Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

(Mark one)

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

For the quarterly period ended April 25, 2009

OR

 

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

For the transition period from                      to                     

Commission file number 0-18225

 

 

CISCO SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

 

California   77-0059951

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

170 West Tasman Drive

San Jose, California 95134

(Address of principal executive office and zip code)

(408) 526-4000

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

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

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

As of May 14, 2009, 5,767,880,540 shares of the registrant’s common stock were outstanding.

 

 

 


Table of Contents

Cisco Systems, Inc.

FORM 10-Q for the Quarter Ended April 25, 2009

INDEX

 

              Page

Part I.

     Financial Information   
 

Item 1.

   Financial Statements (Unaudited)   
     Consolidated Balance Sheets at April 25, 2009 and July 26, 2008    3
     Consolidated Statements of Operations for the three and nine months ended April 25, 2009 and April 26, 2008    4
     Consolidated Statements of Cash Flows for the nine months ended April 25, 2009 and April 26, 2008    5
     Consolidated Statements of Shareholders’ Equity for the nine months ended April 25, 2009 and April 26, 2008    6
     Notes to Consolidated Financial Statements    7
 

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    36
 

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    59
 

Item 4.

   Controls and Procedures    61

Part II.

     Other Information   
 

Item 1.

   Legal Proceedings    61
 

Item 1A.

   Risk Factors    62
 

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    77
 

Item 3.

   Defaults Upon Senior Securities    77
 

Item 4.

   Submission of Matters to a Vote of Security Holders    77
 

Item 5.

   Other Information    77
 

Item 6.

   Exhibits    78
     Signature    79

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

CISCO SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(in millions, except par value)

(Unaudited)

 

     April 25,
2009
    July 26,
2008

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 7,359     $ 5,191

Investments

     26,192       21,044

Accounts receivable, net of allowance for doubtful accounts of $203 at April 25, 2009 and $177 at July 26, 2008

     2,392       3,821

Inventories

     1,023       1,235

Deferred tax assets

     2,050       2,075

Prepaid expenses and other current assets

     2,320       2,333
              

Total current assets

     41,336       35,699

Property and equipment, net

     4,089       4,151

Goodwill

     12,569       12,392

Purchased intangible assets, net

     1,656       2,089

Other assets

     5,016       4,403
              

TOTAL ASSETS

   $ 64,666     $ 58,734
              

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Current portion of long-term debt

   $ —       $ 500

Accounts payable

     653       869

Income taxes payable

     83       107

Accrued compensation

     2,413       2,428

Deferred revenue

     6,110       6,197

Other current liabilities

     3,602       3,757
              

Total current liabilities

     12,861       13,858

Long-term debt

     10,317       6,393

Income taxes payable

     1,038       749

Deferred revenue

     2,663       2,663

Other long-term liabilities

     504       669
              

Total liabilities

     27,383       24,332
              

Minority interest

     27       49

Shareholders’ equity:

    

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

     —         —  

Common stock and additional paid-in capital, $0.001 par value: 20,000 shares authorized; 5,772 and 5,893 shares issued and outstanding at April 25, 2009 and July 26, 2008, respectively

     33,974       33,505

Retained earnings

     3,292       120

Accumulated other comprehensive income (loss)

     (10 )     728
              

Total shareholders’ equity

     37,256       34,353
              

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 64,666     $ 58,734
              

See Notes to Consolidated Financial Statements.

 

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Table of Contents

CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per-share amounts)

(Unaudited)

 

     Three Months Ended     Nine Months Ended
     April 25,
2009
    April 26,
2008
    April 25,
2009
    April 26,
2008

NET SALES:

        

Product

   $ 6,420     $ 8,199     $ 22,402     $ 24,459

Service

     1,742       1,592       5,180       4,717
                              

Total net sales

     8,162       9,791       27,582       29,176
                              

COST OF SALES:

        

Product

     2,327       2,872       8,045       8,592

Service

     606       649       1,904       1,869
                              

Total cost of sales

     2,933       3,521       9,949       10,461
                              

GROSS MARGIN

     5,229       6,270       17,633       18,715

OPERATING EXPENSES:

        

Research and development

     1,243       1,483       3,928       3,975

Sales and marketing

     1,956       2,205       6,394       6,441

General and administrative

     302       324       1,077       1,033

Amortization of purchased intangible assets

     121       117       369       350

In-process research and development

     —         —         3       3
                              

Total operating expenses

     3,622       4,129       11,771       11,802
                              

OPERATING INCOME

     1,607       2,141       5,862       6,913

Interest income, net

     89       201       443       636

Other income (loss), net

     (9 )     (33 )     (145 )     20
                              

Interest and other income (loss), net

     80       168       298       656
                              

INCOME BEFORE PROVISION FOR INCOME TAXES

     1,687       2,309       6,160       7,569

Provision for income taxes

     339       536       1,107       1,531
                              

NET INCOME

   $ 1,348     $ 1,773     $ 5,053     $ 6,038
                              

Net income per share:

        

Basic

   $ 0.23     $ 0.30     $ 0.86     $ 1.00
                              

Diluted

   $ 0.23     $ 0.29     $ 0.86     $ 0.97
                              

Shares used in per-share calculation:

        

Basic

     5,805       5,942       5,844       6,014
                              

Diluted

     5,818       6,069       5,871       6,202
                              

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions)

(Unaudited)

 

     Nine Months Ended  
     April 25,
2009
    April 26,
2008
 

Cash flows from operating activities:

    

Net income

   $ 5,053     $ 6,038  

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

    

Depreciation and amortization

     1,244       1,314  

Employee share-based compensation expense

     835       767  

Share-based compensation expense related to acquisitions and investments

     66       67  

Provision for doubtful accounts

     36       34  

Deferred income taxes

     (166 )     (876 )

Excess tax benefits from share-based compensation

     (25 )     (375 )

In-process research and development

     3       3  

Net losses (gains) on investments

     113       (109 )

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

    

Accounts receivable

     1,337       (219 )

Inventories

     199       54  

Lease receivables, net

     (127 )     (320 )

Accounts payable

     (198 )     12  

Income taxes payable and receivable

     274       405  

Accrued compensation

     120       301  

Deferred revenue

     9       1,553  

Other assets

     (618 )     (357 )

Other liabilities

     (243 )     268  
                

Net cash provided by operating activities

     7,912       8,560  
                

Cash flows from investing activities:

    

Purchases of investments

     (31,865 )     (14,093 )

Proceeds from sales of investments

     17,291       13,043  

Proceeds from maturities of investments

     9,088       1,718  

Acquisition of property and equipment

     (794 )     (908 )

Acquisition of businesses, net of cash and cash equivalents acquired

     (338 )     (385 )

Change in investments in privately-held companies

     (78 )     (63 )

Other

     (54 )     6  
                

Net cash used in investing activities

     (6,750 )     (682 )
                

Cash flows from financing activities:

    

Issuance of common stock

     486       2,501  

Repurchase of common stock

     (2,807 )     (8,982 )

Issuance of long-term debt

     3,991       —    

Repayment of long-term debt

     (500 )     —    

Settlement of interest rate derivatives related to long-term debt

     (42 )     432  

Excess tax benefits from share-based compensation

     25       375  

Other

     (147 )     222  
                

Net cash provided by (used in) financing activities

     1,006       (5,452 )
                

Net increase in cash and cash equivalents

     2,168       2,426  

Cash and cash equivalents, beginning of period

     5,191       3,728  
                

Cash and cash equivalents, end of period

   $ 7,359     $ 6,154  
                

See Notes to Consolidated Financial Statements.

 

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CISCO SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in millions)

(Unaudited)

 

Nine Months Ended April 26, 2008

   Shares
of
Common
Stock
    Common Stock
and Additional

Paid-In
Capital
    Retained
Earnings
(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Shareholders’
Equity
 

BALANCE AT JULY 28, 2007

   6,100     $ 30,687     $ 231     $ 562     $ 31,480  

Cumulative effect of adopting FIN 48

   —         249       202       —         451  
                                      

BALANCE AT JULY 29, 2007

   6,100       30,936       433       562       31,931  

Net income

   —         —         6,038       —         6,038  

Change in unrealized gains and losses on investments

   —         —         —         201       201  

Change in derivative instruments, cumulative translation adjustment and other

   —         —         —         287       287  
                

Comprehensive income

             6,526  
                

Issuance of common stock

   131       2,501       —         —         2,501  

Repurchase of common stock

   (319 )     (1,708 )     (7,314 )     —         (9,022 )

Tax benefits from employee stock incentive plans

   —         359       —         —         359  

Purchase acquisitions

   —         9       —         —         9  

Employee share-based compensation expense

   —         767       —         —         767  

Share-based compensation expense related to acquisitions and investments

   —         67       —         —         67  
                                      

BALANCE AT APRIL 26, 2008

   5,912     $ 32,931     $ (843 )   $ 1,050     $ 33,138  
                                      

Nine Months Ended April 25, 2009

   Shares
of
Common
Stock
    Common Stock
and Additional

Paid-In
Capital
    Retained
Earnings

(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Shareholders’
Equity
 

BALANCE AT JULY 26, 2008

   5,893     $ 33,505     $ 120     $ 728     $ 34,353  

Net income

   —         —         5,053       —         5,053  

Change in unrealized gains and losses on investments

   —         —         —         (173 )     (173 )

Change in derivative instruments, cumulative translation adjustment and other

   —         —         —         (565 )     (565 )
                

Comprehensive income

             4,315  
                

Issuance of common stock

   39       486       —         —         486  

Repurchase of common stock

   (160 )     (936 )     (1,881 )     —         (2,817 )

Tax benefits from employee stock incentive plans

   —         5       —         —         5  

Purchase acquisitions

   —         13       —         —         13  

Employee share-based compensation expense

   —         835       —         —         835  

Share-based compensation expense related to acquisitions and investments

   —         66       —         —         66  
                                      

BALANCE AT APRIL 25, 2009

   5,772     $ 33,974     $ 3,292     $ (10 )   $ 37,256  
                                      

Supplemental Information

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of April 25, 2009, the Company’s Board of Directors had authorized an aggregate repurchase of up to $62 billion of common stock under this program. For additional information regarding stock repurchases, see Note 12 to the Consolidated Financial Statements. The stock repurchases since the inception of this program and the related impact on shareholders’ equity 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 (Loss)
   Total
Shareholders’
Equity

Repurchases of common stock

   2,760    $ 10,494    $ 45,885    $ —      $ 56,379

See Notes to Consolidated Financial Statements.

 

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Table of Contents

CISCO SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Basis of Presentation

The fiscal year for Cisco Systems, Inc. (the “Company” or “Cisco”) is the 52 or 53 weeks ending on the last Saturday in July. Fiscal 2009 and 2008 are 52-week fiscal years. The Consolidated Financial Statements include the accounts of Cisco and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. The Company conducts business globally and is primarily managed on a geographic basis in the 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).

The accompanying financial data as of April 25, 2009 and for the three and nine months ended April 25, 2009 and April 26, 2008 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 26, 2008 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 26, 2008.

In the opinion of management, all adjustments (which include normal recurring adjustments, except as disclosed herein) necessary to present fairly the statement of financial position as of April 25, 2009, results of operations for the three months and nine months ended April 25, 2009 and April 26, 2008, and statements of cash flows and shareholders’ equity for the nine months ended April 25, 2009 and April 26, 2008, as applicable, have been made. The results of operations for the three and nine months ended April 25, 2009 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

During the first quarter of fiscal 2009, the Company began to allocate certain costs, which had previously been recorded in general and administrative expenses (related to information technology, financing business, and human resources), to sales and marketing, research and development, and cost of sales, as applicable. These changes also resulted in reclassifications to prior period gross margin by theater amounts. In addition, the Company has made certain reclassifications to prior period amounts relating to net sales by theater and net sales for similar groups of products due to refinement of the respective categories. The Company has made certain other reclassifications to prior period amounts in order to conform to the current period’s presentation.

 

2. Summary of Significant Accounting Policies

(a) Fair Value Measures

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and enhances fair value measurement disclosure. In October 2008, the FASB issued FASB Staff Position (“FSP”) 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of SFAS No. 157 in a market that is not active, and provides guidance on the key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. Effective July 27, 2008, the Company adopted the measurement and disclosure requirements related to financial assets and financial liabilities pursuant to SFAS 157 and it did not have a material impact on the Company’s results of operations or the fair values of its financial assets and liabilities.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS 159”). Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Effective July 27, 2008, the Company adopted SFAS 159, but the Company has not elected the fair value option for any eligible financial instruments as of April 25, 2009.

 

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(b) Derivative Instruments

In the third quarter of fiscal 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133” (“SFAS 161”), which requires additional disclosures about the objectives of using derivative instruments, the method by which the derivative instruments and related hedged items are accounted for under FASB Statement No. 133 (“SFAS 133”) and its related interpretations, and the effect of derivative instruments and related hedged items on financial position, financial performance, and cash flows. SFAS 161 also requires disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. See Note 10.

(c) Recent Accounting Pronouncements not yet Effective

SFAS 141(R) and SFAS 160

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141(R)”) and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS 160”). In April 2009, the FASB issued FSP FAS 141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies” (“FSP 141(R)-1”).

