Cisco Systems, Inc. is an American company in the telecommunications industry. It is primarily known for its routers and switches, which are used by a substantial part of the Internet backbones. Cisco was founded in December 1984 by a group of scientists (primarily Leonard Bosack and Sandy Lerner) from Stanford University near San Francisco.
1 FORM 10-Q (Mark one) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended JANUARY 25, 1997 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 (I.R.S. Employer of Identification Number) incorporation or organization) 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 filing requirements for the past 90 days. YES X NO --------- -------- As of February 28, 1997 663,646,520 shares of the Registrant's common stock were outstanding.
2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED JANUARY 25, 1997 INDEX <TABLE> <CAPTION> Page <S> <C> <C> Facing sheet 1 Index 2 Part I. Financial information Item 1. a) Consolidated balance sheets at January 25, 1997 and July 28, 1996 3 b) Consolidated statements of operations for the three and six month periods ended January 25, 1997 and January 28, 1996 4 c) Consolidated statements of cash flows for the six month periods ended January 25, 1997 and January 28, 1996 5 d) Notes to consolidated financial statements 6 Item 2. Management's discussion and analysis of financial condition and results of operations 8 Part II. Other information 16 Signature 17 Exhibits Exhibit 3.02, Restated Bylaws of the Corporation 18 Exhibit 10.45, Employment agreement with Don LeBeau Exhibit 11.01, Computation of net income per share </TABLE> 2
3 ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (In thousands) <TABLE> <CAPTION> January 25, July 28, 1997 1996 ----------- ----------- (Unaudited) ASSETS <S> <C> <C> Current assets: Cash and equivalents $ 332,807 $ 279,695 Short-term investments 774,673 758,489 Accounts receivable, net of allowance for doubtful accounts of $17,166 at January 25, 1997 and $21,074 at July 28, 1996 1,024,942 622,859 Inventories, net 203,721 301,188 Deferred income taxes 191,268 101,827 Prepaid expenses and other current assets 91,608 95,582 ----------- ----------- Total current assets 2,619,019 2,159,640 Investments 1,160,995 832,114 Restricted investments 247,649 228,644 Property and equipment, net 410,065 331,315 Other assets 132,316 78,519 ----------- ----------- Total assets $ 4,570,044 $ 3,630,232 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 253,406 $ 153,683 Income taxes payable 172,744 169,894 Accrued payroll and related expenses 252,419 195,197 Other accrued liabilities 269,190 250,579 ----------- ----------- Total current liabilities 947,759 769,353 Minority interest 41,192 41,257 Shareholders' equity: Preferred stock, no par value, 5,000 shares authorized: none issued or outstanding at January 25, 1997 and July 28, 1996 Common stock, no par value, 1,200,000 shares authorized: 661,616 shares issued and outstanding at January 25, 1997 and 649,284 at July 28, 1996 1,180,201 888,067 Retained earnings 2,271,002 1,777,369 Unrealized gains on marketable securities 139,147 158,848 Cumulative translation adjustments (9,257) (4,662) ----------- ----------- Total shareholders' equity 3,581,093 2,819,622 ----------- ----------- Total liabilities and shareholders' equity $ 4,570,044 $ 3,630,232 =========== =========== </TABLE> The accompanying notes are an integral part of these financial statements. 3
4 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per-share amounts) <TABLE> <CAPTION> Three Months Ended Six Months Ended ---------------------------------- --------------------------------- Jan. 25, Jan. 28, Jan. 25, Jan. 28, 1997 1996 1997 1996 ---------------------------------- --------------------------------- (Unaudited) <S> <C> <C> <C> <C> Net sales $1,592,377 $918,510 $3,027,203 $1,716,801 Cost of sales 552,519 312,315 1,053,999 580,057 ---------------- ---------------- --------------- ---------------- Gross margin 1,039,858 606,195 1,973,204 1,136,744 Operating expenses: Research and development 167,652 89,695 312,363 167,875 Sales and marketing 288,341 163,527 547,451 308,778 General and administrative 52,111 31,462 93,887 59,729 Purchased research and development 43,203 217,792 ---------------- ---------------- --------------- ---------------- Total operating expenses 551,307 284,684 1,171,493 536,382 ---------------- ---------------- --------------- ---------------- Operating income 488,551 321,511 801,711 600,362 Realized gain on sale of investment 47,299 102,407 Interest and other income, net 27,064 15,646 48,542 28,504 ---------------- ---------------- --------------- ---------------- Income before provision for income taxes 562,914 337,157 952,660 628,866 Provision for income taxes 224,455 127,420 433,258 237,742 ---------------- ---------------- --------------- ---------------- Net income $ 338,459 $209,737 $ 519,402 $ 391,124 ================ ================ =============== ================ Net income per share $ .49 $ .31 $ .76 $ .59 ================ ================ =============== ================ Shares used in per-share calculation 690,304 666,177 686,824 659,625 ================ ================ =============== ================ </TABLE> The accompanying notes are an integral part of these financial statements. 4
