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 APRIL 26, 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 of (I.R.S. Employer 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 June 2, 1997 669,090,955 shares of the Registrant's common stock were outstanding.
2 CISCO SYSTEMS, INC. FORM 10-Q FOR THE QUARTER ENDED APRIL 26, 1997 <TABLE> <CAPTION> INDEX <S> <C> <C> Page Facing sheet 1 Index 2 Part I. Financial information Item 1. Financial Statements and Supplementary Data a) Consolidated balance sheets at April 26, 1997 and July 28, 1996 3 b) Consolidated statements of operations for the three and nine month periods ended April 26, 1997 and April 28, 1996 4 c) Consolidated statements of cash flows for the nine month periods ended April 26, 1997 and April 28, 1996 5 d) Notes to consolidated financial statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Part II. Other information 18 Signature 19 Exhibits 20 </TABLE> 2
3 ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CISCO SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (In thousands) <TABLE> <CAPTION> April 26, July 28, 1997 1996 ---------------- ---------------- (Unaudited) ASSETS <S> <C> <C> Current assets: Cash and equivalents $ 345,492 $ 279,695 Short-term investments 937,583 758,489 Accounts receivable, net of allowance for doubtful accounts of $15,018 at April 26, 1997 and $21,074 at July 28, 1996 1,139,429 622,859 Inventories, net 233,505 301,188 Deferred income taxes 209,392 101,827 Prepaid expenses and other current assets 72,066 95,582 ---------------- ------------ Total current assets 2,937,467 2,159,640 Investments 1,123,825 832,114 Restricted investments 334,086 228,644 Property and equipment, net 460,389 331,315 Other assets 208,569 78,519 ---------------- ------------ Total assets $ 5,064,336 $ 3,630,232 ================ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 218,286 $ 153,683 Income taxes payable 245,967 169,894 Accrued payroll and related expenses 225,264 195,197 Other accrued liabilities 345,864 250,579 ----------------- ----------- Total current liabilities 1,035,381 769,353 Minority interest 41,230 41,257 Shareholders' equity: Preferred stock, no par value, 5,000 shares authorized: none issued or outstanding at April 26, 1997 and July 28, 1996 Common stock, no par value, 1,200,000 shares authorized: 666,033 shares issued and outstanding at April 26, 1997 and 649,284 at July 28, 1996 1,276,576 888,067 Retained earnings 2,649,323 1,777,369 Unrealized gains on marketable securities 73,703 158,848 Cumulative translation adjustments (11,877) (4,662) ----------------- ------------ Total shareholders' equity 3,987,725 2,819,622 ----------------- ------------ Total liabilities and shareholders' equity $ 5,064,336 $ 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 Nine Months Ended ---------------------------------------------------------- Apr. 26, Apr. 28, Apr. 26, Apr. 28, 1997 1996 1997 1996 ---------------------------------------------------------- (Unaudited) <S> <C> <C> <C> <C> Net sales $1,647,871 $1,087,056 $4,675,074 $2,803,857 Cost of sales 571,339 377,154 1,625,338 957,211 ------------- ---------------------------- -------------- Gross margin 1,076,532 709,902 3,049,736 1,846,646 ------------- ---------------------------- -------------- Operating expenses: Research and development 183,714 107,232 496,077 275,107 Sales and marketing 299,339 187,950 846,790 496,728 General and administrative 54,349 38,148 148,236 97,877 Purchased research and development 217,792 ------------- ---------------------------- -------------- Total operating expenses 537,402 333,330 1,708,895 869,712 ------------- ---------------------------- -------------- Operating income 539,130 376,572 1,340,841 976,934 Realized gain on sale of investment 32,288 134,695 Interest and other income, net 29,093 16,672 77,635 45,176 ------------- ---------------------------- -------------- Income before provision for income taxes 600,511 393,244 1,553,171 1,022,110 Provision for income taxes 222,190 147,595 655,449 385,337 ------------- ---------------------------- -------------- Net income $ 378,321 $ 245,649 $ 897,722 $ 636,773 ============= ============================ ============== Net income per share $ .55 $ .37 $ 1.31 $ .96 ============= ============================ ============== Shares used in per-share calculation 688,452 669,960 687,416 664,348 ============= ============================ ============== </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> Nine Months Ended ---------------------------------- April 26, April 28, 1997 1996 --------------- ------------ (Unaudited) <S> <C> <C> Cash flows from operating activities: Net income $ 897,722 $ 636,773 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 151,044 73,589 Deferred income taxes (82,459) (34,822) Tax benefit of disqualifying dispositions 140,547 140,217 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 (514,374) (173,801) Inventories 70,229 (243,029) Prepaid expenses and other current assets 23,692 (41,380) Accounts payable 64,152 116,907 Income taxes payable 75,973 64,770 Accrued payroll and related expenses 28,912 75,873 Other accrued liabilities 70,228 53,790 --------------- ------------ Net cash provided by operating activities 957,849 668,887 --------------- ------------ Cash flows from investing activities: Purchases of short-term investments (1,045,272) (472,091) Proceeds from sales and maturities of short-term investments 919,396 456,857 Purchases of investments (1,335,381) (616,963) Proceeds from sales of investments 850,949 187,433 Purchases of restricted investments (259,668) (140,754) Proceeds from sales and maturities of restricted investments 155,017 105,430 Acquisition of property and equipment (270,240) (170,789) Acquisition of Telebit Corporation, net of purchased research and development (25,189) Other (26,980) 17,420 --------------- ------------ Net cash used in investing activities (1,037,368) (633,457) --------------- ------------ Cash flows from financing activities: Issuance of common stock 152,531 81,127 Repurchase of common stock (115,610) Other (7,215) (9,882) --------------- ------------ Net cash provided by (used in) financing activities 145,316 (44,365) --------------- ------------ Net increase (decrease) in cash and equivalents 65,797 (8,935) Cash and equivalents, beginning of period 279,695 284,388 --------------- ------------ Cash and equivalents, end of period $ 345,492 $ 275,453 =============== ============ </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 April 26, 1997 and July 28, 1996 and for the three and nine month periods ended April 26, 1997 and April 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. The July 28, 1996 balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. 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 year 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. 6