SFAS 141(R) will significantly change previous practices regarding business combinations. Among the more significant changes, SFAS 141(R) expands the definition of a business and a business combination; requires the acquirer to recognize the assets acquired, liabilities assumed and noncontrolling interests (including goodwill), measured at fair value at the acquisition date; requires acquisition-related expenses and restructuring costs to be recognized separately from the business combination; requires assets acquired and liabilities assumed to be recognized at their acquisition-date fair values with subsequent changes recognized in earnings; and requires in-process research and development to be capitalized at fair value as an indefinite-lived intangible asset. FSP 141(R)-1 amends and clarifies SFAS 141(R) to address application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. SFAS 160 will change the accounting and reporting for minority interests, reporting them as equity separate from the parent entity’s equity, as well as requiring expanded disclosures.

SFAS 141(R), FSP 141(R)-1 and SFAS 160 each are effective for financial statements issued for fiscal years beginning after December 15, 2008 and therefore will be effective for the Company beginning with the first quarter of fiscal 2010. The Company is currently assessing the impact that SFAS 141(R), FSP 141(R)-1 and SFAS 160 will have on its results of operations and financial position.

FSP FAS 157-2

In February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”), which delayed the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of fiscal 2010. The Company is currently assessing the impact that the application of SFAS 157 to nonfinancial assets and liabilities will have on its results of operations and financial position.

FSP FAS 157-4, FSP FAS 115-2, FSP FAS 107-1 and APB 28-1

In April 2009, the FASB released three FSPs intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and impairments of securities. FSP FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP 157-4”), provides additional guidelines for estimating fair value in accordance with SFAS157. FSP FAS 115-2, “Recognition and Presentation of Other-Than-Temporary Impairments”(“FSP 115-2”), provides additional guidance related to the disclosure of impairment losses on securities and the accounting for impairment losses on debt securities. FSP 115-2 does not amend existing guidance related to other-than-temporary impairments of equity securities. FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP 107-1 and APB 28-1”), increases the frequency of fair value disclosures. All of the aforementioned FSPs are effective for interim and annual periods ending after June 15, 2009 and will be effective for the Company beginning with the fourth quarter of fiscal 2009. The Company does not expect the adoption of these FSPs will have a material impact on its results of operations, financial position or its financial statement disclosures as applicable.

 

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3. Business Combinations

(a) Purchase Acquisitions

A summary of the purchase acquisitions for the nine months ended April 25, 2009 is as follows (in millions):

 

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

Pure Networks, Inc.

   $ 105    $ —      $ 30    $ 79

PostPath, Inc.

     197      3      52      152

Other

     54      —        23      33
                           

Total

   $ 356    $ 3    $ 105    $ 264
                           

 

   

The Company acquired Pure Networks, Inc. to provide solutions designed to allow end users to easily set up and manage a home network and connect a range of devices, applications and services.

 

   

The Company acquired PostPath, Inc. to enhance the existing email and calendaring capabilities of Cisco’s WebEx Connect collaboration platform.

Under the terms of the definitive agreements related to the Company’s purchase acquisitions completed during the nine months ended April 25, 2009, the purchase consideration consisted of cash and fully vested share-based awards assumed. The purchase consideration for the Company’s purchase acquisitions is also allocated to tangible assets acquired and liabilities assumed.

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 nine months ended April 25, 2009 have not been presented because the effects of the acquisitions, individually or in the aggregate, were not material to the Company’s financial results.

(b) Compensation Expense Related to Acquisitions and Investments

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Share-based compensation expense

   $ 22    $ 22    $ 66    $ 67

Cash compensation expense

     98      264      257      292
                           

Total

   $ 120    $ 286    $ 323    $ 359
                           

Share-Based Compensation Expense

As of April 25, 2009, the remaining balance of share-based compensation related to acquisitions and investments to be recognized over the vesting periods was approximately $191 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 contingent upon the achievement of certain agreed-upon technology, development, product or other milestones, or the continued employment with the Company of certain employees of the acquired entities. In each case, any additional amounts paid will be recorded as compensation expense. As of April 25, 2009, the Company may be required to recognize future compensation expense pursuant to these agreements of up to $329 million, which includes the remaining potential amount of additional compensation expense related to Nuova Systems, Inc.

 

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Nuova Systems, Inc.

During fiscal 2008, the Company purchased the remaining interests in Nuova Systems, Inc. (“Nuova Systems”) not previously held by the Company, representing approximately 20% of Nuova Systems. Under the terms of the merger agreement, the former minority interest holders of Nuova Systems are eligible to receive up to three milestone payments based on agreed-upon formulas. During the first nine months of fiscal 2009, the Company recorded approximately $120 million of compensation expense, and through April 25, 2009, the Company has recorded aggregate compensation expense of $397 million related to the fair value of amounts that are expected to be earned by the minority interest holders pursuant to a vesting schedule. Actual amounts payable to the former minority interest holders of Nuova Systems will depend upon achievement under the agreed-upon formulas.

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. The potential amount that could be recorded as compensation expense may be up to a maximum of $678 million, including the $397 million that has been expensed through April 25, 2009. The compensation is expected to be paid during fiscal 2010 through fiscal 2012.

 

4. Goodwill and Purchased Intangible Assets

(a) Goodwill

The following table presents the changes in goodwill allocated to the Company’s reportable segments during the nine months ended April 25, 2009 (in millions):

 

     Balance at
July 26,
2008
   Acquisitions    Other     Balance at
April 25,
2009

United States and Canada

   $ 9,059    $ 207    $ (2 )   $ 9,264

European Markets

     1,650      31      (80 )     1,601

Emerging Markets

     405      11      (5 )     411

Asia Pacific

     479      13      —         492

Japan

     799      2      —         801
                            

Total

   $ 12,392    $ 264    $ (87 )   $ 12,569
                            

In the table above, “Other” primarily includes foreign currency translation and purchase accounting adjustments.

(b) Purchased Intangible Assets

The following table presents details of the purchased intangible assets acquired through business combinations during the nine months ended April 25, 2009 (in millions, except years):

 

     TECHNOLOGY    CUSTOMER
RELATIONSHIPS
   TOTAL
     Weighted-
Average

Useful Life
(in Years)
   Amount    Weighted-
Average

Useful Life
(in Years)
   Amount    Amount

Pure Networks, Inc.

   4.0    $ 27    3.0    $ 3    $ 30

PostPath, Inc.

   6.0      52    —        —        52

Other

   6.0      18    3.7      5      23
                          

Total

      $ 97       $ 8    $ 105
                          

 

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

 

April 25, 2009

   Gross    Accumulated
Amortization
    Net

Technology(1)

   $ 1,426    $ (742 )   $ 684

Customer relationships

     1,656      (716 )     940

Other

     165      (133 )     32
                     

Total

   $ 3,247    $ (1,591 )   $ 1,656
                     

July 26, 2008

   Gross    Accumulated
Amortization
    Net

Technology(1)

   $ 1,785    $ (905 )   $ 880

Customer relationships

     1,821      (674 )     1,147

Other

     247      (185 )     62
                     

Total

   $ 3,853    $ (1,764 )   $ 2,089
                     

 

(1)

The technology category includes technology intangible assets acquired through business combinations as well as through technology licenses.

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Amortization of purchased intangible assets

           

Cost of sales

   $ 48    $ 57    $ 166    $ 179

Operating expenses

     121      117      369      350
                           

Total

   $ 169    $ 174    $ 535    $ 529
                           

During the three and nine months ended April 25, 2009, the Company recorded impairment charges of $11 million and $34 million, respectively, from write-downs of purchased intangible assets related to certain technologies and customer relationships due to reductions in expected future cash flows, and the amounts were recorded as amortization of purchased intangible assets.

The estimated future amortization expense of purchased intangible assets as of April 25, 2009 is as follows (in millions):

 

Fiscal Year

   Amount

2009 (remaining three months)

   $ 129

2010

     526

2011

     439

2012

     328

2013

     219

Thereafter

     15
      

Total

   $ 1,656
      

 

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5. Balance Sheet Details

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

 

     April 25,
2009
    July 26,
2008
 

Inventories:

    

Raw materials

   $ 159     $ 111  

Work in process

     39       53  

Finished goods:

    

Distributor inventory and deferred cost of sales

     361       452  

Manufactured finished goods

     273       381  
                

Total finished goods

     634       833  
                

Service-related spares

     156       191  

Demonstration systems

     35       47  
                

Total

   $ 1,023     $ 1,235  
                

Property and equipment, net:

    

Land, buildings, and leasehold improvements

   $ 4,534     $ 4,445  

Computer equipment and related software

     1,822       1,770  

Production, engineering, and other equipment

     5,087       4,839  

Operating lease assets

     224       209  

Furniture and fixtures

     458       439  
                
     12,125       11,702  

Less accumulated depreciation and amortization

     (8,036 )     (7,551 )
                

Total

   $ 4,089     $ 4,151  
                

Other assets:

    

Deferred tax assets

   $ 2,091     $ 1,770  

Investments in privately-held companies

     725       706  

Lease receivables, net

     882       862  

Financed service contracts

     695       588  

Other

     623       477  
                

Total

   $ 5,016     $ 4,403  
                

Deferred revenue:

    

Service

   $ 6,068     $ 6,133  

Product:

    

Unrecognized revenue on product shipments and other deferred revenue

     2,233       2,152  

Cash receipts related to unrecognized revenue from two-tier distributors

     472       575  
                

Total product deferred revenue

     2,705       2,727  
                

Total

   $ 8,773     $ 8,860  
                

Reported as:

    

Current

   $ 6,110     $ 6,197  

Noncurrent

     2,663       2,663  
                

Total

   $ 8,773     $ 8,860  
                

 

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6. Financing Arrangements

(a) Lease Receivables

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

 

     April 25,
2009
    July 26,
2008
 

Gross lease receivables

   $ 1,832     $ 1,730  

Unearned income

     (180 )     (178 )

Allowances

     (204 )     (136 )
                

Lease receivables, net

   $ 1,448     $ 1,416  
                

Reported as:

    

Current

   $ 566     $ 554  

Noncurrent

     882       862  
                

Lease receivables, net

   $ 1,448     $ 1,416  
                

Contractual maturities of the gross lease receivables at April 25, 2009 were $233 million in the remaining three months of fiscal 2009, $634 million in fiscal 2010, $487 million in fiscal 2011, $300 million in fiscal 2012, and $178 million in fiscal 2013 and thereafter. Actual cash collections may differ from the contractual maturities due to early customer buyouts, refinancings, or defaults.

(b) Financed Service Contracts

Financed service contracts are summarized as follows (in millions):

 

     April 25,
2009
    July 26,
2008
 

Gross financed service contracts

   $ 1,589     $ 1,328  

Allowances

     (26 )     (10 )
                

Financed service contracts, net

   $ 1,563     $ 1,318  
                

Reported as:

    

Current

   $ 868     $ 730  

Noncurrent

     695       588  
                

Financed service contracts, net

   $ 1,563     $ 1,318  
                

The revenue related to financed service contracts, which primarily relates to technical support services, is deferred and included in deferred service revenue. The revenue is recognized ratably over the period during which the related services are to be performed, which is typically from one to three years.

 

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Table of Contents

(c) Loan Receivables

Loan receivables are summarized as follows (in millions):

 

     April 25,
2009
    July 26,
2008
 

Gross loan receivables

   $ 663     $ 607  

Allowances

     (83 )     (128 )
                

Loan receivables, net

   $ 580     $ 479  
                

Reported as:

    

Current

   $ 224     $ 263  

Noncurrent

     356       216  
                

Loan receivables, net

   $ 580     $ 479  
                

A portion of the revenue related to loan receivables is deferred and included in deferred product revenue based on revenue recognition criteria.

(d) Financing Guarantees

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

Channel Partner Financing Guarantees

The Company facilitates arrangements for third-party financing extended to channel partners, consisting of revolving short-term financing, generally with payment terms ranging from 60 to 90 days. The Company receives a payment from the third-party financing organizations based on the Company’s standard payment terms. These financing arrangements facilitate the working capital requirements of the channel partners and, in some cases, the Company guarantees a portion of these arrangements. During the three and nine months ended April 25, 2009, the volume of channel partner financing was $3.0 billion and $10.7 billion, respectively, compared with $3.6 billion and $10.5 billion for the three and nine months ended April 26, 2008, respectively. As of April 25, 2009 and July 26, 2008, the balance of the channel partner financing subject to guarantees was $1.0 billion and $1.7 billion, respectively.

Customer Financing Guarantees

The Company also provides financing guarantees for third-party financing arrangements extended to customers related to leases and loans, which typically have terms of three years. During the three and nine months ended April 25, 2009, the volume of financing provided by third parties for leases and loans on which the Company has provided guarantees was $316 million and $960 million, respectively, compared with $313 million and $885 million for the three and nine months ended April 26, 2008, respectively.

