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CSCO > SEC Filings for CSCO > Form 10-Q on 21-May-2013All Recent SEC Filings

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Quarterly Report

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," "strives," "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.

We design, manufacture, and sell Internet Protocol ("IP") based networking and other products related to the communications and information technology ("IT") industry and provide services associated with these products and their use. We provide a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world. Our products are designed to transform how people connect, communicate, and collaborate. Our products are utilized at enterprise businesses, public institutions, telecommunications companies and other service providers, commercial businesses, and personal residences.
A summary of our results is as follows (in millions, except percentages and per-share amounts):

                                 Three Months Ended                           Nine Months Ended
                         April 27,     April 28,                     April 27,     April 28,
                           2013          2012       Variance           2013          2012       Variance

Net sales               $  12,216     $  11,588        5.4  %       $  36,190     $  34,371        5.3  %
Gross margin percentage      61.5 %        61.9 %     (0.4 )  pts        61.0 %        61.5 %     (0.5 )  pts
Research and
development             $   1,542     $   1,358       13.5  %       $   4,425     $   4,072        8.7  %
Sales and marketing     $   2,375     $   2,383       (0.3 )%       $   7,178     $   7,230       (0.7 )%
General and
administrative          $     530     $     562       (5.7 )%       $   1,674     $   1,611        3.9  %
Total R&D, sales and
marketing, general and
administrative          $   4,447     $   4,303        3.3  %       $  13,277     $  12,913        2.8  %
Total as a percentage
of revenue                   36.4 %        37.1 %     (0.7 )  pts        36.7 %        37.6 %     (0.9 )  pts
Amortization of
purchased intangible
assets                  $      89     $      96       (7.3 )%       $     329     $     292       12.7  %
Restructuring and other
charges                 $      33     $      20       65.0  %       $     105     $     225      (53.3 )%
Operating income as a
percentage of revenue        24.1 %        23.7 %      0.4    pts        23.2 %        22.4 %      0.8    pts
Income tax percentage        15.9 %        22.1 %     (6.2 )  pts         7.7 %        21.2 %    (13.5 )  pts
Net income              $   2,478     $   2,165       14.5  %       $   7,713     $   6,124       25.9  %
Net income as a
percentage of revenue        20.3 %        18.7 %      1.6    pts        21.3 %        17.8 %      3.5    pts
Earnings per
share-diluted           $    0.46     $    0.40       15.0  %       $    1.44     $    1.13       27.4  %

Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012
For the third quarter of fiscal 2013, we continued to execute on our plan to deliver profitable growth over the long term by maintaining our focus on operational excellence and portfolio management. Net sales increased 5%, with net product sales increasing 5% and service revenue increasing 7%. The net product sales increase was in large part due to our acquisition of NDS, which was completed at the beginning of fiscal 2013. Total gross margin decreased by 0.4 percentage points. Operating income as a percentage of revenue increased by 0.4 percentage points, primarily as a result of our continuing focus on expense management. Diluted earnings per share increased by 15% from the prior year period, a result of both a 14% increase in net income and a decline in our diluted share count by 69 million shares. Net income for the third quarter of fiscal 2013 benefited from a lower effective tax rate.
For the third quarter of fiscal 2013, as compared with the prior year period, net sales increased by $0.6 billion. The Americas contributed the majority of the increase led by a sales increase in the United States. APJC was flat, while EMEA experienced a slight decline.
For the third quarter of fiscal 2013, as compared with the prior year period, net product sales and service revenue increased by $0.5 billion and $0.2 billion, respectively. The product sales increase was driven by the following:
an increase of $0.3 billion from Service Provider Video products driven in large part by the acquisition of NDS at the beginning of fiscal 2013; an increase of $0.2 billion from Data Center products, due to continued strong customer demand, and an increase of $0.1 billion from Wireless products, due to continued demand for these solutions. These net product sales increases, along with the service revenue contribution, reflect, in our view, the success we are experiencing with our technology architectures and our ability to deliver customer solutions, particularly in both the enterprise and service provider data center and cloud environments.
These increases were partially offset by net product sales decreases in our Switching, Security, and Collaboration product categories. In addition, sales in our Other Products category decreased by $0.1 billion due in large part to the sale of our Linksys product line which was completed in the third quarter of fiscal 2013.
In summary, during the third quarter of fiscal 2013, we continued to execute on our plan to deliver profitable growth over the long term. We did so even as we continued to experience the global macroeconomic challenges we have faced in recent quarters including, in particular, weakness in the European economy, global public sector spending, and a conservative approach to IT-related capital spending by customers.
Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Net sales increased 5%, with net product sales increasing 4% and service revenue increasing 10%. The increase in net product sales was due in large part to our acquisition of NDS. We achieved net sales increases in our Americas and APJC geographic segments, while net sales in our EMEA geographic segment declined. Total gross margin decreased by 0.5 percentage points. As a percentage of revenue, research and development, sales and marketing, and general and administrative expenses collectively declined by 0.9 percentage points primarily due to lower sales and marketing expenses. Operating income as a percentage of revenue increased by 0.8 percentage points, primarily as a result of lower restructuring charges and our continuing focus on expense management. Diluted earnings per share increased by 27% from the prior year, a result of both a 26% increase in net income and a decline by our diluted share count of 57 million shares. A significant portion of the increase in net income was attributable to total tax benefits of $1.1 billion, primarily related to a tax settlement with the IRS, the reinstatement of the U.S. federal R&D tax credit, and lapses of the time period for assessment of tax in certain foreign jurisdictions.
Strategy and Focus Areas
Our focus continues to be on our five foundational priorities:
Leadership in our core business (routing, switching, and associated services), which includes comprehensive security and mobility solutions