5 CISCO SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) <TABLE> <CAPTION> Six Months Ended --------------------------------- January 25, January 28, 1997 1996 ----------- ----------- (Unaudited) <S> <C> <C> Cash flows from operating activities: Net income $ 519,402 $ 391,124 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 98,541 52,798 Deferred income taxes (61,461) (22,129) Tax benefit of disqualifying dispositions 101,546 93,704 Adjustment to conform StrataCom, Inc. fiscal year (11,020) Purchased research and development from Netsys Technology, Inc. acquisition 43,203 Change in operating assets and liabilities: Accounts receivable (399,887) (124,117) Inventories 100,013 (157,357) Prepaid expenses and other current assets 4,150 (29,257) Income taxes payable 2,750 33,866 Accounts payable 99,272 74,283 Accrued payroll and related expenses 56,447 30,353 Other accrued liabilities 4,315 30,537 ----------- ----------- Net cash provided by operating activities 557,271 373,805 ----------- ----------- Cash flows from investing activities: Purchases of short-term investments (697,891) (337,811) Proceeds from sales and maturities of short-term investments 706,535 269,814 Purchases of investments (1,007,291) (319,996) Proceeds from sales of investments 618,377 130,404 Purchases of restricted investments (133,744) (72,348) Proceeds from sales and maturities of restricted investments 114,071 58,165 Acquisition of property and equipment (169,372) (101,249) Acquisition of Telebit Corporation, net of purchased research and development (25,189) Other (8,000) (13,652) ----------- ----------- Net cash used in investing activities (602,504) (386,673) ----------- ----------- Cash flows from financing activities: Issuance of common stock 102,940 50,335 Repurchase of common stock (112,734) Other (4,595) (9,424) ----------- ----------- Net cash provided by (used in)financing activities 98,345 (71,823) ----------- ----------- Net increase (decrease) in cash and equivalents 53,112 (84,691) Cash and equivalents, beginning of period 279,695 284,388 ----------- ----------- Cash and equivalents, end of period $ 332,807 $ 199,697 =========== =========== </TABLE> The accompanying notes are an integral part of these financial statements. 5
6 CISCO SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Cisco Systems Inc. ("Cisco" or "the Company") develops, manufactures, markets and supports high-performance, multiprotocol internetworking systems that link geographically dispersed local-area and wide-area networks (LANs and WANs, respectively). Cisco's products include a wide range of routers, LAN and WAN switches, dial access servers, and network management solutions. The Company sells its products in approximately 90 countries through a combination of direct sales and reseller and distribution channels. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Fiscal Year The Company's fiscal year is the 52 or 53 weeks ending on the last Saturday in July. Fiscal years 1997 and 1996 are both 52 week years. Prior to fiscal year 1997, the Company's fiscal year was the 52 or 53 weeks ending on the last Sunday in July. Basis of Presentation The accompanying financial data as of January 25, 1997 and July 28, 1996 and for the three and six month periods ended January 25, 1997 and January 28, 1996, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. 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 financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended July 28, 1996. In July 1996, the Company acquired StrataCom, Inc.("StrataCom"), a Company that develops, manufactures, and supports high speed LAN and WAN switching equipment. The merger was accounted for as a pooling of interests and, accordingly, the Company's consolidated financial statements were restated for all periods prior to the merger to include the results of operations, financial positions, and cash flows for StrataCom for the twelve months ended June 30, 1996. Prior to the merger, StrataCom used a calendar year-end. In order for both companies to operate on the same fiscal calendar for 1997, StrataCom's operations for the one month period ended July 28, 1996, which are not material to the consolidated companies, have been reflected as an adjustment to retained earnings in the first quarter of fiscal 1997. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the 6
7 financial position, results of operations, and cash flows for the three and six month periods ended January 25, 1997 and January 28, 1996, have been made. The results of operations for the period ended January 25, 1997 are not necessarily indicative of the operating results for the full year. The July 28, 1996 balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Computation of Net Income Per Share Net income per common share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of stock options. 