 

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Table of Contents

Financing Guarantee Summary

The aggregate amount of financing guarantees outstanding at April 25, 2009 and July 26, 2008, representing the total maximum potential future payments under financing arrangements with third parties, and the related revenue deferred in accordance with revenue recognition policies and FIN 45 are summarized below (in millions):

 

     April 25,
2009
   July 26,
2008

Maximum potential future payments relating to guarantees:

     

Channel partner financing

   $ 348    $ 450

Customer financing

     398      380
             

Total

   $ 746    $ 830
             

Deferred revenue associated with guarantees:

     

Channel partner financing

   $ 199    $ 263

Customer financing

     368      347
             

Total

   $ 567    $ 610
             

 

7. Investments

(a) Summary of Investments

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

 

April 25, 2009

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value

Fixed income securities:

          

Government securities

   $ 9,017    $ 41    $ (2 )   $ 9,056

Government agency securities(1)

     14,259      120      (1 )     14,378

Corporate debt securities

     1,823      35      (138 )     1,720

Asset-backed securities

     272      1      (35 )     238
                            

Total fixed income securities

     25,371      197      (176 )     25,392

Publicly traded equity securities

     800      136      (136 )     800
                            

Total

   $ 26,171    $ 333    $ (312 )   $ 26,192
                            

July 26, 2008

   Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
Value

Fixed income securities:

          

Government securities

   $ 7,249    $ 50    $ (33 )   $ 7,266

Government agency securities

     5,815      34      (10 )     5,839

Corporate debt securities

     5,814      24      (96 )     5,742

Asset-backed securities

     1,035      5      (18 )     1,022
                            

Total fixed income securities

     19,913      113      (157 )     19,869

Publicly traded equity securities

     860      391      (76 )     1,175
                            

Total

   $ 20,773    $ 504    $ (233 )   $ 21,044
                            

 

(1)

Government agency securities as of April 25, 2009 include bank-issued securities that are guaranteed by the Federal Deposit Insurance Corporation (FDIC).

 

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The Company’s management has determined that the unrealized losses on its investment securities at April 25, 2009 are temporary in nature. The Company reviews its investments to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

(b) Gains and Losses on Investments

The following table summarizes the realized net gains (losses) associated with the Company’s investments (in millions):

 

     Three Months Ended     Nine Months Ended
     April 25,
2009
    April 26,
2008
    April 25,
2009
    April 26,
2008

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

   $ (10 )   $ (2 )   $ 58     $ 82

Net (losses) gains on investments in fixed income securities

     36       (10 )     (123 )     25
                              

Net (losses) gains on investments

   $ 26     $ (12 )   $ (65 )   $ 107
                              

For the third quarter and first nine months of fiscal 2009, net gains and losses on fixed income securities included impairment charges of $17 million and $219 million, respectively, and net gains and losses on publicly traded equity securities included impairment charges of $4 million and $39 million, respectively. The impairment charges in both periods were due to a decline in the fair value of the investments below their cost basis that were judged to be other-than-temporary and were recorded as a reduction to the amortized cost of the respective investments. There were no impairments of fixed income securities or publicly traded equity securities during the first nine months of fiscal 2008.

(c) Maturities of Fixed Income Securities

The following table summarizes the maturities of the Company’s fixed income securities at April 25, 2009 (in millions):

 

     Amortized
Cost
   Fair
Value

Less than 1 year

   $ 16,040    $ 16,093

Due in 1 to 2 years

     5,852      5,894

Due in 2 to 5 years

     2,935      2,942

Due after 5 years

     544      463
             

Total

   $ 25,371    $ 25,392
             

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

 

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Table of Contents
8. Fair Value Measures

SFAS 157 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

(a) Fair Value Hierarchy

SFAS 157 requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. SFAS 157 establishes a fair value hierarchy based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. SFAS 157 prioritizes the inputs into three levels that may be used to measure fair value:

Level 1

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

Level 2

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

Level 3

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

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

Assets and liabilities measured at fair value on a recurring basis as of April 25, 2009 were as follows (in millions):

 

     Fair Value Measurements Using

April 25, 2009

   Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1)
   Significant Other
Observable Inputs

(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Total Balance

Assets:

           

Money market funds

   $ 5,968    $ —      $ —      $ 5,968

Government securities

     —        9,195      —        9,195

Government agency securities

     —        14,666      —        14,666

Corporate debt securities

     —        1,727      —        1,727

Asset-backed securities

     —        —        238      238

Publicly traded equity securities

     800      —        —        800

Derivative assets

     —        58      6      64
                           

Total assets measured at fair value

   $ 6,768    $ 25,646    $ 244    $ 32,658
                           

Liabilities:

           

Derivative liabilities

   $ —      $ 60    $ —      $ 60
                           

Total liabilities measured at fair value

   $ —      $ 60    $ —      $ 60
                           

 

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Table of Contents

Level 2 fixed income securities are priced using quoted market prices for similar instruments, nonbinding market prices that are corroborated by observable market data, or discounted cash flow techniques. The Company’s derivative instruments are primarily classified as Level 2 as they are not actively traded and are valued using pricing models that use observable market inputs. Level 3 assets include asset-backed securities and certain derivative assets, whose values are determined based on discounted cash flow models using inputs that the Company could not corroborate with market data.

Assets and liabilities measured at fair value on a recurring basis were presented on the Company’s Consolidated Balance Sheet as of April 25, 2009 as follows (in millions):

 

     FAIR VALUE MEASUREMENTS USING

April 25, 2009

   Quoted Prices in
Active Markets
for Identical
Instruments
(Level 1)
   Significant Other
Observable Inputs

(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Total Balance

Cash equivalents

   $ 5,968    $ 434    $ —      $ 6,402

Investments

     800      25,154      238      26,192

Prepaid expenses and other current assets

     —        58      4      62

Other assets

     —        —        2      2
                           

Total assets measured at fair value

   $ 6,768    $ 25,646    $ 244    $ 32,658
                           

Other current liabilities

   $ —      $ 60    $ —      $ 60
                           

Total liabilities measured at fair value

   $ —      $ 60    $ —      $ 60
                           

The following table presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended April 25, 2009 (in millions):

 

     Three Months Ended
April 25, 2009
    Nine Months Ended
April 25, 2009
 
     Asset-Backed
Securities
    Derivative
Instruments
   Total     Asset-Backed
Securities
    Derivative
Instruments
   Total  

Beginning balance

   $ 284     $ —      $ 284     $ —       $ —      $ —    

Transfers in to Level 3

     —         6      6       618       6      624  

Total gains and losses (realized and unrealized):

              

Included in other income (loss), net

     (8 )     —        (8 )     (28 )     —        (28 )

Included in other comprehensive income

     3       —        3       (12 )     —        (12 )

Purchases, sales, and maturities

     (41 )     —        (41 )     (340 )     —        (340 )
                                              

Ending balance

   $ 238     $ 6    $ 244     $ 238     $ 6    $ 244  
                                              

Impairment charges in other income (loss), net attributable to assets still held as of April 25, 2009

   $ (7 )   $ —      $ (7 )   $ (14 )   $ —      $ (14 )

 

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Table of Contents

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

The following table presents the Company’s financial assets that were measured at fair value on a nonrecurring basis and the impairment charges recorded to other income (loss), net on those assets (in millions):

 

        FAIR VALUE MEASUREMENTS USING            
    Net Carrying
Value as of

April 25, 2009
  Quoted Prices
In Active
Markets for
Identical
Instruments

(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs

(Level 3)
  Impairment
Charges for the
Three Months
Ended

April 25, 2009
    Impairment
Charges for the
Nine Months
Ended

April 25, 2009
 

Investments in Privately-Held Companies

  $ 37   $ —     $ —     $ 37   $ (15 )   $ (66 )

Impairment charges on assets no longer held

            —         (2 )
                       

Total losses for nonrecurring measurements

          $ (15 )   $ (68 )
                       

The above assets were measured at fair value during the first nine months of fiscal 2009 due to events or circumstances the Company identified that significantly impacted the fair value of these investments. The Company measured fair value using financial metrics, comparison to other private and public companies, analysis of the financial condition and near-term prospects of the investees, including recent financing activities and their capital structure as well as other economic variables. These investments were classified as Level 3 assets because the Company used unobservable inputs to value them, reflecting the Company’s assessment of the assumptions market participants would use in pricing these investments due to the absence of quoted market prices and inherent lack of liquidity.

 

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Table of Contents
9. Borrowings

(a) Long-Term Debt

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

 

     April 25, 2009     July 26, 2008  
     Amount     Effective
Rate
    Amount     Effective
Rate
 

Senior notes:

        

Floating-rate notes, due 2009

   $ —         $ 500     2.74 %

5.25% fixed-rate notes, due 2011

     3,000     3.12 %     3,000     3.12 %

5.50% fixed-rate notes, due 2016

     3,000     4.34 %     3,000     4.34 %

4.95% fixed-rate notes, due 2019

     2,000     5.08 %     —      

5.90% fixed-rate notes, due 2039

     2,000     6.11 %     —      
                    

Total senior notes

     10,000         6,500    

Other notes

     2         4    

Unaccreted discount

     (21 )       (15 )  

Hedge accounting adjustment of the carrying amount of the 2011 and 2016 Notes

     336         404    
                    

Total

   $ 10,317       $ 6,893    
                    

Reported as:

        

Current portion of long-term debt

   $ —         $ 500    

Long-term debt

     10,317         6,393    
                    

Total

   $ 10,317       $ 6,893    
                    

In February 2006, the Company issued $500 million of senior floating interest rate notes based on the London Interbank Offered Rate (“LIBOR”) 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. In February 2009, the Company issued $2.0 billion of 4.95% senior notes due 2019 (the “2019 Notes”), and $2.0 billion of 5.90% senior notes due 2039 (the “2039 Notes”), for an aggregate principal amount of $4.0 billion. The Company repaid in full the 2009 Notes when they were due in February 2009.

The effective rates for the fixed-rate debt include the interest on the notes, the accretion of the discount, and adjustments related to hedging. The Company was in compliance with all debt covenants as of April 25, 2009. Each class of the senior fixed-rate notes (due 2011, 2016, 2019 and 2039) is redeemable by the Company at any time, subject to a make-whole premium.

Interest is payable semi-annually on the 2011, 2016, 2019 and 2039 Notes. Interest expense and cash paid for interest are summarized as follows (in millions):

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Interest expense

   $ 105    $ 68    $ 232    $ 255

Cash paid for interest

   $ 164    $ 177    $ 333    $ 362

 

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(b) Credit Facility

In August 2007, the Company entered into a credit agreement with certain institutional lenders that provides for a $3.0 billion unsecured revolving credit facility that is scheduled to expire on August 17, 2012. Due to the bankruptcy of one of the lenders during the first quarter of fiscal 2009, the credit facility has been reduced to $2.9 billion.

Any advances under the credit agreement will accrue interest at rates that are equal to, based on certain conditions, either (i) the higher of the Federal Funds rate plus 0.50% or Bank of America’s “prime rate” as announced from time to time, or (ii) LIBOR plus a margin that is based on the Company’s senior debt credit ratings as published by Standard & Poor’s Ratings Services and Moody’s Investors Service, Inc. The credit agreement requires that the Company maintain an interest coverage ratio as defined in the agreement.

As of April 25, 2009, the Company was in compliance with the required interest coverage ratio, and the Company had not borrowed any funds under the credit facility. The Company may also, upon the agreement of either the then existing lenders or of additional lenders not currently parties to the agreement, increase the commitments under the credit facility up to a total of $5.0 billion and/or extend the expiration date of the credit facility up to August 15, 2014.

 

10. Derivative Instruments

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

The fair values of the Company’s derivative instruments and the line items on the Consolidated Balance Sheet to which they were recorded as of April 25, 2009 are summarized as follows (in millions):

 

   

DERIVATIVE ASSETS

 

DERIVATIVE LIABILITIES

   

Balance Sheet Line Item

  Fair Value  

Balance Sheet Line Item

  Fair Value

Derivatives designated as hedging instruments under SFAS 133:

       

Foreign currency derivatives

 

Prepaid expenses and other current assets

  $ 15  

Other current liabilities

  $ 45

Other derivatives

 

Prepaid expenses and other current assets

    —    

Other current liabilities

    2
               

Total

      15       47

Derivatives not designated as hedging instruments under SFAS 133:

       

Foreign currency derivatives

 

Prepaid expenses and other current assets

    43  

Other current liabilities

    13

Equity derivatives

 

Prepaid expenses and other current assets

    4  

Other current liabilities

    —  

Equity derivatives

 

Other assets

    2  

Other long-term liabilities

    —  
               

Total

      49       13
               

Total

    $ 64     $ 60
               

 

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The effects of the Company’s derivative instruments on other comprehensive income (OCI) and the Consolidated Statement of Operations for the three months ended April 25, 2009 are summarized as follows (in millions):

 

          

GAINS (LOSSES) RECLASSIFIED FROM
ACCUMULATED OCI INTO INCOME

(EFFECTIVE PORTION)

  

GAINS (LOSSES) RECOGNIZED

IN INCOME ON DERIVATIVES (INEFFECTIVE
PORTION) (1)

Derivatives Designated as

Cash Flow Hedging

Instruments under SFAS 133

   Gains (Losses)
Recognized in OCI
on Derivatives
(Effective Portion)
   

Line Item in Statements

of Operations

  

Amount

  

Line Item in Statements

of Operations

  

Amount

Foreign currency derivatives

   $ 16    

Operating expenses

   $      (38)   

Other income (loss), net

   $      —  
    

Cost of sales-service

   (5)   

Other income (loss), net

   —  

Interest rate derivatives

     (42 )  

Interest income, net

   —      Interest income, net    (4)

Other derivatives

     (2 )  

Operating expenses

   (1)   

Other income (loss), net

   —  
                       

Total

   $ (28 )      $      (44)       $      (4)
                       

 

(1)

The Company did not exclude any component of the changes in fair value of the derivative instruments from the assessment of hedge effectiveness.