Data center virtualization and cloud


Architectures for business transformation

We believe that focusing on these priorities best positions us to continue to expand our share of our customers' information technology spending.

We continue to undergo product transitions in our core business, including the introduction of next-generation products with higher price performance and architectural advantages compared with both our prior generation of products and the product offerings of our competitors. We believe that many of these product transitions are gaining momentum based on the strong year-over-year product revenue growth across these next-generation product families. We believe that our strategy and our ability to innovate and execute may enable us to improve our relative competitive position in many of our product areas even in uncertain or difficult business conditions and, therefore, may continue to provide us with long-term growth opportunities. However, we believe that these newly introduced products may continue to negatively impact product gross margins, which we are currently striving to address through various initiatives, including value engineering; effective supply chain management; and delivering greater customer value through offers that include hardware, software, and services. We continue to seek to capitalize on market transitions, which we believe will continue to come at an increasing pace. Market transitions relating to the network are becoming, in our view, more significant as intelligent networks have moved from being a mere cost center issue-that is, where the focus is on reducing network operating costs and increasing network-related productivity-to becoming, additionally and increasingly, a platform for improved revenue generation as well as driving business agility and strategy execution. Market transitions for which we are primarily focused include those related to the increased role of virtualization/the cloud, video, collaboration, networked mobility technologies, the transition from Internet Protocol Version 4 to Internet Protocol Version 6, and the Internet of Everything. For example, a market in which a significant market transition is underway is the enterprise data center market, where a transition to virtualization/the cloud is rapidly evolving. There is a continued growing awareness that intelligent networks are becoming the platform for productivity improvement and global competitiveness. We believe that disruption in the enterprise data center market is accelerating, due to changing technology trends such as the increasing adoption of virtualization, the rise in scalable processing, and the advent of cloud computing and cloud-based IT resource deployments and business models. These key terms are defined as follows:
Virtualization: Refers to the process of creating a virtual, or nonphysical, version of a device or resource, such as a server, storage device, network or an operating system, in such a way that human users as well as other devices and resources are able to interact with the virtual resource as if it were an actual physical resource. For example, one type of virtualization is server or data center virtualization, which consists of aggregating the current siloed data center resources into unified, shared resource pools that can be dynamically delivered to applications on demand, thus enabling the ability to move content and applications between devices and the network.

The cloud: Refers to an information technology hosting and delivery system in which resources, such as servers or software applications, are no longer tethered to a user's physical infrastructure but instead are delivered to and consumed by the user "on demand" as an Internet-based service, whether singularly or with multiple other users simultaneously.