3. BUSINESS COMBINATIONS In September 1996, the Company acquired Nashoba Networks ("Nashoba"). The Company issued approximately 1.6 million shares of common stock for all the outstanding stock of Nashoba in a transaction accounted for as a pooling of interests. The Company also assumed options to purchase Nashoba stock that remain outstanding as options to purchase approximately .1 million shares of the Company's common stock. Also, in September 1996, the Company acquired Granite Systems, Inc. ("Granite"), a company established to develop, market, and sell multilayer switching and gigabit Ethernet equipment. The Company issued approximately 2.2 million shares of common stock for all the outstanding stock of Granite in a transaction accounted for as a pooling of interests. The Company also assumed options to purchase Granite stock that remain outstanding as options to purchase approximately 1.6 million shares of the Company's common stock. The historical operations of Nashoba and Granite are not material to the Company's consolidated operations and financial position on either an individual or an aggregated basis. Therefore, prior period statements have not been restated for these acquisitions. In October 1996, the Company acquired substantially all of the assets of Telebit Corporation ("Telebit") and its Modem ISDN Channel Aggregation (MICA) technologies for approximately $200 million in cash. The Company purchased Telebit patents, MICA intellectual property and established employment contracts with MICA personnel, and assumed certain preferred stock and notes receivable related to a management buyout of the remaining assets of Telebit. The transaction was accounted for as a purchase. Accordingly, the results of operations of the acquired business and the fair values of the acquired assets and liabilities were included in the Company's financial statements as of the effective date. As part of this transaction, the Company recorded approximately $174 million in purchased research and development expense in the first quarter of fiscal 1997. In November 1996, the Company acquired Netsys Technologies ("Netsys"), a privately held innovator of network infrastructure 7
8 management and performance analysis software. Under the terms of the agreement, shares of the Company's common stock worth approximately $79 million have been exchanged for all outstanding shares and options of Netsys in a transaction accounted for as a purchase. The Company had held a minority equity interest in Netsys since February 1995 and had also entered into a strategic reseller agreement. As part of this transaction, the Company recorded approximately $43 million in purchased research and development expense and $41 million of goodwill and other intangible assets in the second quarter of fiscal 1997. Amounts allocated to goodwill and other intangibles will be amortized on a straight-line basis over a five year period. The historical operations of Telebit and Netsys are not material to the Company's consolidated operations and financial position on either an individual or an aggregated basis, therefore, pro forma summaries are not presented. The amounts allocated to purchased research and development were determined through established valuation techniques in the high technology communications industry, and were expensed upon acquisition, because technological feasibility had not been established and no future alternative uses existed. 4. BALANCE SHEET DETAIL (In thousands) <TABLE> <CAPTION> January 25, July 28, Inventories: 1997 1996 -------- -------- (Unaudited) <S> <C> <C> Raw materials $ 85,993 $134,531 Work in process 77,127 99,723 Finished goods 18,551 51,920 Demonstration systems 22,050 15,014 -------- -------- $203,721 $301,188 ======== ======== </TABLE> 5. INCOME TAXES The Company paid income taxes of $390 million for the six months ended January 25, 1997 and $136 million for the six months ended January 28, 1996. The Company's income taxes currently payable for both federal and state purposes have been reduced by the tax benefit from stock option transactions. This benefit totaled $102 million in the first six months of 1997, and was credited directly to shareholders' equity. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, statements containing the words "believes," "anticipates," "estimates," "expects," and words of similar import, constitute "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Readers are referred to the "Other Risk Factors" section of the Company's 1996 Form 10-K filed on October 25, 1996, as well as the "Financial Risk Management", "Future Growth Subject to Risks", "Potential Volatility in Operating Results", "Risks Associated With Internet Infrastructure", and "Volatility of Stock Price" sections contained in this report, which identify important risk factors that 8
9 could cause actual results to differ from those contained in the forward-looking statements. Net sales grew to $1,592 million in the second quarter of 1997 from $919 million in the second quarter of 1996. Net sales for the first half of 1997 were $3,027 million, compared to $1,717 million in the first half of 1996. The 73.2% increase in net sales between the two three month periods and the 76.3% increase in net sales between the two six month periods was primarily the result of increasing unit sales of the Cisco 2500 product family, the Cisco 4700, LAN switching products such as the Catalyst 5000, and high end routers such as the Cisco 7500 product family. These increases were partially offset by decreasing unit sales of the Company's older product lines, consisting of the Cisco 7000 and Cisco 4000. Sales to international customers decreased to 43.6% of net sales in the second quarter of 1997, from 51.9% for the second quarter of 1996. International sales in the first six months of 1997 were 45.1% of net sales compared with 49.7% of net sales for the same period in 1996. These decreases reflect slower sales growth in certain international markets, particularly Japan, France, Germany and Italy. Sales growth in these markets have been impacted by certain factors such as weaker economic conditions, delayed government spending, a stronger dollar versus the local currencies, and slower adoption