debt. See Note 8 to the Consolidated Financial Statements. We were in compliance with all debt covenants as of January 27, 2007.

 

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Deferred Revenue

The following table presents the breakdown of deferred revenue (in millions):

 

     January 27,
2007
   July 29,
2006
   Increase
(Decrease)

Service

   $     4,229    $     4,088    $     141

Product

     1,832      1,561      271
                    

Total

   $ 6,061    $ 5,649    $ 412
                    

Reported as:

        

Current

   $ 4,718    $ 4,408    $ 310

Noncurrent

     1,343      1,241      102
                    

Total

   $ 6,061    $ 5,649    $ 412
                    

The increase in deferred service revenue reflects a seasonal increase in the volume of technical support contract initiations and renewals partially offset by ongoing amortization of deferred service revenue. The increase in deferred product revenue was related to shipments not having met revenue recognition criteria and the timing of cash receipts related to unrecognized revenue from two-tier distributors.

Contractual Obligations

Operating Leases

We lease office space in several U.S. locations. Outside the United States, larger sites include Australia, Belgium, Canada, China, France, Germany, India, Italy, Japan, and the United Kingdom. The future minimum lease payments under all our noncancelable operating leases with an initial term in excess of one year as of January 27, 2007 were $1.4 billion. For additional information see Note 8 to the Consolidated Financial Statements.

Purchase Commitments with Contract Manufacturers and Suppliers

We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Consequently, only a portion of our reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. The purchase commitments for inventory are expected to be fulfilled within one year. As of January 27, 2007, we had total purchase commitments for inventory of $2.5 billion, compared to $2.0 billion as of July 29, 2006. The increase in purchase commitments is due to increased volume, including the impact of lean manufacturing as well as longer lead times of certain components for targeted high-demand products.

In addition to the above, we record a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of our future demand forecasts consistent with the valuation of our inventory. As of January 27, 2007, the liability for these purchase commitments was $140 million, compared to $148 million as of July 29, 2006 and was included in other accrued liabilities in our Consolidated Balance Sheets.

Nuova Systems, Inc.

In the first quarter of fiscal 2007, we made an investment in Nuova Systems, which conducts research and development on data center-related products. As a result of this investment, we own approximately 80% of Nuova Systems and have consolidated the results of Nuova Systems in our Consolidated Financial Statements beginning in the first quarter of fiscal 2007. This investment includes $50 million of funding and a license to certain of our technology. In addition, upon the occurrence of certain events, we have committed up to $42 million of additional funding to Nuova Systems.

In connection with this investment, Nuova Systems and we have entered into a call option agreement that provides us with the right to purchase the remaining interests of approximately 20% in Nuova Systems. If exercised by us, the call option provides that the minority interest holders would be eligible to receive two milestone payments based on a formula set forth in the call option

 

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agreement. The amounts due under the milestone payments will be recognized by us when it is determined that the exercise of the call option is probable. These amounts will be recorded as compensation expense based on an estimate of the fair value of the amounts earned by the minority interest holders pursuant to a vesting schedule. Subsequent changes to the fair value of the amounts probable of being earned and the continued vesting will result in adjustments to the recorded compensation expense. If we exercise the call option, the potential amount that would be recorded as compensation expense would be up to a maximum of $578 million.

Other Commitments

We have entered into an agreement to invest approximately $800 million in venture funds managed by SOFTBANK that are required to be funded on demand. The total commitment is to be invested in venture funds and as senior debt with entities as directed by SOFTBANK. Our commitment to fund the senior debt is contingent upon the achievement of certain agreed-upon milestones. As of January 27, 2007, we had invested $606 million in the venture funds pursuant to the commitment, compared to $523 million as of July 29, 2006. In addition, as of January 27, 2007 and July 29, 2006, we had invested $49 million in the senior debt pursuant to the commitment, all of which has been repaid.

We also have certain other funding commitments related to our privately held investments that are based on the achievement of certain agreed-upon milestones. The funding commitments were approximately $23 million as of January 27, 2007, compared to approximately $34 million as of July 29, 2006.

Off-Balance Sheet Arrangements

We consider our investments in unconsolidated variable interest entities to be off-balance sheet arrangements. In the ordinary course of business, we have investments in privately held companies and provide financing to certain customers through our wholly owned subsidiaries, which may be considered to be variable interest entities. We have evaluated our investments in these privately held companies and customer financings and have determined that there were no significant unconsolidated variable interest entities as of January 27, 2007.