This virtualization and cloud-driven market transition in the enterprise data center market is being brought about through the convergence of networking, computing, storage, and software technologies. We are seeking to take advantage of this market transition through, among other things, our Cisco Unified Computing System platform and Cisco Nexus product families, which are designed to integrate the previously siloed technologies in the enterprise data center with a unified architecture. We are also seeking to capitalize on this market transition through the development of other cloud-based product and service offerings through which we intend to enable customers to develop and deploy their own cloud-based IT solutions, including software-as-a-service ("SaaS") and other-as-a-service ("XaaS") solutions.
The competitive landscape in the enterprise data center market is changing. Very large, well-financed, and aggressive competitors are each bringing their own new class of products to address this new market. We expect this competitive market trend to continue. 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, further industry consolidation, and new alliances among companies as they seek to serve 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.
We believe that the architectural approach that we have undertaken in the enterprise data center market is adaptable to other markets. An example of a market where we aim to apply this approach is mobility, where growth of IP traffic on handheld devices is driving the need for more robust architectures, equipment and services in order to accommodate not only an increasing number of worldwide mobile device users, but also increased user demand for broadband-quality business network and consumer web applications to be delivered on such devices. A key term in this mobility-centered market transition is "BYOD," an acronym for "bring your own device," which in the context of IT usage in companies, universities, and other organizations refers to the growing trend of employees, customers, students, and others associated with such entities to bring and use their own laptop computers, smartphones, tablets or other mobile devices for their work or participation, instead of using equipment provided by the organization.

With regard to this market transition, to help such organizations meet the demands of increasing BYOD usage, our product development strategy involves a comprehensive architectural approach that will allow for, among other things, a unified security policy across the whole organization; a simplified operations and network management structure that understands application performance from a user's perspective, enhances troubleshooting capability and lowers network operating costs; and an uncompromised user experience over the organization's entire wireless and wired network that embraces use of any kind of device. Our mobility-related products and solutions reflect this architectural-based approach.
Other market transitions on which we are focusing particular attention include those related to the convergence of video, collaboration, and networked mobility technologies, which we believe will drive productivity and growth in network loads and which convergence appears to be evolving even more quickly and more significantly than we had previously anticipated. Cisco TelePresence systems are one example of product offerings that have incorporated video, collaboration, and networked mobility technologies, as customers evolve their communications and business models. More generally, we are focused on simplifying and expanding the creation, distribution, and use of end-to-end video solutions for businesses and consumers.
A market transition on which we are focusing is the move toward more programmable, flexible, and virtual networks, sometimes called Software Defined Networking, or SDN. This move to network programmability encompasses technologies such as SDN and is focused on moving from a hardware-centric approach for networking to a virtualized network environment that is designed to enable flexible, application-driven customization of network infrastructures. We believe the successful products and solutions in this market will combine application-specific-integrated-circuits ("ASICs") with hardware and software elements together to meet customers' total cost of ownership, quality, security, scalability and experience requirements. In our view, there is no single architecture that supports all customer requirements in this area. Our strategy is targeted to address a broad range of specific customer use cases, and we believe we have an effective strategy that also enables us to look to next steps that will follow the initial implementations that are underway.
We have announced our strategy to address this opportunity with the Cisco Open Network Environment, or Cisco ONE, including overlay network technology, application programming interfaces ("APIs"), and network-operation tools called agents and controllers and we have several customers in a trial phase for these solutions. In our view, this evolution is in its very early stages, but we believe we have a differentiated strategy. We intend to continue to drive internal innovation, partner for co-development, and make strategic investments to lead this evolution.
Other Key Financial Measures
The following is a summary of our other key financial measures for the third quarter and first nine months of fiscal 2013 (in millions, except days sales outstanding in accounts receivable ("DSO") and annualized inventory turns):

                                            April 27,   July 28,
                                              2013        2012
Cash and cash equivalents and investments    $47,388    $48,716
Deferred revenue                             $12,685    $12,880
DSO                                          37 days    34 days
Inventories                                  $1,469      $1,663
Annualized inventory turns                    12.4        11.7

