Cisco Systems, Inc. — Form 10-Q Summary
Reporting period: Second quarter and first six months of fiscal 2014, ended January 25, 2014. Unaudited; comparisons are with the corresponding periods ended January 26, 2013 unless noted. Amounts are in U.S. dollars.
Business context and performance
Cisco designs, manufactures, and sells networking and communications products and related services. It reports geographically across the Americas, EMEA, and APJC. Management’s stated priorities include core routing and switching, collaboration, data center and cloud, video, and business-transformation architectures.
| Metric | Q2 FY2014 | Q2 FY2013 | Six months FY2014 | Six months FY2013 |
|---|---|---|---|---|
| Revenue | $11.155B | $12.098B | $23.240B | $23.974B |
| Gross margin | $5.951B; 53.3% | $7.343B; 60.7% | $13.358B; 57.5% | $14.582B; 60.8% |
| Operating income | $1.667B; 14.9% of revenue | $2.789B; 23.1% | $4.122B; 17.7% | $5.440B; 22.7% |
| Net income | $1.429B | $3.143B | $3.425B | $5.235B |
| Diluted EPS | $0.27 | $0.59 | $0.64 | $0.98 |
- Q2 revenue fell 7.8% year over year: product revenue declined 10.7% to $8.423B, while service revenue increased 2.7% to $2.732B. For the six months, revenue fell 3.1%; product revenue declined 4.9% and service revenue rose 3.4%.
- Q2 product gross margin was 48.7%, down from 59.1%; service gross margin was 67.8%, up from 66.3%. For the six months, product gross margin was 54.7% versus 59.4%, and service gross margin was 66.6% versus 65.9%.
- Product-category contrasts: Q2 Data Center revenue grew 10% and Security grew 17%, while Switching fell 12%, NGN Routing 11%, and Service Provider Video 22%. Sourcefire acquisition revenue contributed to Security growth.
Cash flow, liquidity, and debt
- Six-month operating cash flow was $5.522B, compared with $5.814B; capital expenditures were $577M, yielding company-defined free cash flow of $4.945B versus $5.262B.
- At January 25, cash and cash equivalents were $5.339B and investments were $41.726B, totaling $47.065B, down from $50.610B at fiscal year-end. Approximately $43.8B was held by foreign subsidiaries and $3.3B was available in the United States; repatriation could trigger additional taxes.
- Current assets were $60.689B and current liabilities $22.944B. Deferred revenue totaled $13.244B. Accounts receivable was $4.378B; days sales outstanding improved to 36 from 40 at fiscal year-end.
- Short- and long-term debt totaled $17.147B on the balance sheet, including $1.0B of commercial paper. Senior notes had $16.0B principal outstanding. Cisco reported covenant compliance and no borrowings under its $3.0B revolving credit facility.
- Cash uses in the first six months included $5.680B of share repurchases, $1.810B of dividends, $2.784B of net cash for acquisitions, and $577M of capital expenditures. The board declared a quarterly dividend of $0.19 per share for payment in April 2014.
Material changes, outlook, and unusual items
- Management attributed the revenue decline to weaker product orders, particularly in emerging markets and among service providers, customer caution on IT capital spending, and product transitions in switching and routing. BRICM product revenue declined 13% in Q2. Management said these challenges could persist for at least several quarters.
- Cisco said it expected revenue and EPS to decline year over year in Q3 FY2014; the filing text provided here does not state specific Q3 guidance figures.
- A $655M product cost-of-sales charge for remediation of failures involving memory components in products sold during 2005–2010 reduced Q2 gross margin by 5.9 percentage points. Cisco expanded its remediation response after observing a growing number of customer failures; the ultimate cost depends on claims and servicing costs.
- Revenue and earnings also reflected acquisition-related items. Cisco completed five acquisitions in the six months, including Sourcefire for $2.449B and WhipTail for $351M. It recorded $311M of compensation expense related to acquiring the remaining interest in Insieme; up to approximately $863M could ultimately be recorded under the arrangement, with milestone payments expected primarily in FY2016 and FY2017.
- The August 2013 workforce plan targets up to 4,000 employees, or 5% of the workforce. Cisco recorded $310M of restructuring charges in the first six months and expected total charges not to exceed $550M. Management did not expect significant overall cost savings because resources would be reinvested in growth areas.
- Prior-year comparisons were affected by $926M of tax benefits recognized in Q2 FY2013, primarily from an IRS audit settlement and reinstatement of the federal R&D tax credit. Q2 effective tax rates were 18.6% in FY2014 and (13.1)% in FY2013.
- Notable contingencies include Brazilian tax claims of approximately $360M in alleged taxes, $1.1B in interest, and $1.6B in penalties; Cisco disputes the claims and cannot estimate the likelihood or range of loss. Cisco was also cooperating with SEC and DOJ investigations into possible FCPA violations involving Russia and certain CIS operations. The filing describes patent matters, including an appeal by XpertUniverse after the $70M fraud verdict was vacated.
Most important facts for investors to verify
- Whether product demand, especially in service-provider and emerging markets, stabilizes and whether Q3 revenue and EPS meet management’s stated year-over-year decline expectation.
- Whether the memory-component remediation charge proves sufficient, and whether additional costs or customer claims arise.
- How much of the reported earnings decline reflects operating performance versus the prior-year tax benefit, restructuring, and Insieme compensation expense.
- Whether acquisition-related milestone compensation, planned debt refinancing, and shareholder returns affect cash balances and leverage, particularly given the concentration of cash and investments overseas.
- Developments in the Brazilian tax claims and Russia/CIS investigations, and any resulting financial or reputational consequences.