7 In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows for the three and nine month periods ended April 26, 1997 and April 28, 1996, have been made. The results of operations for the period ended April 26, 1997 are not necessarily indicative of the operating results for the full year. 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"), an innovator in token ring switching technologies. 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 remaining outstanding Nashoba stock options which were converted to 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 remaining outstanding Granite stock options which were converted to 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 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 7
8 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 are 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. Research and development costs to bring the Telebit and Netsys products to technological feasibility are not expected to have a material impact on the Company's future results of operations, cash flows, or liquidity. 4. BALANCE SHEET DETAIL (In thousands) <TABLE> <CAPTION> Inventories: April 26, July 28, 1997 1996 --------------- ---------- (Unaudited) <S> <C> <C> Raw materials $ 79,690 $ 134,531 Work in process 106,047 99,723 Finished goods 17,495 51,920 Demonstration systems 30,273 15,014 --------------- ----------- $ 233,505 $ 301,188 =============== =========== </TABLE> 5. INCOME TAXES The Company paid income taxes of $514 million during the nine months ended April 26, 1997 and $227 million during the nine months ended April 28, 1996. The Company's effective tax rate for the fiscal year 1997 has been affected by the purchased research and development from the acquisition of Netsys and Telebit. The Company's income taxes currently payable for both federal and state purposes have been reduced by the tax benefit of disqualifying dispositions of stock options. The benefit is the difference between the market value of the stock issued at the time of exercise and the option price tax effected at the Company's effective tax rate. This benefit totaled $141 million in the first nine months of 1997, and was credited directly to shareholders' equity. 6. RECENT ACCOUNTING PRONOUNCEMENTS During February 1997, the Financial Accounting Standards Board issued Statement No. 128 (SFAS No. 128), "Earnings per Share," (EPS). Under SFAS No. 128 the Company will be required to change the method currently used to compute earnings per share and to restate all prior periods. The Statement modifies the standards for computing earnings per share in APB Opinion No. 15 "Earnings per Share," and makes them comparable to international EPS standards. It also replaces the 8
9 presentation of primary EPS with a presentation of basic EPS, and fully diluted EPS with diluted EPS. Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS includes the potential dilution that could occur from the exercise or conversion of securities or other contracts to issue common stock. The statement also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. SFAS No. 128 is effective for periods ending after December 15, 1997, including interim periods. The Company will adopt SFAS No. 128 in its second quarter of fiscal year 1998. 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 could cause actual results to differ from those contained in the forward-looking statements. Net sales grew to $1,648 million in the third quarter of 1997 from $1,087 million in the third quarter of 1996. Net sales for the first nine months of 1997 were $4,675 million, compared to $2,804 million in the first nine months of 1996. The 51.6% increase in net sales between the two three month periods and the 66.7% increase in net sales between the two nine month periods were primarily the result of increasing unit sales of LAN switching products such as the Catalyst 5000, remote access routers such as the Cisco 2500 product family, high end routers such as the Cisco 7500 product family, and modular access routers such as the Cisco 4700. These increases were partially offset by decreasing unit sales of the Company's older product lines, consisting of the Cisco 7000 and Cisco 4000. The sales growth rate for lower priced access and switching products targeted toward small and medium sized businesses has grown at a faster rate than the Company's high-end core router products. These products typically carry lower average selling prices, and is one factor which contributed to the slowdown in the Company's overall sequential growth rate. Additionally, the Company believes customers are awaiting the introduction of its new high-end product offerings, primarily the gigabit switch router targeted for the service provider market. As such, the Company has noted a slowing of its growth rate in its existing high-end product offerings. Sales to international customers decreased slightly to 49.6% of net sales in the third quarter of 1997, from 49.9% for the third quarter of 1996. International sales in the first nine months of 1997 were 48.7% of net sales compared with 49.8% of net sales for the same period in 1996. These decreases reflect slower sales growth in certain international 9