                                                           Nine Months Ended
                                                         April 27,   April 28,
                                                           2013        2012
Cash provided by operating activities                     $8,908      $8,403
Repurchases of common stock - stock repurchase program    $1,613      $2,560
Dividends                                                 $2,392      $1,076

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 year ended July 28, 2012, as updated as applicable in Note 2 to the Consolidated Financial Statements herein, describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The accounting policies described below are significantly affected by critical accounting estimates. Such accounting policies require significant judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies.
Revenue Recognition
Revenue is recognized when all of the following criteria have been met:
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 deliverables, such as sales of products that include services, the multiple deliverables are evaluated to determine the unit of accounting, and the entire fee from the arrangement is allocated to each unit of accounting based on the relative selling price. Revenue is recognized when the revenue recognition criteria for each unit of accounting are met.
The amount of product and service revenue recognized in a given period is affected by our judgment as to whether an arrangement includes multiple deliverables and, if so, our valuation of the units of accounting for multiple deliverables. According to the accounting guidance prescribed in Accounting Standards Codification ("ASC") 605, Revenue Recognition, we use vendor-specific objective evidence of selling price ("VSOE") for each of those units, when available. We determine VSOE based on our normal pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the historical standalone transactions have the selling prices for a product or service fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical standalone transactions falling within plus or minus 15% of the median rates. When VSOE does not exist, we apply the selling price hierarchy to applicable multiple-deliverable arrangements. Under the selling price hierarchy, third-party evidence of selling price ("TPE") will be considered if VSOE does not exist, and estimated selling price ("ESP") will be used if neither VSOE nor TPE is available. Generally, we are not able to determine TPE because our go-to-market strategy differs from that of others in our markets, and the extent of our proprietary technology varies among comparable products or services from those of our peers. In determining ESP, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. We typically arrive at an ESP for a product or service that is not sold separately by considering company-specific factors such as geographies, competitive landscape, internal costs, profitability objectives, pricing practices used to establish bundled pricing, and existing portfolio pricing and discounting.
Some of our sales arrangements have multiple deliverables containing software and related software support components. Such sales arrangements are subject to the accounting guidance in ASC 985-605, Software-Revenue Recognition. As our business and offerings evolve over time, our pricing practices may be required to be modified accordingly, which could result in changes in selling prices, including both VSOE and ESP, in subsequent periods. There were no material impacts during the quarter nor do we currently expect a material impact in the next twelve months on our revenue recognition due to any changes in our VSOE, TPE, or ESP.
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 deferred revenue for products was $4.0 billion and $3.7 billion as of April 27, 2013 and July 28, 2012, respectively. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which typically is from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our deferred revenue for services was $8.7 billion and $9.2 billion as of April 27, 2013 and July 28, 2012, respectively.

We make sales to distributors and retail partners, which we refer to as two-tier systems of sales to the end customer. Revenue from distributors and retail partners is recognized 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.
Allowances for Receivables and Sales Returns The allowances for receivables were as follows (in millions, except percentages):

                                                 April 27,     July 28,
                                                   2013          2012
Allowance for doubtful accounts                 $     225     $    207
Percentage of gross accounts receivable               4.4 %        4.5 %
Allowance for credit loss - lease receivables   $     245     $    247
Percentage of gross lease receivables                 6.5 %        7.2 %
Allowance for credit loss - loan receivables    $      93     $    122
Percentage of gross loan receivables                  5.6 %        6.8 %

The allowance for doubtful accounts is based on our assessment of the collectibility of customer accounts. We regularly review the adequacy of these allowances by considering internal factors such as historical experience, credit quality and age of the receivable balances, as well as external factors such as economic conditions that may affect a customer's ability to pay and expected default frequency rates, which are published by major third-party credit-rating agencies and are generally updated on a quarterly basis. We also consider the concentration of receivables outstanding with a particular customer in assessing the adequacy of our allowances for doubtful accounts. If a major customer's creditworthiness deteriorates, 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 operating results. . . .

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