 

Derivatives not Designated

as Hedging Instruments

under SFAS 133

  

Line Item in Statements

of Operations

   Amount  

Foreign currency derivatives

  

Other income (loss), net

   $ (20 )

Equity derivatives

  

Other income (loss), net

     2  
           

Total

      $ (18 )
           

As of April 25, 2009, the Company estimates that approximately $80 million of net derivative losses related to its cash flow hedges included in accumulated other comprehensive income will be reclassified into earnings within the next twelve months.

(a) Foreign Currency Risk

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 such contracts for trading purposes.

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

 

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The Company enters into foreign exchange forward contracts to reduce the short-term effects of foreign currency fluctuations on assets and liabilities such as foreign currency receivables including long-term customer financings, investments, and payables and these derivatives are not designated as hedging instruments under SFAS 133. Gains and losses on the contracts are included in other income (loss), net, 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 hedges certain net investments in its foreign subsidiaries with forward contracts which generally have maturities of up to six months. The Company recognized a gain of $6 million in OCI for the effective portion of its net investment hedges during the three months ended April 25, 2009. The Company’s net investment hedges are not included in the above tables.

The notional amounts of the Company’s foreign currency derivatives as of April 25, 2009 were as follows (in millions):

 

     Notional
Amounts

Derivatives designated as cash flow hedging instruments under SFAS 133

   $ 1,793

Derivatives designated as net investment hedging instruments under SFAS 133

     77

Derivatives not designated as hedging instruments under SFAS 133

     3,220
      

Total

   $ 5,090
      

(b) Interest Rate Risk

Interest Rate Derivatives, Investments

The Company’s primary objective for holding fixed income securities is to achieve an appropriate investment return consistent with preserving principal and managing risk. To realize these objectives, the Company may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. As of April 25, 2009, the Company did not have any outstanding interest rate derivatives related to its fixed income securities.

Interest Rate Derivatives, Long-Term Debt

During the third quarter of fiscal 2009, in connection with the issuance of the 2019 and 2039 Notes, the Company entered into interest rate derivatives to hedge against interest rate movements prior to the pricing of the notes. The effective portion of the hedge was recorded to accumulated other comprehensive income and will be amortized to interest expense over the respective lives of the 2019 and 2039 Notes. See Note 9.

(c) Equity Risk

The Company maintains a portfolio of publicly traded equity securities that are subject to price risk. The Company may hold equity securities for strategic purposes or diversify its overall investment portfolio. To manage its exposure to changes in the fair value of certain equity securities, the Company may enter into equity derivatives that are designated as accounting hedges. The changes in the value of the hedging instruments are included in other income (loss), net, and offset the change in the fair value of the underlying hedged investment. In addition, the Company periodically manages the risk of its investment portfolio by entering into equity derivatives that are not designated as accounting hedges. The changes in the fair value of these derivatives were also included in other income (loss), net. As of April 25, 2009, there were no equity derivatives outstanding related to the Company’s investment portfolio.

The Company is exposed to variability in compensation charges related to certain deferred compensation obligations to employees. Although not designated as accounting hedges, the Company utilizes equity derivatives to economically hedge this exposure. As of April 25, 2009, the notional amount of the derivative instruments used to hedge such liabilities was $73 million.

(d) Credit-Risk-Related Contingent Features

Certain of the Company’s derivative instruments contain credit-risk-related contingent features, such as provisions that allow a counterparty to terminate a transaction if the Company’s debt rating falls below investment grade. These provisions did not affect the Company’s financial position as of April 25, 2009.

 

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11. Commitments and Contingencies

(a) Operating Leases

The Company leases office space in several U.S. locations. Outside the United States, larger leased sites include sites in Australia, Belgium, China, France, Germany, India, Israel, 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 April 25, 2009 are as follows (in millions):

 

Fiscal Year

   Amount

2009 (remaining three months)

   $ 70

2010

     244

2011

     189

2012

     142

2013

     121

Thereafter

     482
      

Total

   $ 1,248
      

(b) Purchase Commitments with Contract Manufacturers and Suppliers

The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the Company’s requirements. A significant portion of the Company’s reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Company’s requirements based on its business needs prior to firm orders being placed. As of April 25, 2009 and July 26, 2008, the Company had total purchase commitments for inventory of $2.2 billion and $2.7 billion, respectively.

In addition, the Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the valuation of the Company’s excess and obsolete inventory. As of April 25, 2009 and July 26, 2008, the liability for these purchase commitments was $186 million and $184 million, respectively, and was included in other current liabilities.

(c) Compensation Expense Related to Acquisitions and Investments

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 contingent upon the achievement of certain agreed-upon technology, development, product or other milestones, or the continued employment with the Company of certain employees of acquired entities. See Note 3.

(d) Other Commitments

The Company also has certain funding commitments primarily related to its investments in privately-held companies and venture funds, some of which are based on the achievement of certain agreed-upon milestones, and some of which are required to be funded on demand. The funding commitments were approximately $311 million and $359 million as of April 25, 2009 and July 26, 2008, respectively.

(e) Variable Interest Entities

In the ordinary course of business, the Company has investments in privately-held companies and provides financing to certain customers. These privately-held companies and customers may be considered to be variable interest entities. The Company has evaluated its investments in these privately-held companies and its customer financings and has determined that there were no significant unconsolidated variable interest entities as of April 25, 2009.

 

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(f) Product Warranties and Guarantees

The following table summarizes the activity related to the product warranty liability during the nine months ended April 25, 2009 and April 26, 2008 (in millions):

 

     Nine Months Ended  
     April 25,
2009
    April 26,
2008
 

Balance at beginning of period

   $ 399     $ 340  

Provision for warranties issued

     282       376  

Payments

     (343 )     (340 )

Fair value of warranty liability acquired

     —         3  
                

Balance at end of period

   $ 338     $ 379  
                

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. In addition, the Company has entered into indemnification agreements with its officers and directors, and the Company’s bylaws contain similar indemnification obligations to the Company’s agents. It is not possible to determine the maximum potential amount under these indemnification agreements due to the Company’s limited history with prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on the Company’s operating results, financial position, or cash flows.

The Company also provides financing guarantees, which are generally for various third-party financing arrangements to channel partners and other customers. See Note 6. The Company’s other arrangements as of April 25, 2009 that were subject to recognition and disclosure requirements under FIN 45 were not material.

(g) Legal Proceedings

Brazilian authorities are investigating the Company’s Brazilian subsidiary and certain of its current and former employees, as well as a Brazilian importer of the Company’s products, and its affiliates and employees, relating to the allegation of evading import taxes and other alleged improper transactions involving the subsidiary and the importer. The Company is conducting a thorough review of the matter. In December 2008, Brazilian authorities asserted claims against the Company for calendar year 2003 and the Company believes claims may also be asserted for calendar year 2004 through calendar year 2007. The Company believes the asserted claims are without merit and intends to defend the claims vigorously. The Company is unable to determine the likelihood of an unfavorable outcome on any potential further claims against it. While the Company believes there is no legal basis for its alleged liability, due to the complexities and uncertainty surrounding the judicial process in Brazil, and the nature of the claims asserting joint liability with the importer, the Company is unable to reasonably estimate a range of loss, if any. In addition, the Company is investigating the allegations regarding improper transactions, the Company has proactively communicated with United States authorities to provide information and report on its findings, and the United States authorities are currently investigating such allegations.

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

 

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12. Shareholders’ Equity

(a) Stock Repurchase Program

In September 2001, the Company’s Board of Directors authorized a stock repurchase program. As of April 25, 2009, the Company’s Board of Directors had authorized an aggregate repurchase of up to $62 billion of common stock under this program and the remaining authorized repurchase amount was $5.6 billion with no termination date. The stock repurchase activity under the stock repurchase program during the first nine months of fiscal 2009 is summarized as follows (in millions, except per-share amounts):

 

Nine Months Ended April 25, 2009

   Shares
Repurchased
   Weighted-
Average Price
per Share
   Amount
Repurchased

Cumulative balance at July 26, 2008

   2,600    $ 20.60    $ 53,579

Repurchase of common stock (1)

   160      17.59      2,800
              

Cumulative balance at April 25, 2009

   2,760    $ 20.43    $ 56,379
              

 

(1)

Includes stock repurchases that were pending settlement as of April 25, 2009.

The purchase price for the shares of the Company’s stock repurchased is 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.

(b) Other Repurchases of Common Stock

The Company also repurchases shares in settlement of employee tax withholding obligations due upon the vesting of restricted stock or stock units.

(c) Comprehensive Income

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    April 25,
2009
    April 26,
2008
 

Net income

   $ 1,348     $ 1,773     $ 5,053     $ 6,038  

Other comprehensive income, change in net of tax:

        

Unrealized gains and losses on investments

     (19 )     (285 )     (195 )     254  

Derivative instruments

     17       27       (136 )     15  

Cumulative translation adjustment and other

     5       178       (429 )     272  
                                

Comprehensive income before minority interest

     1,351       1,693       4,293       6,579  

Change in minority interest

     (9 )     18       22       (53 )
                                

Total

   $ 1,342     $ 1,711     $ 4,315     $ 6,526  
                                

The Company consolidates its investment in a venture fund managed by SOFTBANK Corp. and its affiliates (“SOFTBANK”) as the Company 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 (loss) and is reflected as a change in minority interest.

 

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Table of Contents
13. Employee Benefit Plans

(a) 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 at present is approximately six months after the subscription date. The Purchase Plan terminates on January 3, 2010. The Company issued 14 million shares and 9 million shares, under the Purchase Plan, during the nine months ended April 25, 2009 and April 26, 2008, respectively. As of April 25, 2009, 48 million shares were available for issuance under the Purchase Plan.

(b) Employee Stock Incentive Plans

Stock Incentive Plan Program Description

As of April 25, 2009, the Company had five stock incentive plans: the 2005 Stock Incentive Plan (the “2005 Plan”); the 1996 Stock Incentive Plan (the “1996 Plan”); the 1997 Supplemental Stock Incentive Plan (the “Supplemental Plan”); the Cisco Systems, Inc. SA Acquisition Long-Term Incentive Plan (the “SA Acquisition Plan”); and the Cisco Systems, Inc. WebEx Acquisition Long-Term Incentive Plan (the “WebEx Acquisition Plan”). In addition, the Company has, in connection with the acquisitions of various companies, assumed the share-based awards granted under stock incentive plans of the acquired companies or issued share-based awards in replacement thereof. Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, government regulations, and other factors. Since the inception of the stock incentive plans, the Company has granted share-based awards to a significant percentage of its employees, and the majority has been granted to employees below the vice president level. The Company’s primary stock incentive plans are summarized as follows:

2005 Plan

As amended on November 15, 2007, the maximum number of shares issuable under the 2005 Plan over its term is 559 million shares plus the amount of any shares underlying awards outstanding on November 15, 2007 under the 1996 Plan, the SA Acquisition Plan and the WebEx Acquisition Plan that are forfeited or are terminated for any other reason before being exercised or settled. However, any shares underlying awards outstanding on November 15, 2007 under the 1996 Plan, the SA Acquisition Plan, and the WebEx Acquisition Plan that expire unexercised at the end of their maximum terms will not be considered to become available for reissuance under the 2005 Plan. If any awards granted under the 2005 Plan are forfeited or are terminated for any other reason before being exercised or settled, then the shares underlying the awards will again be available under the 2005 Plan. The number of shares available for issuance under the 2005 Plan will be reduced by 2.5 shares for each share awarded as stock grants or stock units.

The 2005 Plan permits the granting of stock options, stock, stock units, and stock appreciation rights to employees (including employee directors and officers) and consultants of the Company and its subsidiaries and affiliates, and non-employee 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% or 25% of the option shares one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Stock grants and stock units will generally vest with respect to 20% or 25% of the shares covered by the grant on each of the first through fifth or fourth anniversaries of the date of the grant, respectively. The Compensation and Management Development Committee of the Board of Directors has the discretion to use different vesting schedules. Stock appreciation rights may be awarded in combination with stock options or stock grants and such awards shall provide that the stock appreciation rights will not be exercisable unless the related stock options or stock grants are forfeited. Stock grants may be awarded in combination with non-statutory stock options, and such awards may provide that the stock grants will be forfeited in the event that the related non-statutory stock options are exercised.