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

Stock Repurchase Program

In September 2001, our Board of Directors authorized a stock repurchase program. As of January 27, 2007, our Board of Directors had authorized an aggregate repurchase of up to $47 billion of common stock under this program. The stock repurchase activity under the stock repurchase program during the first six months of fiscal 2007 is summarized as follows (in millions, except per-share amounts):

 

     Shares
Repurchased
   Price
per Share
   Remaining
Amount
Authorized
 

Balance at July 29, 2006

   1,931    $ 18.36    $ 4,552  

Additional authorization on November 15, 2006

   —        —        7,000  

Repurchase of common stock

   187      25.55      (4,781 )
                

Balance at January 27, 2007

   2,118    $ 19.00    $ 6,771  
                

The purchase price for the shares of our common stock repurchased was reflected as a reduction to shareholders’ equity. In accordance with Accounting Principles Board Opinion No. 6, “Status of Accounting Research Bulletins,” we are required to allocate the purchase price of the repurchased shares as (i) a reduction to retained earnings until retained earnings are zero and then as an increase to accumulated deficit and (ii) a reduction of common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock incentive plans are recorded as an increase to common stock and additional paid-in capital. As a result of future repurchases, we may continue to report an accumulated deficit included in shareholders’ equity in our Consolidated Balance Sheets. Our accumulated deficit as of January 27, 2007 is a result of the accounting effect of stock repurchases and is not reflective of our financial performance or our liquidity.

 

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Liquidity and Capital Resource Requirements

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Investments

We maintain an investment portfolio of various holdings, types, and maturities. See Note 6 to the Consolidated Financial Statements. As of January 27, 2007, these securities are classified as available-for-sale and consequently are recorded in the Consolidated Balance Sheets at fair value with unrealized gains or losses, to the extent unhedged, reported as a separate component of accumulated other comprehensive income, net of tax.

Fixed Income Securities

At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of our fixed income investment portfolio. Conversely, declines in interest rates could have a material adverse impact on interest income for our investment portfolio. Our fixed income instruments are not leveraged as of January 27, 2007, and are held for purposes other than trading.

Publicly Traded Equity Securities

The values of our equity investments in several publicly traded companies are subject to market price volatility. The following tables present the hypothetical fair values of publicly traded equity securities as a result of selected potential decreases and increases in the price of each equity security in the portfolio, excluding hedged equity securities. Potential fluctuations in the price of each equity security in the portfolio of plus or minus 10%, 20%, and 30% were selected based on potential near-term changes in those security prices. The hypothetical fair values as of January 27, 2007 are as follows (in millions):

 

     Valuation of Securities Given an
X% Decrease in Each Stock’s
Price
   Fair Value
As of
January 27,
2007
  

Valuation of Securities

Given an X% Increase in Each Stock’s
Price

     (30%)    (20%)    (10%)       10%    20%    30%

Publicly traded equity securities

   $     597    $     682    $     768    $     853    $     938    $     1,024    $     1,109

Our equity portfolio consists of securities with characteristics that most closely match the Standard & Poor’s 500 Index or NASDAQ Composite Index. These equity securities are held for purposes other than trading. There were no impairment charges on publicly traded equity securities during the first six months of fiscal 2007 or fiscal 2006.

Investments in Privately Held Companies

We have invested in privately held companies, some of which are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire initial investment in these companies. These investments are primarily carried at cost, which as of January 27, 2007 was $636 million, compared with $574 million at July 29, 2006, and are recorded in other assets in the Consolidated Balance Sheets. Our impairment charges on investments in privately held companies were not material.

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

Long-Term Debt

At any time, a sharp fall in interest rates could have a material adverse impact on the fair value of $6.0 billion of our fixed-rate debt. Conversely, a sharp rise in interest rates could have a material favorable impact. We have entered into $6.0 billion notional amount of interest rate swaps designated as fair value hedges, and gains and losses in the fair value of these swaps offset changes in

 

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the fair value of the fixed-rate debt. In effect, these swaps convert the fixed interest rates to floating interest rates based on LIBOR. A sharp change in rates would not have a material impact on the fair value of our $500 million variable-rate debt.

A sharp rise in short-term interest rates could have a material adverse impact on interest expense, while a sharp fall in short-term rates could have a material favorable impact. To mitigate these impacts, we presently invest a portion of our interest-bearing assets in instruments with similar interest rate characteristics as the swapped debt.

