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CSCO > SEC Filings for CSCO > Form 10-Q on 22-Nov-2011All 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.


A summary of our results is as follows (in millions, except percentages and
per-share amounts):

                                                                Three Months Ended
                                                October 29,          October 30,
                                                   2011                 2010              Variance
Net sales                                      $      11,256        $      10,750              4.7  %
Gross margin percentage                                 61.2 %               62.8 %            (1.6 ) pts
Research and development                       $       1,375        $       1,431              (3.9 ) %
Sales and marketing                            $       2,452        $       2,402              2.1  %
General and administrative                     $         552        $         458             20.5  %
Total R&D, sales and marketing, general
and administrative                             $       4,379        $       4,291              2.1  %
Total as a percentage of revenue                        38.9 %               39.9 %            (1.0 ) pts
Amortization of purchased intangible
assets                                         $          99        $         113             (12.4 ) %
Restructuring and other charges                $         202        $          -                 NM
Operating margin percentage                             19.6 %               21.9 %            (2.3 ) pts
Net income                                     $       1,777        $       1,930              (7.9 ) %
Net income as a percentage of revenue                   15.8 %               18.0 %            (2.2 ) pts
Earnings per share-diluted                     $        0.33        $        0.34              (2.9 ) %

Three Months Ended October 29, 2011 Compared with Three Months Ended October 30, 2010

Net sales increased 5%, with net product sales increasing 3% and service revenue increasing 12%. We achieved net sales increases across each of our geographic segments. Total gross margin declined by 1.6 percentage points primarily as a result of higher sales discounts and unfavorable product pricing and product mix shifts offset by lower manufacturing costs and higher volume. As a percentage of revenue, research and development, sales and marketing, and general and administrative expenses collectively decreased by 1.0 percentage points. Restructuring and other charges in the first quarter of fiscal 2012 totaled $202 million. Diluted earnings per share decreased by 2.9% from the prior year period, a result of a 7.9% decrease in net income, the impact of which was partially offset by a decline in our diluted share count of 268 million shares which primarily resulted from our stock repurchase program. For further details see our Results of Operations discussion beginning on page 43.

In the first quarter of fiscal 2012, we experienced improvement in our business momentum continuing from the fourth quarter of fiscal 2011. We also are beginning to achieve benefits from our restructuring and organizational changes made to simplify our operating model and to align to our five foundational priorities. For the first quarter of fiscal 2012, as compared with the first quarter of fiscal 2011, we experienced balanced revenue growth across most of our geographic segments and customer markets. In addition, we experienced positive net sales growth trends within several of our key priority areas including Collaboration, Service Provider Video, Data Center, and increased Service revenue. Our gross margin performance in the first quarter of fiscal 2012, while negative overall on a year-over-year basis, nonetheless, in our view, reflected some consistency with respect to our Switching product portfolio. Total Switching gross margins for the quarter were consistent with gross margin levels achieved in the first quarter of fiscal 2011, reflecting a return on our value engineering investments as we undergo product transitions related to our Cisco Nexus products. On a companywide basis, the gross margin impacts we experienced during the first quarter of fiscal 2012 from discounts and pricing actions were within our expected range and were partially offset by cost savings. We continue to execute on our planned $1 billion reduction to operating expenses and we believe that we are on track to meet the targets we committed to in fiscal 2011. These outcomes reflect the continued progress we are making on executing on our comprehensive action plan for growth and profitability. We continue to monitor and be cautious about the global macroeconomic environment and the impact that it may have on our business including the potential impacts from the macroeconomic challenges in Europe and the global economy, continued weakness in public sector spending, and the flooding in Thailand that occurred in the first quarter of fiscal 2012.

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In the first quarter of fiscal 2012, as we aligned our operations to support our five foundational priorities, we reorganized our geographic segments into the following segments: the Americas; Europe, Middle East, and Africa ("EMEA"); and Asia Pacific, Japan, and China ("APJC"). We have recast our reportable segment data for the periods presented to reflect such change. We continue to manage our business primarily on a geographic basis. Additionally, to better align our reporting of product revenues to our five foundational priorities, as of the first quarter of fiscal 2012, we have regrouped our product classifications. We regrouped our presentation of products and technologies (formerly grouped as Routers, Switches, New Products, and Other) into new categories called Switching, Next Generation Network (NGN) Routing, Collaboration, Service Provider Video, Wireless, Security, Data Center and Other Products.

Strategy and Focus Areas

We announced a plan in May 2011, which we began implementing in fiscal 2011 and expect to complete in fiscal 2012, to realign our sales, service and engineering organizations in order to simplify our operating model and focus 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 will best position us to continue to expand our share of our customers' information technology spending.

We are currently undergoing 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. Market transitions on which we are primarily focused include those related to the increased role of virtualization/the cloud, video, collaboration, networked mobility technologies and the transition from Internet Protocol Version 4 to Internet Protocol Version
6. For example, a market in which a significant market transition is under way 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 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.

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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.

Other market transitions on which we are focusing particular attention include those related to the increased role of video, collaboration, and networked mobility technologies. The key market transitions relative to the convergence of video, collaboration, and networked mobility technologies, which we believe will drive productivity and growth in network loads, appear 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. We are focused on simplifying and expanding the creation, distribution, and use of end-to-end video solutions for businesses and consumers.

We believe that the architectural approach that has served us well in the past in addressing market opportunities in the communications and IT industry will be 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.

