Cisco Systems, Inc. — Q2 FY2015 Form 10-Q
Business context and reporting period. Cisco designs, manufactures, and sells IP-based networking products and related services. This unaudited report covers the three and six months ended January 24, 2015, compared with the periods ended January 25, 2014. Fiscal 2015 ends July 25, 2015.
Financial performance
| Metric | Q2 FY2015 | Q2 FY2014 | Six months FY2015 | Six months FY2014 |
|---|---|---|---|---|
| Revenue | $11.936bn | $11.155bn | $24.181bn | $23.240bn |
| Gross margin | $7.090bn; 59.4% | $5.951bn; 53.3% | $14.423bn; 59.6% | $13.358bn; 57.5% |
| Operating income | $2.622bn; 22.0% of revenue | $1.667bn; 14.9% | $4.964bn; 20.5% | $4.122bn; 17.7% |
| Net income | $2.397bn | $1.429bn | $4.225bn | $3.425bn |
| Diluted EPS | $0.46 | $0.27 | $0.82 | $0.64 |
| Cash from operations | Not separately stated | Not separately stated | $5.374bn | $5.522bn |
| Free cash flow | Not separately stated | Not separately stated | $4.824bn | $4.945bn |
Q2 revenue rose 7% year over year, with product revenue up 8% and service revenue up 5%. Six-month revenue grew 4%. Q2 product-category growth included Data Center +40%, Switching +11%, and Wireless +18%; Service Provider Video fell 19%. For the six months, Americas revenue grew 6%, EMEA grew 5%, and APJC declined 4%.
Operating cash flow was $5.374bn for the first half, down from $5.522bn. Capital expenditures were $550m, yielding company-defined free cash flow of $4.824bn, versus $4.945bn. Cash dividends paid were $1.947bn and repurchases under the buyback program were $2.221bn.
Balance sheet and liquidity
- Cash and cash equivalents plus investments totaled $53.022bn at January 24, 2015, up from $52.074bn at July 26, 2014. Cash alone was $4.797bn; investments were $48.225bn.
- Approximately $49.8bn of cash and investments was held by foreign subsidiaries; $3.2bn was available in the United States. Repatriation could incur U.S. income and foreign withholding taxes.
- Total debt carrying value was approximately $20.5bn, including $855m short-term debt and $19.667bn long-term debt. Cisco reported compliance with debt covenants and no commercial paper outstanding; its $3bn revolving credit facility was undrawn.
- Current assets were $67.882bn and current liabilities $20.034bn. Deferred revenue totaled $14.021bn, including $9.020bn service and $5.001bn product.
- Accounts receivable declined to $4.541bn from $5.157bn; DSO improved to 35 days from 38. Inventory rose to $1.890bn from $1.591bn, while annualized inventory turns fell to 10.9 from 12.7.
Material changes, unusual items, and management outlook
- The sharp year-over-year gross-margin and earnings improvement partly reflects the absence of the $655m supplier-component remediation charge recorded in Q2 FY2014. Product pricing pressures and lower service gross margin offset some improvement.
- First-half results included a $188m product cost-of-sales charge related to the Rockstar patent portfolio. A licensing transaction closed January 28, 2015, after quarter-end: Cisco paid approximately $300m, recorded against the reserve and as an intangible asset, and the participating litigation was dismissed.
- Other income benefited from a $126m gain related to restructuring Cisco’s VCE investment; Cisco reduced its ownership from 35% to 10% and wrote the investment down to zero. Q2 other income also included higher investment gains.
- Cisco recorded $56m of purchased-intangible impairment charges, primarily reflecting lower expected future cash flows from certain technology assets. The effective tax rate fell to 16.6% in Q2 and 19.3% for the half, partly due to retroactive reinstatement of the U.S. federal R&D tax credit.
- The FY2015 restructuring plan generated $387m of charges in the first half; total charges are not expected to exceed $600m, with the remainder expected during the rest of FY2015. Management plans to reinvest substantially all savings in growth areas; savings were not material in the periods reported.
- Management reported continued weakness in service-provider spending and certain emerging markets, and expected these challenges to persist for at least a few quarters. It cited solid growth in public-sector, enterprise, and commercial markets, and strong Data Center demand. The filing provides no numerical revenue or earnings guidance.
- The board declared a quarterly dividend of $0.21 per share, payable April 22, 2015. Cisco stated that available liquidity, operating cash generation, capital-market access, and credit lines should meet requirements for at least the next 12 months.
Risks and contingencies
- Brazilian tax authorities asserted claims totaling approximately $3.135bn, comprising $335m taxes, $1.3bn interest, and $1.5bn penalties. Cisco disputes the claims but said it cannot determine the likelihood of an adverse outcome or reasonably estimate any loss; resolution may take years.
- Cisco was investigating alleged Foreign Corrupt Practices Act violations involving operations and resellers in Russia and certain Commonwealth of Independent States countries, cooperating with the SEC and Department of Justice. Those countries represented less than 2% of revenue; Cisco did not expect a material adverse effect.
- Remaining supplier-component remediation liability was $613m. Financing receivables totaled $7.759bn net, with credit-loss allowance of $375m; overdue receivables and customer credit quality remain relevant exposures.
- Other risks highlighted include volatile service-provider and emerging-market demand, pricing and competitive pressure, product and supply-chain issues, inventory obsolescence, customer financing and guarantees, foreign exchange and investment-market exposure, tax uncertainty, and intellectual-property claims.
Most important facts for investors to verify
- How much of reported margin and earnings growth reflects the prior-year $655m remediation charge, and whether product pricing and service-cost trends are changing.
- Whether Data Center and other growing categories can offset weakness in Service Provider Video, service-provider demand, and APJC/China.
- The location and practical availability of Cisco’s $53.0bn cash-and-investment balance, including the tax costs of repatriation.
- Developments in the Brazil tax claims, the Russia/CIS investigation, the $613m remediation liability, and other litigation or indemnification exposures.
- Whether inventories, purchase commitments of $4.257bn, financing receivables, and deferred revenue develop consistently with demand and collections.