10 markets, particularly Japan, France, and Germany. 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 remained constant at 65.3% in the third quarter of 1997 compared with the third quarter of 1996. Gross margins for the first nine months of 1997 were 65.2% compared with 65.9% for the same period in 1996. This decrease is due to several factors including the continued shift in revenue mix to the Company's lower margin products consisting primarily of access and workgroup products for the small to medium-sized customer. These products traditionally have fewer features and less software functionality than the Company's service provider and enterprise offerings. 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. In the third quarter of fiscal 1997, component prices were relatively stable, however the Company noted some upward movement in the cost of memory chips, which was offset by improvements in manufacturing efficiencies. 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 switching products for the small to medium sized customer will continue to increase at a faster rate than the market for the Company's higher margin router and high-performance switching products. The Company is attempting to mitigate this trend through various means, such as 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 $76 million in the third quarter of 1997 over the third quarter of 1996, and increased $221 million in the first nine months of 1997 over the first nine months of 1996. This represents an increase to 11.1% from 9.9% of net sales in the quarter to quarter period and to 10.6% from 9.8% of net sales for the first nine 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 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 third quarter of fiscal 1997 increased $111 million over the third quarter of fiscal 1996, and $350 million over the first nine months of 1996. This represents slight increases to 18.2% from 17.3% of net sales in the quarter to quarter 10
11 period and to 18.1% from 17.7% of net sales for the first nine 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 $16 million in the third quarter of 1997 versus the third quarter of 1996 which is a slight decrease to 3.3% from 3.5% of net sales. These expenses increased $50 million in the first nine months of 1997 from the first nine months of 1996, representing a slight decrease to 3.2% from 3.5% of net sales for the comparable nine 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 certain 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 first nine months of fiscal 1997 arose from the acquisition of the outstanding shares of Netsys, and 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 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 11
12 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. During February 1997, the Financial Accounting Standards Board issued Statement No. 128 (SFAS No. 128), "Earnings per Share," (EPS). Under SFAS No. 128 the Company will be required to change the method currently used to compute earnings per share and to restate all prior periods. The Statement modifies the standards for computing earnings per share in APB Opinion No. 15 "Earnings per Share," and makes them comparable to international EPS standards. It also replaces the presentation of primary EPS with a presentation of basic EPS, and fully diluted EPS with diluted EPS. Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS includes the potential dilution that could occur from the exercise or conversion of securities or other contracts to issue common stock. The statement also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. SFAS No. 128 is effective for periods ending after December 15, 1997, including interim periods. The Company will adopt SFAS No. 128 in its second quarter of fiscal year 1998. 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 hedging activity undertaken by the Company is intended to offset the impact of currency fluctuations on certain non-functional currency assets and liabilities. The success of this activity depends upon forecasts of transaction activity denominated in various currencies, primarily the Japanese Yen, Canadian Dollar, Australian Dollar, and certain European currencies. To the extent these forecasts are over or understated during periods of currency volatility, the Company could experience unanticipated currency gains and losses. 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 12
13 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 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. Failure to manage growth effectively and successfully integrate acquisitions made by the Company could adversely affect the Company's business and operating results. The Company has a number of strategic partnerships with companies including GTE, Hewlett-Packard, Intel, and Microsoft. These contractual arrangements are generally limited to specific projects, the goal of which is generally to facilitate product compatibility and adoption of industry standards. If successful, these relationships will be mutually beneficial resulting in industry growth. However, these partnerships carry an element of risk because, in most cases, the Company must compete in some business areas, and at the same time cooperate with these companies in other business areas, and because if these companies fail to perform, Cisco could suffer delays in product development or other operational difficulties. Failure to manage them effectively could adversely impact the Company's business and operating results. 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. 13
14 There has been a trend toward industry consolidation for several years. In recent months, the Company has seen this trend continue, as two significant industry mergers were announced. In February 1997, 3COM and U.S. Robotics announced an agreement and plan of merger. In March 1997, Ascend Communications, Inc. and Cascade Communications Corporation announced that they had signed a definitive merger agreement. The Company expects this trend toward industry consolidation to continue, as companies attempt to strengthen or hold their market positions as the industry evolves. The Company believes that industry consolidation may provide stronger competitors that are better able to compete as sole source vendors for customers. This could lead to more variability in operating results as the Company competes to be a single vendor solution. The Company has announced that it will realign its business around three key customer groups. The three groups will include Enterprise, which will be focused on serving large corporate and institutional customers; Service Provider, which will serve telecommunications carriers, Internet service providers, and cable and wireless companies; and Small/Medium Business focused on the small and medium sized business customer. The Company believes this realignment of resources will enable it to better meet the needs of its customers. However, there are risks inherent in any business realignment and the Company can give no assurance that the realignment will meet its intended objectives. Failure to manage this transition to a new business model could have a material and adverse impact on the Company's 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. In the Company's most recent quarter, the sequential sales growth slowed from prior levels, and a disproportionate share of the sales occurred in the last month of the quarter. These occurrences are extremely difficult to predict and may happen in the future. The Company's ability to meet financial expectations could be hampered if the nonlinear sales pattern continues in future periods. 