 

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Table of Contents

1996 Plan

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

Supplemental Plan

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

Acquisition Plans

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

General Share-Based Award Information

Stock Option Awards

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

 

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

BALANCE AT JULY 28, 2007

   1,289     $ 26.60

Granted and assumed

   159       31.12

Exercised

   (146 )     18.50

Canceled/forfeited/expired

   (103 )     30.74
        

BALANCE AT JULY 26, 2008

   1,199       27.83

Granted and assumed

   5       21.40

Exercised

   (20 )     14.69

Canceled/forfeited/expired

   (156 )     49.34
        

BALANCE AT APRIL 25, 2009

   1,028     $ 24.79
        

 

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The following table summarizes significant ranges of outstanding and exercisable stock options as of April 25, 2009 (in millions, except years and share prices):

 

     STOCK OPTIONS OUTSTANDING    STOCK OPTIONS EXERCISABLE

Range of Exercise Prices

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

$  0.01  – 15.00

   84    3.00    $ 11.25    $ 602    79    $ 11.29    $ 558

  15.01  – 18.00

   184    4.23      17.29      208    141      17.14      182

  18.01  – 20.00

   247    3.82      19.22      1    221      19.22      1

  20.01  – 25.00

   217    5.23      22.46      —      137      22.23      —  

  25.01  – 35.00

   177    7.07      30.53      —      60      30.36      —  

  35.01  – 68.56

   119    0.52      53.23      —      119      53.22      —  
                                

Total

   1,028    4.30    $ 24.79    $ 811    757    $ 24.81    $ 741
                                

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price of $18.42 as of April 24, 2009, which would have been received by the option holders had those option holders exercised their stock options as of that date. The total number of in-the-money stock options exercisable as of April 25, 2009 was 223 million. As of July 26, 2008, 795 million outstanding stock options were exercisable and the weighted-average exercise price was $29.53.

Restricted Stock and Stock Unit Awards

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

 

     Restricted
Stock/Stock
Units
    Weighted-
Average Price
per Share

BALANCE AT JULY 28, 2007

   11     $ 22.52

Granted and assumed

   4       27.29

Vested

   (4 )     22.49

Canceled/forfeited

   (1 )     24.24
        

BALANCE AT JULY 26, 2008

   10       24.27

Granted and assumed

   38       21.57

Vested

   (3 )     23.39

Canceled/forfeited

   (1 )     22.93
        

BALANCE AT APRIL 25, 2009

   44     $ 22.29
        

Certain of the restricted stock units are awarded contingent on the future achievement of financial performance metrics.

 

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Table of Contents

Share-Based Awards Available for Grant

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

 

     Share-
Based
Awards
Available
for Grant
 

BALANCE AT JULY 28, 2007

   294  

Options granted and assumed

   (159 )

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

   (11 )

Share-based awards canceled/forfeited

   27  

Additional shares reserved

   211  
      

BALANCE AT JULY 26, 2008

   362  

Options granted and assumed

   (5 )

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

   (95 )

Share-based awards canceled/forfeited

   32  

Additional shares reserved

   2  
      

BALANCE AT APRIL 25, 2009

   296  
      

As reflected in the table above, for each share awarded as restricted stock or subject to a restricted stock unit award under the 2005 Plan subsequent to November 15, 2007, an equivalent of 2.5 shares is deducted from the available share-based award balance.

Valuation and Expense Information Under SFAS 123(R)

Share-based compensation expense recognized under Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”) consists primarily of expenses for stock options, stock purchase rights, restricted stock, and restricted stock units granted to employees. The following table summarizes employee share-based compensation expense (in millions):

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Cost of sales—product

   $ 12    $ 10    $ 33    $ 30

Cost of sales—service

     31      27      94      80
                           

Employee share-based compensation expense in cost of sales

     43      37      127      110
                           

Research and development

     82      78      248      224

Sales and marketing

     103      114      320      324

General and administrative

     49      39      140      109
                           

Employee share-based compensation expense in operating expenses

     234      231      708      657
                           

Total employee share-based compensation expense (1)

   $ 277    $ 268    $ 835    $ 767
                           

 

(1)

Share-based compensation expense of $22 million and $66 million related to acquisitions and investments for the three and nine months ended April 25, 2009, respectively, and $22 million and $67 million for the three and nine months ended April 26, 2008, respectively, is disclosed in Note 3 and is not included in the above table.

As of April 25, 2009, total compensation cost related to unvested share-based awards, including share-based compensation relating to acquisitions and investments, not yet recognized was $3.1 billion, which is expected to be recognized over approximately 3.0 years on a weighted-average basis. The income tax benefit for employee share-based compensation expense was $74 million and $224 million for the three and nine months ended April 25, 2009, respectively, and $87 million and $247 million for the three and nine months ended April 26, 2008, respectively.

 

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Valuation of Employee Stock Options and Employee Stock Purchase Rights

Upon adoption of SFAS 123(R) at the beginning of fiscal 2006, the Company began estimating the value of employee stock options and employee stock purchase rights on the date of grant using a lattice-binomial option-pricing model. The Company’s employee stock options have vesting provisions and various restrictions including 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 valuation of employee stock options is summarized as follows:

 

     Nine Months Ended  
     April 25,
2009
    April 26,
2008
 

Number of options granted (in millions)

     5       148  

Weighted-average assumptions:

    

Expected volatility

     37.7 %     31.0 %

Risk-free interest rate

     2.9 %     4.3 %

Expected dividend

     0.0 %     0.0 %

Kurtosis

     4.6       4.6  

Skewness

     (0.27 )     (0.80 )

Weighted-average expected life (in years)

     5.9       6.3  

Weighted-average estimated grant date fair value (per option share)

   $ 6.81     $ 9.75  

The valuation of employee stock purchase rights is summarized as follows:

 

     Nine Months Ended  
     April 25,
2009
    April 26,
2008
 

Expected volatility

     43.4 %     33.0 %

Risk-free interest rate

     0.3 %     3.3 %

Expected dividend

     0.0 %     0.0 %

Weighted-average expected life (in years)

     0.5       0.5  

Weighted-average estimated grant date fair value (per share)

   $ 4.61     $ 6.58  

The determination of the fair value of share-based payment awards on the date of grant using the lattice-binomial model is impacted 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:

 

   

For employee stock options, 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”). For employee stock purchase rights, the Company used the implied volatility for six-month traded options on the Company’s stock. 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 and employee stock purchase rights.

 

   

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, and 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.

 

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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 the fair value of share-based payment awards is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because the Company’s employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion, the existing valuation models may not provide an accurate measure of the fair value 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.

 

14. Income Taxes

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    April 25,
2009
    April 26,
2008
 

Effective tax rate

     20.1 %     23.2 %     18.0 %     20.2 %

Cash paid for income taxes

   $ 406     $ 590     $ 999     $ 1,992  

The effective tax rate for the nine months ended April 25, 2009 reflected a $106 million tax benefit recorded in the first quarter of fiscal 2009 as a result of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, which reinstated the U.S. federal R&D tax credit retroactive to January 1, 2008. The effective tax rate for the nine months ended April 26, 2008 reflected a net tax benefit of $162 million recorded in the first quarter of fiscal 2008 from the settlement of certain tax matters with the Internal Revenue Service (“IRS”).

The amount of unrecognized tax benefits was determined in accordance with Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”). The Company had $2.6 billion of unrecognized tax benefits as of April 25, 2009, of which $2.2 billion, if recognized, would favorably impact the effective tax rate at April 25, 2009. Although timing of the resolution of audits is highly uncertain, the Company does not believe it is reasonably possible that the total amount of unrecognized tax benefits as of April 25, 2009 will materially change in the next 12 months.

 

15. 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), metropolitan-area networks (MANs) and wide-area networks (WANs).

(a) Net Sales and Gross Margin by Theater

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.

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 include the information in its measurement of the performance of the operating segments. In addition, the Company does not allocate amortization of acquisition-related intangible assets and share-based compensation expense to the gross margin for each theater because management does not include this information in its measurement of the performance of the operating segments.

 

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Summarized financial information by theater for the three and nine months ended April 25, 2009 and April 26, 2008, based on the Company’s internal management system and as utilized by the Company’s Chief Operating Decision Maker (CODM), is as follows (in millions):

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008 (3)
    April 25,
2009
    April 26,
2008 (3)
 

Net sales:

        

United States and Canada (1)

   $ 4,308     $ 5,094     $ 14,593     $ 15,805  

European Markets

     1,848       2,154       6,009       6,053  

Emerging Markets

     880       1,130       3,198       3,232  

Asia Pacific

     808       1,042       2,753       3,077  

Japan

     318       371       1,029       1,009  
                                

Total

   $ 8,162     $ 9,791     $ 27,582     $ 29,176  
                                

Gross margin:

        

United States and Canada

   $ 2,825     $ 3,279     $ 9,515     $ 10,354  

European Markets

     1,231       1,425       3,987       3,961  

Emerging Markets

     532       718       1,959       1,980  

Asia Pacific

     499       683       1,727       2,000  

Japan

     228       259       723       709  
                                

Theater total

     5,315       6,364       17,911       19,004  

Unallocated corporate items (2)

     (86 )     (94 )     (278 )     (289 )
                                

Total

   $ 5,229     $ 6,270     $ 17,633     $ 18,715  
                                

 

(1)

Net sales in the United States were $4.1 billion and $4.8 billion for the three months ended April 25, 2009 and April 26, 2008, respectively. Net sales in the United States were $13.8 billion and $15.0 billion for the nine months ended April 25, 2009 and April 26, 2008, respectively.

 

(2)

The unallocated corporate items for the three and nine months ended April 25, 2009 and April 26, 2008 include the effects of amortization of acquisition-related intangible assets and share-based compensation expense.

 

(3)

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

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

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Net sales:

           

Routers

   $ 1,385    $ 2,028    $ 4,785    $ 5,858

Switches

     2,588      3,222      9,196      9,918

Advanced technologies

     2,077      2,371      7,191      7,060

Other

     370      578      1,230      1,623
                           

Product

     6,420      8,199      22,402      24,459

Service

     1,742      1,592      5,180      4,717
                           

Total

   $ 8,162    $ 9,791    $ 27,582    $ 29,176
                           

 

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

The Company refers to some of its products and technologies as advanced technologies. As of April 25, 2009, the Company had identified the following advanced technologies for particular focus: application networking services, home networking, 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.

 

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(c) Other Segment Information

The majority of the Company’s assets, excluding cash and cash equivalents and investments, as of April 25, 2009 and July 26, 2008 were attributable to its U.S. operations. The Company’s total cash and cash equivalents and investments held outside of the United States in various foreign subsidiaries was $27.2 billion as of April 25, 2009, and the remaining $6.4 billion was held in the United States. For the three months and nine months ended April 25, 2009 and April 26, 2008, 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):

 

     April 25,
2009
   July 26,
2008

Property and equipment, net:

     

United States

   $ 3,414    $ 3,478

International

     675      673
             

Total

   $ 4,089    $ 4,151
             

 

16. Net Income per Share

SFAS No. 128, “Earnings per Share,” requires that employee equity share options, unvested 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 and nonvested restricted stock and stock units, which is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares.

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Net income

   $ 1,348    $ 1,773    $ 5,053    $ 6,038
                           

Weighted-average shares — basic

     5,805      5,942      5,844      6,014

Effect of dilutive potential common shares

     13      127      27      188
                           

Weighted-average shares — diluted

     5,818      6,069      5,871      6,202
                           

Net income per share — basic

   $ 0.23    $ 0.30    $ 0.86    $ 1.00
                           

Net income per share — diluted

   $ 0.23    $ 0.29    $ 0.86    $ 0.97
                           

Antidilutive employee share-based awards

     977      649      1,008      557

 

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17. Pending Business Combinations

On April 9, 2009, the Company announced a definitive agreement to acquire privately-held Tidal Software, Inc. (“Tidal Software”) for an estimated $105 million payable in cash and retention-based incentives. Tidal Software is the creator of intelligent application management and automation solutions, which are expected to further advance the Company’s enterprise data center strategy by enhancing product and service delivery offerings. The acquisition closed on May 19, 2009.

On March 19, 2009, the Company announced that it had entered into a definitive agreement to acquire privately-held Pure Digital Technologies, Inc. (“Pure Digital”) for an estimated $590 million, payable in stock in exchange for all shares of Pure Digital, and up to $15 million in retention-based equity incentives for continuing employees. Pure Digital is a pioneer in developing consumer-friendly video solutions with mass-market appeal. The acquisition of Pure Digital supports the Company’s strategy regarding the media-enabled home and the consumer market transition to visual networking. The acquisition is expected to close in May 2009.

 

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “endeavors,” “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

In the third quarter of fiscal 2009, our results reflected a 17% decrease in net sales compared with the third quarter of fiscal 2008. Net sales were down 5% for the first nine months of fiscal 2009 compared with the corresponding period of fiscal 2008. In the third quarter of fiscal 2009, our markets continued to be affected by the global macroeconomic downturn across our geographic theaters. During the third quarter and first nine months of fiscal 2009, our sales to the service provider, enterprise, and commercial markets declined as a result of cautious spending by customers in those markets. Our public sector sales increased in some theaters but declined overall.

Compared with the corresponding periods of fiscal 2008, net income decreased by 24% and 16% in the third quarter and the first nine months of fiscal 2009, respectively, primarily as a result of the lower revenue. Lower interest and other income during the third quarter and the first nine months of fiscal 2009, compared with the corresponding periods in fiscal 2008, also contributed to the decrease in net income. These factors were partially offset by lower operating expenses, which were due in part to our expense management initiatives. Net income per diluted share decreased by 21% and 11% in the third quarter and the first nine months of fiscal 2009, respectively, compared with the corresponding periods of fiscal 2008.

Strategy and Focus Areas

We are pursuing a multifaceted strategy for managing through the economic downturn and addressing the current business climate that involves our focus on the following:

 

   

Execution on our vision and strategy: Our vision of how the industry will evolve is being driven by the increasing role intelligent networks will play as nearly all forms of communication and information technology are enabled by the network. Our differentiated strategy enabled by networked collaboration, we believe, will allow us to move into market adjacencies with speed, scale and flexibility.

