Cisco Systems, Inc. — Q3 Fiscal 2014 Form 10-Q
Reporting period: Three and nine months ended April 26, 2014. Financial statements are unaudited. Dollar amounts are in millions unless stated otherwise.
Business context and results
Cisco designs, manufactures, and sells IP networking and related communications and IT products, and provides associated services. Revenue continued to face weakness in product sales, particularly among service providers and emerging markets; services grew modestly.
| Metric | Q3 FY2014 | Q3 FY2013 | Nine months FY2014 | Nine months FY2013 |
|---|---|---|---|---|
| Revenue | $11,545 | $12,216 | $34,785 | $36,190 |
| Gross margin | $7,006; 60.7% | $7,511; 61.5% | $20,364; 58.5% | $22,093; 61.0% |
| Operating income | $2,542; 22.0% of revenue | $2,942; 24.1% | $6,664; 19.2% | $8,382; 23.2% |
| Net income | $2,181 | $2,478 | $5,606 | $7,713 |
| Diluted EPS | $0.42 | $0.46 | $1.06 | $1.44 |
| Cash from operating activities | Not separately stated | Not separately stated | $8,720 | $8,908 |
Liquidity, debt, and capital allocation
- At April 26, 2014, cash, cash equivalents, and investments totaled $50,469, versus $50,610 at July 27, 2013. Of the current total, $45.9 billion was held by foreign subsidiaries and $4.6 billion was available in the United States; repatriation of foreign funds could incur additional taxes.
- Debt carrying value was approximately $20.9 billion, compared with $16.2 billion at fiscal year-end. Cisco issued $8.0 billion of senior notes in March and repaid $3.3 billion of maturing notes; no commercial paper was outstanding. The company reported covenant compliance and no borrowings on its $3.0 billion revolving credit facility.
- Nine-month free cash flow, as defined by Cisco (operating cash flow less property and equipment purchases), was $7,770, versus $8,065 a year earlier. Capital expenditures were $950.
- Nine-month cash uses included $8,025 of stock repurchases, $2,784 of dividends, and $2,784 of net cash paid for acquisitions. Dividends declared were $0.53 per share for the nine months, up from $0.45.
- Management said available liquidity, operating cash generation, capital-market access, and committed credit lines were expected to meet liquidity needs for at least the next 12 months.
Material changes and management commentary
- Q3 revenue fell 5.5% year over year: product revenue declined 7.7% to $8,820, while service revenue rose 2.6% to $2,725. For the nine months, product revenue fell 5.8% and service revenue grew 3.1%.
- Q3 declines were broad-based: Service Provider Video fell 26%, NGN Routing 10%, Switching 6%, and Collaboration 12%. Data Center grew 29% and Security 10%. APJC revenue fell 8.7%, with notable product weakness in India, Australia, and Russia across relevant regions and markets.
- Management attributed pressure to reduced service-provider spending, weakness in emerging countries, early-stage product transitions, cautious customer IT-capital spending, pricing, and product mix. It said these challenges in emerging countries, the service-provider market, Switching, and NGN Routing could persist for at least several quarters.
- Q3 gross margin declined 0.8 percentage points, primarily from pricing and mix, partly offset by productivity improvements. Nine-month product gross margin was also affected by a $655 charge for remediation of memory-component failures in previously sold products.
- Nine-month net income and EPS were also affected by the higher effective tax rate: 19.2% versus 7.7% a year earlier. Cisco attributed much of the comparison to a fiscal 2013 net tax benefit from an IRS settlement; fiscal 2014 also included a tax charge for nondeductible compensation.
Guidance, unusual items, and risks
- No specific numerical revenue or earnings guidance is provided in the supplied filing text. Management expects certain market and product-category challenges to continue for at least several quarters and described its strategic priorities as core networking and services, collaboration, data center and cloud, video, and business-transformation architectures.
- The August 2013 workforce-rebalancing plan targets up to 4,000 employees, about 5% of the workforce. Nine-month charges were $336; total pretax charges were not expected to exceed $500, with substantially all remaining charges expected in Q4 FY2014. Cisco did not expect significant overall savings because resources would be reinvested in growth areas.
- The Insieme acquisition generated $363 of nine-month compensation expense related to potential milestone payments; total compensation expense under the arrangement could reach approximately $856, net of forfeitures. Payments, if earned, are expected primarily in FY2016 and FY2017.
- The supplier-component remediation liability was $702 at quarter-end after the $655 second-quarter charge. Further costs may differ from estimates as claims and service costs develop.
- Contingencies include Brazilian tax claims totaling approximately $3.4 billion (about $389 of asserted taxes, $1.3 billion interest, and $1.7 billion penalties). Cisco disputes the claims, but cannot estimate the likelihood or range of loss. The company is also investigating possible FCPA issues involving Russia and certain CIS operations, cooperating with the SEC and DOJ; it did not expect a material adverse effect. Rockstar patent litigation has uncertain outcomes; the filing also describes an appeal in XpertUniverse and reports the VirnetX matter as final in Cisco’s favor on infringement.
- Other risks highlighted include ongoing pricing and competitive pressure, exposure to customer and financing-receivable credit risk, supply-chain constraints and inventory obsolescence, product-quality and warranty costs, acquisition integration, tax uncertainty, and market-value and interest-rate exposure.
Important facts for investors to verify
- Whether revenue trends improve in service-provider and emerging markets, and whether product transitions support growth in core routing and switching.
- Whether pricing, product mix, and the $655 remediation issue continue to pressure gross margin or require additional charges.
- How much of the potential Insieme milestone compensation is ultimately recognized and paid, and whether restructuring charges remain within the stated ceiling.
- Debt maturity, interest-rate exposure, and the availability and tax implications of foreign-held liquidity, alongside continued repurchases and dividends.
- Developments in the Brazilian tax claims, FCPA investigation, and patent proceedings, including any change in estimated exposure or legal status.