of networking technologies, among other factors. Gross margins decreased to 65.3% in the second quarter of 1997 from 66.0% for the second quarter of 1996. Gross margins for the first six months of 1997 were 65.2% compared with 66.2% for the same period in 1996. This is due principally to the continued shift in revenue mix to the Company's lower margin products consisting primarily of products in the Access and Workgroup business units, and to a lesser extent to write-downs of inventory and higher warranty costs. The prices of component parts have fluctuated in the recent past, and the Company expects that this trend may continue. An increase in the price of component parts may have a material adverse impact on gross margins. The Company expects that gross margins will continue to decrease in the future, because it believes that the market for lower margin remote access and high-speed switching products will continue to increase at a faster rate than the market for the Company's higher margin router products. The Company is attempting to mitigate this trend through various means, such as emphasizing software content, increasing the functionality of its products, controlling royalty costs, and improving manufacturing efficiencies. There can be no assurance that any efforts made by the Company in these and other areas will successfully offset decreasing margins. Research and development expenses increased $78 million in the second quarter of 1997 over the second quarter of 1996, and increased $144.5 million in the first six months of 1997 over the first six months of 1996. This represents an increase to 10.5% from 9.8% of net sales in the quarter to quarter period and to 10.3% from 9.8% of net sales for the first six months of each fiscal year. The increase reflects the Company's ongoing research and development efforts, including the further development of the CiscoFusion(TM) architecture, as well as the acquisition of technologies to bring a broad range of products to the market in a timely fashion. A significant portion of the increase was due to the addition of new personnel, as well as higher 9
10 expenditures on prototypes and depreciation on new equipment. The Company is primarily developing new technologies internally. Accordingly, research and development expenses are expected to increase at the same, or a slightly greater rate than the sales growth rate. If the Company believes it is unable to enter a particular market in a timely manner, it may acquire other businesses or license technology from other businesses as an alternative to internal research and development. All of the Company's research and development costs are expensed as incurred. Sales and marketing expenses in the second quarter of fiscal 1997 increased $124.8 million over the second quarter of fiscal 1996, and $238.7 million over the first six months of 1996. This represents slight increases to 18.1% from 17.8% of net sales in the quarter to quarter period and to 18.1% from 18.0% of net sales for the first six months of each fiscal year. The increases in these expenses resulted from an increase in the size of the Company's direct sales force and related commissions, additional marketing programs to support the launch of new products, the entry into new markets, both domestic and international, and expanding distribution channels. General and administrative expenses rose by $21 million in the second quarter of 1997 versus the second quarter of 1996 which is a slight decrease to 3.3% from 3.4% of net sales. These expenses increased $34 million in the first half of 1997 from the first half of 1996, representing a slight decrease to 3.1% from 3.5% of net sales for the comparable six month periods, which reflects management's continued efforts to control discretionary spending. The dollar increase reflects increased personnel costs necessary to support the Company's business infrastructure, as well as merger and acquisition related costs. The Company is continuously evaluating potential acquisition candidates as part of its growth strategy and incurs legal, accounting, and other related costs associated with this activity. It is management's intent to keep general and administrative costs relatively constant as a percentage of net sales; however, this goal is dependent upon the level of acquisition activity, among other factors. The amount expensed to purchased research and development in the second quarter of fiscal 1997 arose from the acquisition of the outstanding shares of Netsys. The remaining purchased research and development for the first six months of fiscal 1997 is due to the acquisition of assets and assumption of liabilities of Telebit (See Note 3). Recent Accounting Pronouncements During March 1995, the Financial Accounting Standards Board issued Statement No. 121 (SFAS No. 121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," which requires the Company to review for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In certain situations, an impairment loss would be recognized. SFAS No. 121 is effective for the Company's fiscal year 1997. The Company does not expect the adoption of SFAS No. 121 to have a material 10