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 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 the stage of completion of expanding network infrastructures, the availability of funding, and the extent that they are affected by regulatory and 14
15 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 operating results and financial condition. Changes in domestic and international telecommunication requirements could affect the Company's sales of its products. Future changes in tariffs by regulatory agencies, or application of tariff requirements to currently untariffed services, could affect the sales of the Company's products for certain classes of customers. Additionally, in the U.S. the Company's products must comply with various Federal Communication Commission requirements and regulations. In countries outside of the U.S., the Company's products must meet various requirements of local telecommunications authorities. Changes in tariffs, or failure to obtain timely approval of products could have a material adverse effect on the Company's 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 third quarter of fiscal 1997, the Company experienced slower sales growth in Japan, France and Germany , as well as certain other parts of Europe and Asia. 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 switching products targeted toward the small to medium sized customer have continued to grow at a faster rate than the Company's higher margin router and high-performance switching products targeted toward the enterprise and service provider customers. 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. The Company has experienced component shortages in the past, which have adversely affected its operations. 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 operating expenses to support its business. The Company plans its operating 15
16 expense levels based primarily on forecasted revenue levels. As 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 third 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 Gigabit ethernet and Tag switching; 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, customers 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 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 $537 million from July 28, 1996 to April 26, 1997, primarily as a result of cash generated by operations and to a lesser extent through the exercise of employee stock options. These cash flows were partially offset by tax payments of approximately $514 million, capital expenditures of approximately $270 million and cash payments to former Telebit Corporation shareholders and optionees for approximately $200 million. In fiscal 1996, the Company hedged 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 the minority investment in fiscal 1997 were approximately $136 million. 16
17 Accounts receivable increased 82.9% from July 28, 1996 to April 26, 1997. Days sales outstanding in receivables increased to 63 days as of April 26, 1997 from 43 days at July 28, 1996. Inventories decreased 22.5% between July 28, 1996 and April 26, 1997 which reflects the Company's continued inventory 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 42.0% at April 26, 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 38.0%, primarily due to higher deferred revenue on service contracts. At April 26, 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 $334 million of its investments as collateral for certain obligations of the leases. The Company anticipates that it will occupy more leased property in the future which will require similar pledged securities, however the Company does not expect the impact of this activity to be material to liquidity. 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. 17
18 PART II. OTHER INFORMATION <TABLE> <CAPTION> ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K <S> <C> <C> (a) Exhibits 10.46 Lease Agreement between the Company and First State Realty of America, Inc., dated February 7, 1997, for the Company's site in Santa Clara, California 10.47 Lease Agreement between the Company and Berg & Berg Enterprises, Inc., dated December 31, 1996, for the Company's site in Santa Clara, California 10.48 Lease (Buildings "A" and "C") by and between SBC&D Co., Inc. and the Company, dated November 26, 1996, located in San Jose, California 10.49 Lease (Buildings "B" and "D") by and between SBC&D Co., Inc. and the Company dated November 26, 1996, located in San Jose, California 11.01 Computation of Net Income per Share 27 Financial Data Schedule (b) Reports on Form 8-K None </TABLE> 18
19 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: June 9, 1997 By /s/ Larry R. Carter --------------------------- Larry R. Carter, Vice President Finance, and Chief Financial Officer (Principal Financial and Accounting Officer) 19
20 <TABLE> <CAPTION> EXHIBIT INDEX - -------------- <S> <C> 10.46 Lease Agreement between the Company and First State Realty of America, Inc., dated February 7, 1997, for the Company's site in Santa Clara, California 10.47 Lease Agreement between the Company and Berg & Berg Enterprises, Inc., dated December 31, 1996, for the Company's site in Santa Clara, California 10.48 Lease (Buildings "A" and "C") by and between SBC&D Co., Inc. and the Company, dated November 26, 1996, located in San Jose, California 10.49 Lease (Buildings "B" and "D") by and between SBC&D Co., Inc. and the Company dated November 26, 1996, located in San Jose, California 11.01 Computation of Net Income per Share 27 Financial Data Schedule </TABLE>