 

   

Collaboration and Web 2.0 technologies: The investments we have made and our architectural approach are based on the belief that collaboration and networked Web 2.0 technologies that enable user collaboration, including unified communications and Cisco TelePresence systems, will create new market opportunities for us.

 

   

Resource management and realignment: During the third quarter of fiscal 2009, we continued to realign resources to increase the focus on our priorities and reduce expenses. We plan to continue such initiatives in the fourth quarter of fiscal 2009.

 

   

United States and selected emerging countries: We intend to continue to devote particular attention to two distinct geographic sectors: the United States and selected emerging market countries. We continue to believe the U.S. economy may be the first major economy to recover. We also believe that selected emerging countries may be less adversely impacted during this economic downturn as compared with other countries.

 

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The network as the platform: We believe that video applications, including Internet Protocol television (IPTV), Cisco TelePresence systems, unified communications, physical security and other video products, have the potential to accelerate the growth of bandwidth demand and to increase loads on networks, which may require upgrades to existing networks, as well as to accelerate deployment of collaboration infrastructure within enterprises. We believe that the increased use of the network as the platform for all forms of communications and information technology will continue to create opportunities for us.

Our strategy draws from our experience from managing through previous economic downturns. As we have done in the past, we will attempt to use the current economic downturn as an opportunity to expand our share of our customers’ information technology spending and to continue moving into product markets similar, related, or adjacent to those in which we currently are active, which we refer to as market adjacencies. We have expanded our movement into market adjacencies while at the same time realigning our resources and reducing expenses.

We believe the market is at an inflection point, in terms of its awareness, that intelligent networks are becoming the platform for productivity and global competitiveness. We further believe that disruption in the enterprise data center will accelerate in the next 12 months, due to changing technology trends such as the increasing adoption of virtualization and the rise in scaleable processing. As a result of these developments, a significant market transition appears to be underway in the enterprise data center as networking, computing, storage and software technologies begin to converge in new ways. We are seeking to capitalize on this market transition through, among other things, our recently announced Cisco Unified Computing System and Cisco Nexus product families, which are designed to integrate the previously siloed technologies in the enterprise data center with a unified architecture.

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

In addition to focusing on the enterprise data center, our strategy seeks to move into market adjacencies, and to capitalize on the increased role of video, collaboration, and networked Web 2.0 technologies across our customer markets. Cisco TelePresence systems are one example of our product offerings in the service provider, enterprise, and commercial markets with regard to video, collaboration, and networked Web 2.0 technologies, as customers in these markets evolve their communications and business models.

Our approach of aiming to achieve balance across products and services, customer markets, and geographic theaters has contributed to the growth we experienced in the past. We have delivered several new products recently, and we are pleased with the breadth and depth of our innovation across all aspects of our business and the impact that we believe this innovation will have on our long-term prospects. We believe that our strategy and our ability to innovate and execute may enable us to improve our relative competitive position in difficult business conditions and may continue to provide us with long-term growth opportunities.

Revenue

For the third quarter and first nine months of fiscal 2009, our total revenue decreased across our four largest geographic theaters on a year-over-year basis. In the third quarter and the first nine months of fiscal 2009, our net service revenue increased by approximately 9% and 10%, respectively, compared with the corresponding periods of fiscal 2008, reflecting increased service revenue in all of our geographic theaters. Our service and support strategy seeks to capitalize on increased globalization. We believe this strategy, along with our architectural approach, has the potential to further differentiate us from competitors. Our net product sales declined year over year across almost all of our product categories in the third quarter and first nine months of fiscal 2009, except for sales of our advanced technologies, which increased slightly in the first nine months of fiscal 2009. Within our advanced technologies category, video systems, unified communications and security products showed strength relative to other products in this category during the first nine months of fiscal 2009.

In the third quarter and the first nine months of fiscal 2009, our revenue from routing products declined by 32% and 18%, respectively, compared with the corresponding periods of fiscal 2008, as sales decreased across all router product categories from high-end to low-end routers. In the third quarter and the first nine months of fiscal 2009, our revenue from switching products declined by 20% and 7%, respectively, compared with the corresponding periods of fiscal 2008.

In view of the decline in our business that we experienced in the second and third quarters of fiscal 2009, we anticipate that our total revenue will continue to decline on a year-over-year basis in the fourth quarter of fiscal 2009.

 

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Gross Margin

In the third quarter of fiscal 2009, our gross margin percentage increased slightly compared with the third quarter of fiscal 2008. The slight increase resulted from higher service gross margin, partially offset by lower product gross margin. Product gross margin was lower compared with the third quarter of fiscal 2008 due to higher sales discounts and rebates, product pricing, product mix, and lower shipment volume, partially offset by lower manufacturing costs. Our gross margin percentage for the first nine months of fiscal 2009 declined slightly compared with the corresponding period of fiscal 2008. If our shipment volumes, product mix, pricing, or other significant factors that impact our product gross margin continue to be adversely affected by the economic downturn or market factors, our gross margin could decline.

Operating Expenses

Operating expenses in the third quarter and the first nine months of fiscal 2009 decreased in absolute dollars, but increased as a percentage of revenue, compared with the corresponding periods of fiscal 2008. For the third quarter of fiscal 2009, lower headcount-related and discretionary expenses, as well as lower acquisition-related milestone payments, contributed to the decrease in absolute dollars. For the first nine months of fiscal 2009, operating expenses were relatively flat compared with the corresponding period of fiscal 2008. During the third quarter of fiscal 2009, we continued to realign resources to better focus on our priorities as well as to reduce our operating expenses, as part of our strategy to address the global economic downturn. In the near term, we anticipate that despite our efforts in this area, operating expenses may continue to increase as a percentage of total revenue, as the anticipated cost savings may not keep pace with expected revenue declines.

Other Financial Highlights

The following is a summary of other financial highlights for the third quarter and first nine months of fiscal 2009:

 

   

We generated cash flows from operations of $2.0 billion and $7.9 billion during the third quarter and first nine months of fiscal 2009, respectively. Our cash and cash equivalents, together with our investments, were $33.6 billion at the end of the third quarter of fiscal 2009, compared with $26.2 billion at the end of fiscal 2008.

 

   

Our total deferred revenue at the end of the third quarter of fiscal 2009 was $8.8 billion, compared with $8.9 billion at the end of fiscal 2008.

 

   

We repurchased 77 million shares of our common stock for $1.2 billion during the third quarter of fiscal 2009 and a total of 160 million shares for $2.8 billion for the first nine months of fiscal 2009.

 

   

Days sales outstanding in accounts receivable (DSO) at the end of the third quarter of fiscal 2009 was 27 days, compared with 34 days at the end of fiscal 2008.

 

   

Our inventory balance was $1.0 billion at the end of the third quarter of fiscal 2009, compared with $1.2 billion at the end of fiscal 2008. Annualized inventory turns were 11.0 in the third quarter of fiscal 2009, compared with 11.9 in the fourth quarter of fiscal 2008. Our purchase commitments with contract manufacturers and suppliers were $2.2 billion at the end of the third quarter of fiscal 2009, compared with $2.7 billion at the end of fiscal 2008.

 

   

During the third quarter of fiscal 2009, we completed an offering of senior unsecured notes in an aggregate principal amount of $4.0 billion.

We believe that our strong cash position, our solid balance sheet, our visibility into our supply chain, our high-quality investment portfolio management, and our financing capabilities together provide a key competitive advantage and collectively enable us to be well positioned to manage our business through the current economic downturn.

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 26, 2008, as updated where applicable in Note 2 herein, describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements.

 

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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, or in hosting arrangements, we apply the provisions of Staff Accounting Bulletin No. 104, “Revenue Recognition,” and all related interpretations. Revenue is recognized when all of the following criteria have been met:

 

   

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

 

   

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

 

   

The fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment.

 

   

Collectibility is reasonably assured. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. The amount of product and service revenue recognized is affected by our 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.

Revenue deferrals relate to the timing of revenue recognition for specific transactions based on financing arrangements, service, support, and other factors. Financing arrangements may include sales-type, direct-financing, and operating leases, loans, and guarantees of third-party financing. Our total deferred revenue for products was $2.7 billion as of both April 25, 2009 and July 26, 2008. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which typically ranges from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our total deferred revenue for services was $6.1 billion as of both April 25, 2009 and July 26, 2008.

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 under 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 $2.4 billion and $3.8 billion as of April 25, 2009 and July 26, 2008, respectively. The allowance for doubtful accounts was $203 million, or 7.8% of the gross accounts receivable balance, as of April 25, 2009, and $177 million, or 4.4% of the gross accounts receivable balance, as of July 26, 2008. 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.

Our provision for doubtful accounts was $36 million and $34 million for the first nine months of fiscal 2009 and 2008, respectively. If a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our revenue.

A reserve for future sales returns is established based on historical trends in product return rates. The reserve for future sales returns as of April 25, 2009 and July 26, 2008 was $73 million and $103 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.

 

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

Our inventory balance was $1.0 billion and $1.2 billion as of April 25, 2009 and July 26, 2008, respectively. Inventory is written down based on excess and obsolete inventories determined primarily by future demand forecasts. Inventory write-downs are measured as the difference between the cost of the inventory and market based upon assumptions about future demand and are charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

We record a liability for firm, noncancelable, and unconditional purchase commitments with contract manufacturers and suppliers for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory. As of April 25, 2009, the liability for these purchase commitments was $186 million, compared with $184 million as of July 26, 2008 and was included in other current liabilities.

Our provision for inventory was $64 million and $83 million for the first nine months of fiscal 2009 and 2008, respectively. The provision for the liability related to purchase commitments with contract manufacturers and suppliers was $77 million and $75 million for the first nine months of fiscal 2009 and 2008, respectively. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory write-downs and our liability for purchase commitments with contract manufacturers and suppliers and gross margin could be adversely affected. Inventory and supply chain management remain areas of focus as we balance the need to maintain supply chain flexibility to help ensure competitive lead times with the risk of inventory obsolescence.

Warranty Costs

The liability for product warranties, included in other current liabilities, was $338 million as of April 25, 2009, compared with $399 million as of July 26, 2008. See Note 11 to the Consolidated Financial Statements. Our products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products we provide a limited lifetime warranty. We accrue for warranty costs as part of our cost of sales based on associated material costs, technical support labor costs, and associated overhead. Material cost is estimated based primarily upon historical trends in the volume of product returns within the warranty period and the cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities.

The provision for product warranties issued during the first nine months of fiscal 2009 and 2008 was $282 million and $376 million, respectively. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our gross margin could be adversely affected.

Share-Based Compensation Expense

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Employee share-based compensation expense

   $ 277    $ 268    $ 835    $ 767

Share-based compensation expense related to acquisitions and investments

     22      22      66      67
                           

Total

   $ 299    $ 290    $ 901    $ 834
                           

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.

 

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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 forfeitures. 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.

Fair Value Measurements

Our fixed income and publicly traded equity securities, collectively, are reflected in the Consolidated Balance Sheets at a fair value of $26.2 billion as of April 25, 2009, compared with $21.0 billion as of July 26, 2008. See Note 7 to the Consolidated Financial Statements. We apply SFAS 157 in determining the fair value of our investment securities. As described more fully in Note 8 to the Consolidated Financial Statements, SFAS 157 establishes a valuation hierarchy based on the level of independent, objective evidence available regarding the value of the investments. It establishes three classes of investments: Level 1 consists of securities for which there are quoted prices in active markets for identical securities; Level 2 consists of securities for which inputs other than Level 1 inputs are used, such as prices for similar securities in active markets or for identical securities in inactive markets and model-derived valuations for which the variables are derived from, or corroborated by, observable market data; and Level 3 consists of securities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value.

Our fixed income investment portfolio consists primarily of high-quality investment grade securities and as of April 25, 2009 had a weighted-average credit rating exceeding AA. Our Level 2 securities are valued using quoted market prices for similar instruments, nonbinding market prices that are corroborated by observable market data, or discounted cash flow techniques in limited circumstances. We use inputs such as actual trade data, benchmark yields, broker/dealer quotes, and other similar data, which are obtained from independent pricing vendors, quoted market prices, or other sources to determine the ultimate fair value of our assets and liabilities. We use such pricing data as the primary input, to which we have not made any material adjustments during the first nine months of fiscal 2009, to make our assessments and determinations as to the ultimate valuation of our investment portfolio and we are ultimately responsible for the financial statements and underlying estimates. The fair value and inputs are reviewed for reasonableness, may be further validated by comparison to publicly available information and could be adjusted based on market indices or other information that management deems material to their estimate of fair value.

In the current market environment, the assessment of fair value can be difficult and subjective. However, because of the relative reliability of the inputs we use to value our investment portfolio, and because substantially all of our valuation inputs are obtained using quoted market prices for similar or identical assets, we do not believe that the nature of estimates and assumptions affected by levels of subjectivity and judgment was material to the valuation of the investment portfolio as of April 25, 2009. Level 3 assets do not represent a significant portion of our total investment portfolio as of April 25, 2009.