11 impact on the Company's financial condition or results of operations. During October 1995, the Financial Accounting Standards Board issued Statement No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation." This statement, which establishes a fair value-based method of accounting for stock-based compensation plans, also permits an election to continue following the requirements of APB Opinion No. 25, "Accounting for Stock Issued to Employees," with disclosures on a pro forma basis of net income and earnings per share under the new method. SFAS No. 123 is effective for fiscal year 1997. The Company has elected to continue to measure compensation cost for its employee stock compensation plans using the intrinsic value-based method of accounting prescribed by APB Opinion No. 25. Pro forma disclosure of net income and earnings per share, which will be made on an annual basis, will reflect the difference between compensation cost included in net income and the related cost measured by the fair value-based method defined in SFAS No. 123, including tax effects, that would have been recognized in the consolidated statement of operations if the fair value-based method had been used. Financial Risk Management As a global concern, the Company faces exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on the Company's financial results. Historically, the Company's primary exposures related to non dollar-denominated sales in Japan, Canada, and Australia and non dollar-denominated operating expenses in Europe, Latin America, and Asia where the Company sells primarily in U.S. dollars. The Company is planning to expand its business activities in Europe. As a result, the Company expects to have exposures related to non dollar-denominated sales in several European currencies. At the present time, the Company hedges only those currency exposures associated with certain assets and liabilities denominated in non-functional currencies and does not generally hedge anticipated foreign currency cash flows. The Company maintains investment portfolio holdings of various issuers, types, and maturities. These securities are generally classified as available for sale, and consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of shareholders' equity. Part of this portfolio includes minority equity investments in several publicly traded companies, the value of which is subject to market price volatility. The Company also has certain real estate lease commitments with payments tied to short-term interest rates. Given the current profile of interest rate exposures, a sharp rise in interest rates could have a material adverse impact on the market value of the Company's investment portfolio while increasing the costs associated with its lease commitments. The Company does not currently hedge these interest rate exposures. Future Growth Subject to Risks The Company's operating performance each quarter is subject to various risks and uncertainties as discussed in the Company's Annual Report on Form 10-K for 1996 filed on October 25, 1996, and the 11
12 Company's Registration Statement on Form S-4 filed on June 7, 1996. This report on Form 10-Q should be read in conjunction with such Annual Report and Form S-4, particularly "Other Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report on Form 10-K and "Risk Factors" contained in Form S-4. The internetworking business is highly competitive, and as such, the Company's growth is dependent upon market growth and its ability to enhance its existing products and introduce new products on a timely basis. One of the ways the Company has addressed and will continue to address the need to develop new products is through acquisitions of other companies. Acquisitions involve numerous risks, including difficulties in assimilation of the operations, technologies, and products of the acquired companies; risks of entering markets in which the Company has no or limited direct prior experience and where competitors in such markets have stronger market positions; and the potential loss of key employees of the acquired company. The Company must also maintain its ability to manage any such growth effectively. In particular, this would include potential growth associated with the StrataCom acquisition. Failure to manage growth effectively and successfully integrate StrataCom or other acquisitions made by the Company could adversely affect the Company's business and operating results. The Company has essentially completed the functional integration of StrataCom. The Company is now focusing on training the sales force, and further integrating StrataCom's products and technologies into its sales channels. Although the integration has met the Company's sales expectations to date, it may be a year or more before the Company can assess the commercial success of the acquisition. The markets for the Company's products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions, and evolving methods of building and operating networks. There can be no assurance that the Company will successfully identify new product opportunities and develop and bring new products to market in a timely manner, or that products and technologies developed by others will not render Cisco's products or technologies obsolete or noncompetitive. The failure of Cisco's new product development efforts could have a material adverse effect on Cisco's business operating results and financial condition. Potential Volatility in Operating Results The Company expects that, in the future, its net sales may grow at a slower rate than was experienced in previous periods and that on a quarter-to-quarter basis, the Company's growth in net sales may be significantly lower than its historical quarterly growth rate. The Company generally has had one quarter of a fiscal year when backlog has been reduced. Traditionally, it has been the third quarter. While such a reduction has not occurred in the past two fiscal years, such reductions are extremely difficult to predict and may occur in the future. In addition, in response to customer demand, the Company has attempted to reduce its product manufacturing lead times which may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less 12