Derivative Instruments

Foreign Currency Derivatives

Our foreign exchange forward and option contracts are summarized as follows (in millions):

 

     January 27, 2007     July 29, 2006  
     Notional
Amount
   Fair
Value
    Notional
Amount
   Fair
Value
 

Forward contracts:

          

Purchased

   $     1,363    $ 1     $     1,376    $ (2 )

Sold

   $ 534    $ (7 )   $ 554    $ (3 )

Option contracts:

          

Purchased

   $ 390    $ 18     $ 591    $     20  

Sold

   $ 362    $ (1 )   $ 573    $ (2 )

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

Approximately 75% of our operating expenses are U.S.-dollar denominated. To reduce variability in operating expenses caused by the remaining non-U.S.-dollar denominated operating expenses, we periodically hedge certain foreign currency forecasted transactions with currency options and forward contracts with maturities up to 18 months. These hedging programs are not designed to provide foreign currency protection over longer time horizons. In designing a specific hedging approach, we consider several factors, including offsetting exposures, significance of exposures, costs associated with entering into a particular hedge instrument, and potential effectiveness of the hedge. The gains and losses on foreign exchange contracts mitigate the variability in operating expenses associated with currency movements. Primarily because of our limited currency exposure to date, the effect of foreign currency fluctuations has not been material to our Consolidated Financial Statements. The effect of foreign currency fluctuations, net of hedging, increased total research and development, sales and marketing, and general and administrative expenses by approximately 1.5% and 1.0% in the second quarter and first six months of fiscal 2007, respectively, compared with the second quarter and first six months of fiscal 2006. The impact of foreign currency fluctuations on sales has not been material because our sales are primarily denominated in U.S. dollars.

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

Interest Rate Derivatives

Our interest rate derivatives are summarized as follows (in millions):

 

     January 27, 2007     July 29, 2006  
     Notional
amount
   Fair
value
    Notional
amount
  

Fair

value

 

Interest rate derivatives:

          

Interest rate swaps—investments

   $     1,000    $     35     $     1,000    $         45  

Interest rate swaps—long-term debt

   $ 6,000    $ (72 )   $ 6,000    $ (155 )

 

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Our primary objective for holding fixed income securities is to achieve an appropriate investment return consistent with preserving principal and managing risk. To realize these objectives, we may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. We have entered into $1.0 billion of interest rate swaps designated as fair value hedges of our investment portfolio. Under these interest rate swap contracts, we make fixed-rate interest payments and receive interest payments based on LIBOR. The effect of these swaps is to convert fixed-rate returns to floating-rate returns based on LIBOR for a portion of our fixed income portfolio. The gains and losses related to changes in the value of the interest rate swaps are included in other income, net, in the Consolidated Statements of Operations and offset the changes in fair value of the underlying hedged investment. The fair values of the interest rate swaps designated as hedges of our investments were reflected in prepaid expenses and other current assets in the Consolidated Balance Sheets.

In conjunction with our issuance of fixed-rate senior notes in February 2006, we entered into $6.0 billion of interest rate swaps designated as fair value hedges of our fixed-rate debt. Under these interest rate swap contracts, we receive fixed-rate interest payments and make interest payments based on LIBOR. The effect of these swaps is to convert fixed-rate interest expense to floating-rate interest expense based on LIBOR. 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 debt. The fair values of the interest rate swaps designated as hedges of our debt were reflected in other long-term liabilities in the Consolidated Balance Sheets.

Equity Derivatives

Our equity derivatives are summarized as follows (in millions):

 

     January 27, 2007    July 29, 2006
     Notional
Amount
   Fair
Value
   Notional
Amount
   Fair
Value

Equity derivatives:

           

Forward sale and option agreements

   $ 244    $ 39    $ 164    $ 93

We maintain a portfolio of publicly traded equity securities which are subject to price risk. We may hold equity securities for strategic purposes or to diversify our overall investment portfolio. To manage our exposure to changes in the fair value of certain equity securities, we may, from time to time, enter into equity derivative contracts. As of January 27, 2007, we have entered into forward sale and option agreements on certain publicly traded equity securities designated as fair value hedges. The gains and losses due to changes in the value of the hedging instruments are included in other income, net, in the Consolidated Statements of Operations and offset the change in the fair value of the underlying hedged investment. The fair values of the equity derivatives were reflected in prepaid expenses and other current assets and other accrued liabilities in the Consolidated Balance Sheets.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in internal control over financial reporting. There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our second quarter of fiscal 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

Item 1. 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 us and certain of our officers and directors. The lawsuits were consolidated, and the consolidated action was purportedly brought on behalf of those who purchased our publicly traded securities during an alleged class period of November 10, 1999 through February 6, 2001. On August 18, 2006, we announced an agreement to resolve the litigation. Pursuant to that agreement, liability insurers paid $91.75 million to the plaintiffs in resolution of all claims against us and our officers and directors. The settlement was approved by the Court on December 5, 2006. Plaintiffs had alleged that defendants made false and misleading statements, purported to assert claims for violations of the federal securities laws, and sought unspecified compensatory damages and other relief. We and the individual defendants continue to deny all allegations in the lawsuit.