We recognize an impairment charge when the declines in the fair values of our fixed income or publicly traded equity securities fall below their cost basis and the declines are judged to be other-than-temporary. The ultimate value realized on these securities, to the extent unhedged, is subject to market price volatility until they are sold. 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. The total impairment charges on investments in fixed income securities and publicly traded equity securities during the first nine months of fiscal 2009 were $258 million. There were no impairments of fixed income or publicly traded equity securities during the first nine months of fiscal 2008. Our impairment charges on investments in privately-held companies were $68 million and $9 million during the first nine months of fiscal 2009 and 2008, 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 in the fourth fiscal quarter and between annual tests in certain circumstances for each reporting unit. The goodwill recorded in the Consolidated Balance Sheets as of April 25, 2009 and July 26, 2008 was $12.6 billion and $12.4 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 nine months of fiscal 2009 and 2008.

 

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Income Taxes

We are subject to income taxes in the United States and numerous foreign jurisdictions. Our effective tax rates differ from the statutory rate primarily due to the tax impact of state taxes, foreign operations, R&D tax credits, tax audit settlements, nondeductible compensation, and international realignments. Our effective tax rate was 20.1% and 23.2% in the third quarter of fiscal 2009 and 2008, respectively. Our effective tax rate was 18.0% and 20.2% for the first nine months of fiscal 2009 and 2008, respectively.

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

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

Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in countries that have lower tax rates and higher than anticipated in countries that have higher tax rates; by changes in the valuation of our deferred tax assets and liabilities; by expiration of or lapses in the R&D tax credit laws; by transfer pricing adjustments including the effect of acquisitions on our intercompany R&D cost sharing arrangement and legal structure; by tax effects of nondeductible compensation; by tax costs related to intercompany realignments; by changes in accounting principles; or by changes in tax laws and regulations including possible U.S. changes to the taxation of earnings of our foreign subsidiaries, the deductibility of expenses attributable to foreign income, or the foreign tax credit rules. Significant judgment is required to determine the recognition and measurement attribute prescribed in FIN 48. In addition, FIN 48 applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely impact our provision for income taxes or additional paid-in capital. Further, as a result of certain of our ongoing employment and capital investment actions and commitments, our income in certain countries is subject to reduced tax rates and in some cases is wholly exempt from tax. Our failure to meet these commitments could adversely affect our provision for income taxes. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse impact on our operating results and financial condition.

Loss Contingencies

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

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

Reclassifications

During the first quarter of fiscal 2009, we began to allocate certain costs, which had previously been recorded in general and administrative expenses (related to information technology, financing business, and human resources), to sales and marketing, research and development, and cost of sales, as applicable. These changes also resulted in reclassifications to prior period gross margin by theater amounts. In addition, we have made certain reclassifications to prior period amounts relating to net sales by

theater and net sales for similar groups of products due to refinement of the respective categories.

 

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Net Sales

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
    April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
 

Net sales:

                

Product

   $ 6,420     $ 8,199     $ (1,779 )   (21.7 )%   $ 22,402     $ 24,459     $ (2,057 )   (8.4 )%

Service

     1,742       1,592       150     9.4 %     5,180       4,717       463     9.8 %
                                                    

Total

   $ 8,162     $ 9,791     $ (1,629 )   (16.6 )%   $ 27,582     $ 29,176     $ (1,594 )   (5.5 )%
                                                    
Net sales, which include product and service revenue, for each theater are summarized in the following table (in millions, except
percentages):
 
     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
    April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
 

Net sales:

                

United States and Canada

   $ 4,308     $ 5,094     $ (786 )   (15.4 )%   $ 14,593     $ 15,805     $ (1,212 )   (7.7 )%

Percentage of net sales

     52.8 %     52.1 %         52.9 %     54.2 %    

European Markets

     1,848       2,154       (306 )   (14.2 )%     6,009       6,053       (44 )   (0.7 )%

Percentage of net sales

     22.6 %     22.0 %         21.8 %     20.7 %    

Emerging Markets

     880       1,130       (250 )   (22.1 )%     3,198       3,232       (34 )   (1.1 )%

Percentage of net sales

     10.8 %     11.5 %         11.6 %     11.1 %    

Asia Pacific

     808       1,042       (234 )   (22.5 )%     2,753       3,077       (324 )   (10.5 )%

Percentage of net sales

     9.9 %     10.6 %         10.0 %     10.5 %    

Japan

     318       371       (53 )   (14.3 )%     1,029       1,009       20     2.0 %

Percentage of net sales

     3.9 %     3.8 %         3.7 %     3.5 %    
                                                    

Total

   $ 8,162     $ 9,791     $ (1,629 )   (16.6 )%   $ 27,582     $ 29,176     $ (1,594 )   (5.5 )%
                                                    

In the third quarter of fiscal 2009, we experienced a decline in our business compared with the third quarter of fiscal 2008 that we believe was due to the continued global economic downturn and the effect it has had on information technology spending. The weakness was reflected among our service provider, enterprise, and commercial markets generally, and across all geographic theaters. We expect that our net product sales across our geographic theaters will continue to be impacted by this unfavorable economic environment.

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

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

 

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Table of Contents

Net Product Sales by Theater

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
    April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
 

Net product sales:

                

United States and Canada

   $ 3,192     $ 4,060     $ (868 )   (21.4 )%   $ 11,271     $ 12,676     $ (1,405 )   (11.1 )%

Percentage of net product sales

     49.6 %     49.5 %         50.3 %     51.8 %    

European Markets

     1,570       1,886       (316 )   (16.8 )%     5,179       5,274       (95 )   (1.8 )%

Percentage of net product sales

     24.5 %     23.0 %         23.1 %     21.6 %    

Emerging Markets

     718       1,010       (292 )   (28.9 )%     2,740       2,912       (172 )   (5.9 )%

Percentage of net product sales

     11.2 %     12.3 %         12.2 %     11.9 %    

Asia Pacific

     679       924       (245 )   (26.5 )%     2,364       2,732       (368 )   (13.5 )%

Percentage of net product sales

     10.6 %     11.3 %         10.6 %     11.2 %    

Japan

     261       319       (58 )   (18.2 )%     848       865       (17 )   (2.0 )%

Percentage of net product sales

     4.1 %     3.9 %         3.8 %     3.5 %    
                                                    

Total

   $ 6,420     $ 8,199     $ (1,779 )   (21.7 )%   $ 22,402     $ 24,459     $ (2,057 )   (8.4 )%
                                                    

United States and Canada

Net product sales in the United States and Canada theater for the third quarter and the first nine months of fiscal 2009 decreased compared with the corresponding periods of fiscal 2008, which we believe was primarily attributable to the continued weakness in the macroeconomic environment in this theater during the third quarter and the first nine months of fiscal 2009 and its effect on our sales across our customer markets. For the third quarter and first nine months of fiscal 2009, we experienced lower sales across our service provider, enterprise, and commercial markets compared with the corresponding periods of fiscal 2008. The lower sales in our service provider market for both periods were primarily due to lower spending by a few large customers, and the lower sales in our enterprise and commercial markets were primarily due to the cautious spending by these customers. Sales to the U.S. federal government increased year over year for both the third quarter and the first nine months of fiscal 2009, while our sales to state and local governments decreased for the respective periods.

European Markets

Net product sales in the European Markets theater during the third quarter of fiscal 2009 decreased compared with the third quarter of fiscal 2008. We experienced a decline in net product sales in most of the large countries in this theater, including the United Kingdom and Germany, primarily due to challenging economic conditions in those countries during the third quarter of fiscal 2009. For the first nine months of fiscal 2009, net product sales decreased only slightly compared with the first nine months of fiscal 2008.

Emerging Markets

In the third quarter of fiscal 2009, net product sales in the Emerging Markets theater decreased compared with the third quarter of fiscal 2008, as a result of decreased sales across our customer markets, with particular weakness in the service provider and enterprise markets. In terms of geographies, in the third quarter of fiscal 2009, we experienced weakness in Russia, Mexico, and Brazil, among other countries in this theater. For the first nine months of fiscal 2009, net product sales in the Emerging Markets theater decreased moderately compared with the first nine months of fiscal 2008, as the weakness in the second and third quarters of fiscal 2009 was partially offset by growth in the first quarter of fiscal 2009. Certain of our customers in the Emerging Markets theater tend to make large and sporadic purchases, and the net sales related to these transactions may also be affected by the timing of revenue recognition. Further, some customers may continue to require greater levels of financing arrangements, service, and support in future periods which may also impact the timing of recognition of the revenue for this theater.

Asia Pacific

The decrease in net product sales in the Asia Pacific theater in the third quarter and first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008 was attributable to a decline in sales across most of our customer markets in this theater. We experienced weakness in India and South Korea during the third quarter of fiscal 2009, while sales in China decreased but to a lesser extent. During the third quarter of fiscal 2009, we experienced relative strength in Australia compared with other countries in this theater, and strength in the public sector, relative to other customer markets in this theater.

 

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Table of Contents

Japan

Net product sales in the Japan theater decreased in the third quarter of fiscal 2009 and decreased slightly in the first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008.

Net Product Sales by Groups of Similar Products

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
    April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
 

Net product sales:

                

Routers

   $ 1,385     $ 2,028     $ (643 )   (31.7 )%   $ 4,785     $ 5,858     $ (1,073 )   (18.3 )%

Percentage of net product sales

     21.6 %     24.7 %         21.4 %     24.0 %    

Switches

     2,588       3,222       (634 )   (19.7 )%     9,196       9,918       (722 )   (7.3 )%

Percentage of net product sales

     40.2 %     39.4 %         41.0 %     40.5 %    

Advanced technologies

     2,077       2,371       (294 )   (12.4 )%     7,191       7,060       131     1.9 %

Percentage of net product sales

     32.4 %     28.9 %         32.1 %     28.9 %    

Other

     370       578       (208 )   (36.0 )%     1,230       1,623       (393 )   (24.2 )%

Percentage of net product sales

     5.8 %     7.0 %         5.5 %     6.6 %    
                                                    

Total

   $ 6,420     $ 8,199     $ (1,779 )   (21.7 )%   $ 22,402     $ 24,459     $ (2,057 )   (8.4 )%
                                                    

Routers

We categorize our routers primarily as high-end, midrange, and low-end routers. Our sales of routers decreased across each of these categories in both the third quarter and the first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008, with the decline in sales of high-end routers representing the most significant decrease in dollar terms. Our high-end router sales are primarily to service providers, and during the third quarter of fiscal 2009 high-end router sales continued to be adversely impacted by, among other factors, a slowdown in capital expenditures in the global service provider market, as well as by the tendency of service providers to make large and sporadic purchases.

Switches

The decrease in net product sales related to switches in the third quarter and the first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008 was due to lower sales of both our modular switches and LAN fixed-configuration switches, consistent with our overall decline in sales to the enterprise market. The year-over-year decrease in sales of modular switches was approximately $350 million for both the third quarter and first nine months of fiscal 2009 and was due to decreased sales of Cisco Catalyst 4500 and 6000 Series Switches, partially offset by increased sales of Cisco Nexus 7000 Series Switches. The year-over-year decrease in sales of LAN fixed-configuration switches of $290 million and $375 million for the third quarter and first nine months of fiscal 2009, respectively, was primarily a result of the lower sales of Cisco Catalyst 3750 and 3560 Series Switches during both periods.

Advanced Technologies

The decrease in net product sales related to advanced technologies in the third quarter of fiscal 2009 compared with the third quarter of fiscal 2008 was due to the following:

 

   

Sales of video systems, which include solutions and systems designed to enable video-specific delivery systems for service providers, decreased by approximately $30 million. The decrease was primarily attributable to a decrease in the demand for high-definition cable set-top boxes partially offset by the increased demand for IP set-top boxes and international growth.

 

   

Sales of unified communications products decreased by approximately $40 million. Our sales of unified communications products were affected by lower sales of IP phones and associated software partially offset by the increased adoption of our web-based collaborative applications.

 

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Sales of security products decreased by approximately $60 million. Our sales of security products were affected by the lower module and line-card sales related to our routers and LAN switches and lower sales of our security appliance products which integrate multiple technologies (including virtual private network (VPN), firewall, and intrusion prevention services) on one platform, partially offset by increased sales of our web and email security products.

 

   

Sales of storage products decreased by approximately $60 million, sales of networked home products and application networking services each decreased by approximately $35 million, and sales of wireless LAN products decreased by approximately $30 million.

The increase in net product sales related to advanced technologies in the first nine months of fiscal 2009 compared with the first nine months of fiscal 2008 was due to the following:

 

   

Sales of video systems products increased by approximately $180 million. The increase was primarily attributable to higher demand for IP set-top boxes and international growth, as well as increased sales of high-definition cable set-top boxes in the first half of fiscal 2009.

 

   

Sales of unified communications products increased by approximately $60 million. The increase was attributable to increased adoption of our web-based collaborative applications.

 

   

Sales of security products increased by approximately $15 million. The increase was a result of higher sales of our web and email security products, as well as higher sales of security appliance products, partially offset by lower sales of module and line-card sales related to our routers and LAN switches.

 

   

Sales of storage products decreased by approximately $75 million, sales of networked home products decreased by approximately $40 million, and sales of wireless LAN products were flat, while application networking products decreased by approximately $10 million.