13 predictability in the Company's quarter-to-quarter net sales and operating results going forward. On the other hand, for certain products, lead times are longer than the Company's goal. If the Company can not reduce manufacturing lead times for such products, the Company's customers may cancel orders, or not place further orders if shorter lead times are available from other manufacturers, thus creating additional variability. Although sales to the service provider market have continued to grow, this market is characterized by large, and often times sporadic purchases. Sales activity in this industry depends upon their status regarding infrastructure build out, the availability of funding, and the extent that they are affected by regulatory and business conditions in the country of operations. A decline or delay in sales orders from this industry could have a material adverse effect on the Company's business operating results and financial condition. The Company conducts business on a global basis. Accordingly, the Company's future results could be adversely affected by a variety of uncontrollable and changing factors including foreign currency exchange rates, regulatory, political or economic conditions in a specific country or region, trade protection measures and other regulatory requirements, government spending patterns, and natural disasters, among other factors. In the second quarter of fiscal 1997 the Company experienced slower sales growth in Japan, France, Germany, and Italy. Any or all of these factors could have a material adverse impact on the Company's future international business in these or other countries. The Company also expects that gross margins may be adversely affected by increases in material or labor costs, heightened price competition, and changes in channels of distribution or in the mix of products sold. For example, the Company believes that gross margins may continue to decline over time, because the sales of lower margin Access and Workgroup business unit products have continued to grow at a faster rate than the Company's higher margin Core business unit products. The Company's gross margins may also be impacted by geographic mix, as well as the mix of configurations within each product group. The Company continues to expand into third-party or indirect distribution channels, which generally result in lower gross margins. In addition, increasing third-party and indirect distribution channels generally result in greater difficulty in forecasting the mix of the Company's products, and to a certain degree the timing of its orders. The Company's growth and ability to meet customer demand also depend in part on its ability to obtain timely supplies of parts from its vendors. During the second quarter, one of the Company's suppliers experienced technical problems with a component. As a result of the component problem, the Company's sales flow was impeded resulting in higher sales volume toward the end of the quarter. Although the Company works closely with its vendors to avoid these types of shortages, there can be no assurance that the Company will not encounter these problems in the future. The Company also expects that its operating margins may decrease as it continues to hire additional personnel and increases other 13
14 operating expenses to support its business. The Company plans its operating expense levels based primarily on forecasted revenue levels. Since these expenses are relatively fixed in the short-term, a shortfall in revenues could lead to operating results being below expectations. The results of operations for the second quarter of 1997 are not necessarily indicative of results to be expected in future periods, and the Company's operating results may be subject to quarterly fluctuations as a result of a number of factors. These factors include the integration of people, operations, and products from acquired businesses and technologies; increased competition in the internetworking industry; the overall trend toward industry consolidation; the introduction and market acceptance of new products, including high-speed switching and ATM technologies; variations in sales channels, product costs, or mix of products sold; the timing of orders and manufacturing lead times; and changes in general economic conditions, any of which could have a material adverse impact on operations and financial results. Risks Associated with Internet Infrastructure The Company's management believes that in the future there will be performance problems with Internet communications which could receive a high degree of publicity and visibility. As the Company is a large supplier of equipment for the Internet infrastructure, customer's perceptions of the Company's products and the marketplace's perception of Cisco as a supplier of internetworking products, whether or not these problems are due to the performance of Cisco's products, may be adversely affected, particularly as the Company migrates toward providing end-to-end solutions for