On February 16, 2005, a purported shareholder derivative lawsuit was filed in the Superior Court of California, County of Santa Clara, against various of our officers and directors and naming us as a nominal defendant. In July 2006, the Superior Court dismissed all claims and gave plaintiff until October 2006 in which to file an amended complaint, if plaintiff chose to do so. Pursuant to agreement between the parties, plaintiff has elected not to amend its complaint or file an appeal challenging the Superior Court’s order. The lawsuit had included derivative and class claims for breach of fiduciary duty, unjust enrichment, constructive trust and violations of the California Corporations Code, was based upon allegations of wrongdoing in connection with option grants and compensation to officers and directors, the timing of option grants, and our share repurchase plan, and sought unspecified compensation and other damages, rescission of options and other relief.

We and other defendants are subject to patent claims asserted by QPSX Developments 5 Pty Ltd (now known as Ipernica Ltd) against us and such other defendants on June 21, 2005 in the United States District Court for the Eastern District of Texas. QPSX alleges that various Cisco switches and routers infringe United States Patent No. 5,689,499 and seeks damages and injunctive relief. Trial is scheduled to begin in April 2007. We believe that we have strong arguments at trial with respect to both non-infringement and invalidity, and believe that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, we are unable to reasonably estimate the ultimate outcome of this litigation at this time.

We and other defendants are also subject to patent claims asserted by Telcordia Technologies, Inc. against us and such other defendants on July 16, 2004 in the Federal District Court for the District of Delaware. Telcordia alleges that various Cisco routers, switches and optical products infringe United States Patent Nos. 4,893,306, 4,835,763 and Re 36,633, and seeks damages and injunctive relief. Based on the Court’s claim construction order, Telcordia has agreed that we do not infringe Patent No. 4,893,306 but has reserved its right to appeal the Court’s decision. Trial on the remaining claims is scheduled to begin in April 2007. We believe that we have strong arguments at trial with respect to both non-infringement and invalidity, and believe that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, we are unable to reasonably estimate the ultimate outcome of this litigation at this time.

In September 2005, Scientific-Atlanta, Inc. (which subsequently was acquired by us) and another plaintiff filed a declaratory judgment action against Forgent Networks in the United States District Court for the Eastern District of Texas after Forgent sued various Scientific-Atlanta customers. In the action, Scientific-Atlanta asserted that its products did not infringe Forgent’s United States Patent No. 6,285,746 and that the patent was invalid. On October 20, 2005, Forgent responded to the complaint by alleging that various Scientific-Atlanta digital video recorders infringe the patent and by seeking damages and injunctive relief. Subsequent to that, another declaratory judgment plaintiff moved to intervene and the cases have been combined. Trial is scheduled to begin in May 2007. We believe that we have strong arguments at trial with respect to both non-infringement and invalidity, and believe that damages are not likely to be material. However, due to the uncertainty surrounding the litigation process, we are unable to reasonably estimate the ultimate outcome of this litigation at this time.

In addition, we are subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations, or cash flows. For additional information regarding intellectual property litigation, see “Part II, Item 1A. Risk Factors—We may be found to infringe on intellectual property rights of others” herein.

 

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Item 1A. Risk Factors

Set forth below and elsewhere in this report and in other documents we file with the Securities and Exchange Commission (SEC) are descriptions of the risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. The description below includes any material changes to and supersedes the description of the risk factors affecting our business previously disclosed in “Part I, Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended July 29, 2006.

Our operating results may fluctuate in future periods, which may adversely affect our stock price

Our operating results have been in the past, and will continue to be, subject to quarterly and annual fluctuations as a result of numerous factors. These factors include:

 

   

Fluctuations in demand for our products and services, especially with respect to Internet businesses and telecommunications service providers, in part due to changes in the global economic environment

 

   

Changes in sales and implementation cycles for our products and reduced visibility into our customers’ spending plans and associated revenue

 

   

Our ability to maintain appropriate inventory levels and purchase commitments

 

   

Price and product competition in the communications and networking industries, which can change rapidly due to technological innovation and different business models from various geographic regions

 

   

The overall movement toward industry consolidation among both our competitors and our customers

 

   

The introduction and market acceptance of new technologies and products and our success in new markets, including emerging and advanced technologies, as well as the adoption of new networking standards

 

   

Variations in sales channels, product costs, or mix of products sold

 

   

The timing, size, and mix of orders from customers

 

   

Manufacturing and customer lead times

 

   

Fluctuations in our gross margins, and the factors that contribute to this as described below

 

   

Our ability to achieve targeted cost reductions

 

   

The ability of our customers, channel partners, and suppliers to obtain financing or to fund capital expenditures

 

   

The timing and amount of employer payroll tax to be paid on our employees’ gains on stock options exercised

 

   

Actual events, circumstances, outcomes, and amounts differing from judgments, assumptions, and estimates used in determining the values of certain assets (including the amounts of related valuation allowances), liabilities, and other items reflected in our Consolidated Financial Statements

 

   

How well we execute on our strategy and operating plans