Other Product Revenue

The decrease in other product revenue in the third quarter and first nine months of fiscal 2009, compared with the corresponding periods of fiscal 2008, was primarily due to the decline in sales of our optical, cable, and service provider voice products, partially offset by increased sales of Cisco TelePresence systems.

Net Service Revenue

Net service revenue increased across all of our geographic theaters on a year-over-year basis in the third quarter and first nine months of fiscal 2009. The increase in net service revenue in the third quarter and first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008 was due to higher revenue from technical support service contracts as well as increased revenue from advanced services, which relates to consulting support services for specific customer networking needs. Renewals and technical support service contract initiations associated with recent product sales have resulted in a larger installed base of equipment being serviced, and revenue is recognized ratably over the period during which the related services are to be performed.

Gross Margin

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

 

     Three Months Ended     Nine Months Ended  
     Amount    Percentage     Amount    Percentage  
     April 25,
2009
   April 26,
2008
   April 25,
2009
    April 26,
2008
    April 25,
2009
   April 26,
2008
   April 25,
2009
    April 26,
2008
 

Gross margin:

                    

Product

   $ 4,093    $ 5,327    63.8 %   65.0 %   $ 14,357    $ 15,867    64.1 %   64.9 %

Service

     1,136      943    65.2 %   59.2 %     3,276      2,848    63.2 %   60.4 %
                                    

Total

   $ 5,229    $ 6,270    64.1 %   64.0 %   $ 17,633    $ 18,715    63.9 %   64.1 %
                                    

 

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

 

     Three Months Ended    Nine Months Ended
     Amount     Percentage    Amount     Percentage
     April 25,
2009
    April 26,
2008
    April 25,
2009
   April 26,
2008
   April 25,
2009
    April 26,
2008
    April 25,
2009
   April 26,
2008

Gross margin:

                   

United States and Canada

   $ 2,825     $ 3,279     65.6%    64.4%    $ 9,515     $ 10,354     65.2%    65.5%

European Markets

     1,231       1,425     66.6%    66.2%      3,987       3,961     66.4%    65.4%

Emerging Markets

     532       718     60.5%    63.5%      1,959       1,980     61.3%    61.3%

Asia Pacific

     499       683     61.8%    65.5%      1,727       2,000     62.7%    65.0%

Japan

     228       259     71.7%    69.8%      723       709     70.3%    70.3%
                                           

Theater Total

     5,315       6,364     65.1%    65.0%      17,911       19,004     64.9%    65.1%

Unallocated corporate items(1)

     (86 )     (94 )           (278 )     (289 )     
                                           

Total

   $ 5,229     $ 6,270     64.1%    64.0%    $ 17,633     $ 18,715     63.9%    64.1%
                                           

 

(1)

The unallocated corporate items primarily include the effects of amortization of acquisition-related intangible assets and employee share-based compensation expense. We do not allocate these items to the gross margin for each theater because management does not include the information in measuring the performance of the operating segments.

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 percentages may or may not be indicative of a trend for that theater.

Product Gross Margin

The decrease in total product gross margin percentage during the third quarter of fiscal 2009 compared with the third quarter of fiscal 2008 was due to the following factors:

 

   

Sales discounts, rebates, and product pricing decreased product gross margin percentage by 2.3%.

 

   

Lower shipment volume, net of certain variable costs, decreased product gross margin percentage by 1.1%.

 

   

Changes in the mix of products sold decreased product gross margin percentage by 0.9%.

 

   

Lower overall manufacturing costs driven by lower component costs, value engineering, and other manufacturing-related costs increased product gross margin percentage by 3.1%. Value engineering is the process by which production costs are reduced through component redesign, board configuration, test processes, and transformation processes.

The decrease in total product gross margin percentage during the first nine months of fiscal 2009 compared with the first nine months of fiscal 2008 was due to the following factors:

 

   

Sales discounts, rebates, and product pricing decreased product gross margin percentage by 1.8%.

 

   

Changes in the mix of products sold decreased product gross margin percentage by 0.9%.

 

   

Lower shipment volume, net of certain variable costs, decreased product gross margin percentage by 0.3%.

 

   

Lower overall manufacturing costs, driven by lower component costs, value engineering, and other manufacturing-related costs, increased product gross margin percentage by 2.2%.

 

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Service Gross Margin

Our service gross margin percentage increased in the third quarter and the first nine months of fiscal 2009, compared with the corresponding periods of fiscal 2008, primarily due to higher technical support and advanced services margins as well as advanced services constituting a lower proportion of total service revenue. The increased margins for technical support and advanced services were attributable primarily to the growth of our service revenue at the same time as certain cost control initiatives have helped to limit costs. For advanced services gross margins also increased due to delays in certain projects. However, our service gross margin may decline in future periods due to the timing of our strategic investments in headcount and resources to support this business. Service gross margin normally will experience some fluctuations due to various factors such as the timing of technical support service contract initiations and renewals. Also, service gross margin from our advanced services is lower than the service gross margin from technical support services. In future periods, we will experience an unfavorable impact to our service gross margin if revenue from advanced services increases to a higher proportion of total service revenue, as a result of our continued focus on providing comprehensive support to our customers’ networking devices, applications, and infrastructures, or for other reasons.

Factors That May Impact Net Sales and Gross Margin

Net product sales may continue to be affected by factors including the current global economic downturn and related market uncertainty, which so far have resulted in reduced or cautious spending in our global enterprise, service provider, and commercial markets; changes in the geopolitical environment and global economic conditions; competition, including price-focused competitors from Asia, especially from 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. Sales to the service provider market have been and may be in the future characterized by large and 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. Certain of our customers in the Emerging Markets theater also tend to make large and sporadic purchases, and the net sales related to these transactions may similarly be affected by the timing of revenue recognition. As we focus on new market opportunities, customers may require greater levels of financing arrangements, service, and support, especially in the Emerging Markets theater, which may result in a delay in the timing of 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 telecommunications service providers and Internet businesses, whether or not driven by any slowdown in capital expenditures in the service provider market; 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 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.

Product gross margin may 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 structures and cost structures, as a result of internal development or through acquisitions; changes in distribution channels; price competition, including competitors from Asia, especially from China; changes in geographic mix of our product sales; the timing of revenue recognition and revenue deferrals; 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; effects of value engineering; inventory holding charges; and the extent to which we successfully execute on our strategy and operating plans. Service gross margin may be impacted by various factors such as the change in mix between technical support services and advanced services, the timing of technical support service contract initiations and renewals, and the timing of our strategic investments in headcount and resources to support this business.

 

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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     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
    April 25,
2009
    April 26,
2008
    Variance
in
Dollars
    Variance
in
Percent
 

Research and development

   $ 1,243     $ 1,483     $ (240 )   (16.2 )%   $ 3,928     $ 3,975     $ (47 )   (1.2 )%

Percentage of net sales

     15.2 %     15.1 %         14.2 %     13.6 %    

Sales and marketing

     1,956       2,205       (249 )   (11.3 )%     6,394       6,441       (47 )   (0.7 )%

Percentage of net sales

     24.0 %     22.5 %         23.2 %     22.1 %    

General and administrative

     302       324       (22 )   (6.8 )%     1,077       1,033       44     4.3 %

Percentage of net sales

     3.7 %     3.3 %         3.9 %     3.5 %    
                                                    

Total

   $ 3,501     $ 4,012     $ (511 )   (12.7 )%   $ 11,399     $ 11,449     $ (50 )   (0.4 )%
                                                    

Percentage of net sales

     42.9 %     41.0 %         41.3 %     39.2 %    

Our total R&D, sales and marketing, and G&A expenses decreased in the third quarter of fiscal 2009 compared with the corresponding period of fiscal 2008. The decrease was due to the following: (i) a decrease in variable compensation and sales commission expenses as a result of lower sales and operating results; (ii) a decrease in certain discretionary expenses such as travel, meetings and events, outside services, marketing, and other expenses; (iii) lower acquisition-related milestone payments; and (iv) favorable foreign currency exchange rates. During the third quarter of fiscal 2009, as we continued to realign resources to better focus on our priorities as well as to reduce our expenses, as part of our strategy to address the global economic downturn, we incurred employee severance and related costs within operating expenses.

Our total combined R&D, sales and marketing, and G&A expenses also decreased in the first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008. Including the effects of foreign currency exchange rates, net of hedging, year-over-year changes within operating expenses were as follows:

R&D Expenses

The decrease in R&D expenses for the third quarter and first nine months of fiscal 2009 compared with the corresponding periods in fiscal 2008 was primarily due to lower acquisition-related compensation expenses related to the agreement entered into during the third quarter of fiscal 2008 to purchase the remaining interest in Nuova Systems. Lower discretionary expenses related to travel, meeting and events, and outside services also contributed to the decrease in R&D costs for the third quarter and first nine months of fiscal 2009. In addition, variable compensation expense was lower for the third quarter of fiscal 2009 compared with the third quarter of fiscal 2008. We have 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 third quarter of fiscal 2009 decreased compared with the third quarter of fiscal 2008 due to a decrease in sales expenses of approximately $163 million and a decrease in marketing expenses of $86 million. The decrease in sales expenses was primarily a result of lower discretionary expenses related to travel, meeting and events, and outside services and lower sales commission expenses associated with lower overall revenue. Marketing expenses decreased as a result of lower program spending as well as lower variable compensation expense. For the first nine months of fiscal 2009, the slight decrease in sales and marketing expenses was a result of lower marketing expenses partially offset by higher sales expenses.

G&A Expenses

G&A expenses for the third quarter of fiscal 2009 decreased compared with the third quarter of fiscal 2008 primarily due to a recovery related to the resolution of a real-estate related contingency and a decrease in variable employee compensation partially offset by increased share-based compensation expense. G&A expenses for the first nine months of fiscal 2009 increased compared with the first nine months of fiscal 2008 due to increased information technology-related expenses and increased share-based compensation expense, partially offset by a recovery related to the resolution of a real-estate related contingency.

 

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Effect of Foreign Currency

Foreign currency fluctuations, net of hedging, decreased total R&D, sales and marketing, and G&A expenses by $137 million, or approximately 3.4%, and $186 million, or approximately 1.6%, in the third quarter and first nine months of fiscal 2009, respectively, compared with the corresponding periods of fiscal 2008.

Headcount

During the third quarter of fiscal 2009, headcount decreased by approximately 760 employees, primarily as a result of employee attrition and the effects of a hiring pause, in addition to the effects of limited workforce reduction actions. Our headcount increased by approximately 430 employees in the first nine months of fiscal 2009, reflecting an increase in hires of college graduates in the first quarter of fiscal 2009 and acquisitions. As we realign and restructure resources in the normal course of our business, we expect that our headcount may continue to decrease in the near term.

Share-Based Compensation Expense

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

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Cost of sales—product

   $ 12    $ 10    $ 33    $ 30

Cost of sales—service

     31      27      94      80
                           

Employee share-based compensation expense in cost of sales

     43      37      127      110
                           

Research and development

     82      78      248      224

Sales and marketing

     103      114      320      324

General and administrative

     49      39      140      109
                           

Employee share-based compensation expense in operating expenses

     234      231      708      657
                           

Total employee share-based compensation expense (1)

   $ 277    $ 268    $ 835    $ 767
                           

 

(1)

Share-based compensation expense of $22 million and $66 million related to acquisitions and investments for the three and nine months ended April 25, 2009, respectively, and $22 million and $67 million for the three and nine months ended April 26, 2008, respectively, is disclosed in Note 3 to the Consolidated Financial Statements and is not included in the above table.

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, whereas compensation expense for all share-based payment awards granted subsequent to July 30, 2005 is recognized using the straight-line single-option method. Employee share-based compensation expense for the first nine months of fiscal 2009 increased compared with the corresponding period of fiscal 2008 primarily due to the effects of straight-line vesting of share-based awards and the higher weighted-average fair value for each share-based award.

 

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

The following table presents the amortization of purchased intangible assets and in-process R&D included in operating expenses (in millions):

 

     Three Months Ended    Nine Months Ended
     April 25,
2009
   April 26,
2008
   April 25,
2009
   April 26,
2008

Amortization of purchased intangible assets

   $ 121    $ 117    $ 369    $ 350

In-process research and development

   $ —      $ —      $ 3    $ 3

The increase in the amortization of purchased intangible assets included in operating expenses for the third quarter and the first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008 was due to impairment charges of $11 and $34 million during the third quarter and first nine months of fiscal 2009, respectively, partially offset by lower amortization as a result of purchased intangible assets which became fully amortized during the periods. For additional information regarding purchased intangibles, see Note 4 to the Consolidated Financial Statements.

Our methodology for allocating the purchase price for 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 nine months of fiscal 2009. In-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist.

Interest Income, Net

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

 

     Three Months Ended     Nine Months Ended  
     April 25,
2009
    April 26,
2008
    April 25,
2009
    April 26,
2008
 

Interest income

   $ 194     $ 269     $ 675     $ 891  

Interest expense

     (105 )     (68 )     (232 )     (255 )
                                

Total

   $ 89     $ 201     $ 443     $ 636  
                                

The decrease in interest income in the third quarter and first nine months of fiscal 2009 compared with the corresponding periods of fiscal 2008 was due to lower average interest rates partially offset by higher average total cash and cash equivalents and fixed income security balances compared with the corresponding periods of fiscal 2008. The increase in interest expense in the third quar