its customers. Such an event could also result in an adverse effect on the market price of the Company's Common Stock and could adversely affect Cisco's business. Volatility of Stock Price The Company's Common Stock has experienced substantial price volatility, particularly as a result of variations between the Company's actual or anticipated financial results and the published expectations of analysts and as a result of announcements by the Company and its competitors. In addition, the stock market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in particular and have often been unrelated to the operating performance of any specific company. These factors, as well as general economic and political conditions, may adversely affect the market price of the Company's Common Stock in the future. LIQUIDITY AND CAPITAL RESOURCES Cash, short-term investments, and investments increased by $398 million from July 28, 1996 to January 25, 1997, primarily as a result of cash generated by operations and to a lesser extent through the exercise of employee stock options. This increase was partially offset by cash payments to Telebit Corporation shareholders and optionees for approximately $200 million, tax payments of approximately $390 million, and capital expenditures of approximately $169 million during this time. In fiscal 1996, the Company hedged 14
15 its minority equity position in a publicly traded company. The hedge expires quarterly over a period of two years which commenced in October 1996. Cash proceeds on the sales of this investment in fiscal 1997 were approximately $104 million. Accounts receivable increased 64.6% from July 28, 1996 to January 25, 1997. Days sales outstanding in receivables increased to 59 days as of January 25, 1997 from 43 days at July 28, 1996. Inventories decreased 32.4% between July 28, 1996 and January 25, 1997 which reflects the Company's continued asset management efforts. Inventory management remains an area of focus, as the Company balances the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence, due to rapidly changing technology and customer requirements. Accounts payable increased by 64.9% at January 25, 1997 over July 28, 1996 because of increases in operating expenses, and material purchases to support the growth in net sales. Other accrued liabilities increased by 7.4%, primarily due to higher deferred revenue on service contracts. At January 25, 1997, the Company had a line of credit totaling $100.0 million, which expires April 1998. There have been no borrowings under this agreement. The Company has entered into certain lease arrangements in San Jose, California, and Research Triangle Park, North Carolina, where it has established its headquarters operations and certain research and development and customer support activities, respectively. In connection with these transactions, the Company pledged $247.6 million of its investments as collateral for certain obligations of the leases. The restricted investments balance will continue to increase as the Company phases in operations at these lease sites. The Company's management believes that its current cash and equivalents, short-term investments, line of credit, and cash generated from operations will satisfy its expected working capital and capital expenditure requirements through the next year. 15
16 PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company's annual meeting of shareholders was held on November 15, 1996. The following actions were taken at this meeting: <TABLE> <CAPTION> Affirmative Negative Votes Broker Votes Votes Withheld Non-Votes ------ ----- -------- --------- a. Election of Directors <S> <C> <C> <C> <C> John T. Chambers 576,028,842 - 3,486,656 - James F. Gibbons 577,066,158 - 2,449,340 - Edward R. Kozel 575,913,735 - 3,601,763 - Richard M. Moley 576,875,312 - 2,640,186 - John P. Morgridge 576,017,327 - 3,498,171 - Robert L. Puette 576,298,912 - 3,216,586 - Masayoshi Son 577,006,159 - 2,509,339 - Donald T. Valentine 576,670,347 - 2,845,151 - Steven M. West 576,900,810 - 2,614,688 - b. Approval of the 1996 Stock Option Plan 339,224,813 148,579,505 1,536,710 90,174,470 c. Amendment to the Company's Bylaws to increase minimum and 557,363,936 2,632,156 1,472,615 18,046,791 maximum number of directors. d. Ratification of Coopers & Lybrand L.L.P. as the Company's independent accountants 578,105,944 501,478 908,076 </TABLE> ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 3.02 The Company's Restated Bylaws, as currently in effect 10.45 Employment Agreement with Don LeBeau 11.01 Computation of net income per share 27 Financial Data Schedule (b) Report on Form 8-K The Company filed one report on Form 8-K during the quarter ended January 25, 1997. The filing was on January 22, 1997. The item reported on was the acquisition of Netsys Technologies, Inc. 16
17 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Cisco Systems, Inc. Date: March 4, 1997 By /s/ LARRY R. CARTER -------------------------------- Larry R. Carter, Vice President Finance, and Chief Financial Officer (Principal Financial and Accounting Officer) 17
18 CISCO SYSTEMS, INC. EXHIBITS TO QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED JANUARY 25, 1997 <TABLE> <CAPTION> Sequentially Exhibit# Description Numbered Plan - -------- ----------- ------------- <S> <C> 3.02 Restated Bylaws of the Corporation 10.45 Employment agreement Don LeBeau 11.01 Computation of net income per share 27 Financial Data Schedule </TABLE>