Net Sales

For the first quarter of fiscal 2012, as compared with the first quarter of fiscal 2011, net sales increased by 5%. Within this increase, net product sales increased 3% and service revenue increased 12%. With regard to our geographic segment performance, on a year-over-year basis net sales increased 4% in the Americas segment, 2% in our EMEA segment, and 11% in our APJC segment. Customer market net product sales performance in the first quarter of fiscal 2012 reflected increases, in order of largest percentage growth, in the service provider, commercial, and enterprise customer markets, partially offset by a decline in sales to the public sector market.

From a product perspective, for the first quarter of fiscal 2012 as compared with the first quarter of fiscal 2011, the 3% increase in net product sales reflected growth across many of our product categories. In particular, we experienced net sales increases of 12% in Collaboration, 13% in Service Provider Video, and 107% in Data Center. In our core product categories we experienced flat net sales growth in Switching, while NGN Routing declined 3%. The growth in Service revenues for the first quarter of fiscal 2012 as compared with the first quarter of fiscal 2011 was experienced across both the technical support services category and advanced services category, with revenue increases of 11% and 17%, respectively.

Gross Margin

In the first quarter of fiscal 2012, our gross margin percentage decreased by approximately 1.6 percentage points, as compared with the first quarter of fiscal 2011. Within this total gross margin change, product gross margin declined by 2.5 percentage points, while service gross margin increased by 1.5 percentage points. The decrease in our product gross margin percentage was a result of higher sales discounts and unfavorable product pricing, and product mix shifts. Partially offsetting these decreases in product gross margin were lower overall manufacturing costs, higher shipment volume, and lower amortization expense from purchased intangible assets. The increase in our service gross margin was due to increased volume, partially offset primarily by increased costs and to a lesser degree, unfavorable mix impacts.

Operating Expenses

Total operating expenses in the first quarter of fiscal 2012 increased by 6%, as compared with the first quarter of fiscal 2011. For the first quarter of fiscal 2012, research and development expenses decreased 4%, sales and marketing expenses increased 2% and general and administrative expenses increased by approximately 21%. Operating expense as a percentage of revenue increased by 0.6 percentage points, primarily as a result of restructuring and other charges of $202 million in the current period partially offset by lower share-based compensation expense, lower acquisition-related costs, and lower expense from purchased intangible asset amortization.

Other Key Financial Measures

The following is a summary of our other key financial measures for the first quarter of fiscal 2012:

We generated cash flows from operations of $2.3 billion and $1.7 billion during the first quarter of fiscal 2012 and 2011, respectively. Our cash and cash equivalents, together with our investments, were $44.4 billion at the end of the first quarter of fiscal 2012, compared with $44.6 billion at the end of fiscal 2011.

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Our total deferred revenue at the end of the first quarter of fiscal 2012 was $12.4 billion compared with $12.2 billion at the end of fiscal 2011.

We repurchased approximately 100 million shares of our common stock at an average price of $15.37 per share for an aggregate purchase price of $1.5 billion during the first quarter of fiscal 2012. As of the end of the first quarter of fiscal 2012, the remaining authorized repurchase amount under the stock repurchase program was $8.7 billion with no termination date.

Days sales outstanding in accounts receivable (DSO) at the end of the first quarter of fiscal 2012 was 35 days, compared with 38 days at the end of fiscal 2011.

Our inventory balance was $1.6 billion at the end of the first quarter of fiscal 2012, compared with $1.5 billion at the end of fiscal 2011. Annualized inventory turns were 11.2 in the first quarter of fiscal 2012 and were 11.8 in the fourth quarter of fiscal 2011.

Critical Accounting Estimates

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended July 30, 2011, as updated as applicable in Note 2 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 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 selling price. VSOE exists across most of our product and service offerings. In certain limited circumstances 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 customization varies among comparable products or services from 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, gross margin objectives, pricing practices used to establish bundled pricing, and existing portfolio pricing and discounting.

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Some of our sales arrangements have multiple deliverables containing software and related software support components. Such sale 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 $4.1 billion and $3.7 billion as of October 29, 2011 and July 30, 2011, 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 Service was $8.3 billion and $8.5 billion as of October 29, 2011 and July 30, 2011, respectively.

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

Allowances for Receivables and Sales Returns

The allowances for receivables were as follows (in millions, except

                                                   October 29,        July 30,
                                                      2011              2011
    Allowance for doubtful accounts               $         180      $       204
    Percentage of gross accounts receivable                4.0  %           4.2  %
    Allowance for credit loss-lease receivables   $         233      $       237
    Percentage of gross lease receivables                  7.6  %           7.6  %
    Allowance for credit loss-loan receivables    $         103      $       103
    Percentage of gross loan receivables                   7.0  %           7.0  %

The allowances are 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, historical default rates, and long-term historical loss rates published by major third-party credit-rating agencies. We also consider the concentration of receivables outstanding with a particular customer in assessing the adequacy of our allowances. In addition, we evaluate the credit quality of our financing receivables and any associated allowance for credit loss by applying the relevant loss factors based on our internal credit risk rating for the respective financing receivables, disaggregated by segment and class. See Note 7 to the Consolidated Financial Statements. Determination of loss factors associated with internal credit risk ratings is complex and subjective. Our ongoing consideration of all these factors could result in an increase in our allowance for credit loss in the future, which could adversely affect our net income. Similarly, 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 revenue. Both accounts receivable and financing receivables are charged off at the point when they are considered uncollectible.

A reserve for future sales returns is established based on historical trends in product return rates. The reserve for future sales returns as of October 29, 2011 and July 30, 2011 was $119 million and $106 million, respectively, and was recorded as a reduction of our accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected.

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

Our inventory balance was $1.6 billion and $1.5 billion as of October 29, 2011 and July 30, 2011, respectively. Inventory is written down based on excess and . . .

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