Cisco Systems, Inc. — Q1 Fiscal 2015 Form 10-Q
Reporting period: Three months ended October 25, 2014; comparable period ended October 26, 2013. Financial statements are unaudited. Dollar amounts below are in U.S. dollars.
Business context and financial performance
Cisco designs, manufactures, and sells IP-based networking products and related services. It reports geographically across the Americas, EMEA, and APJC. Revenue rose modestly, but lower gross margin, higher restructuring costs, and weaker investment gains contributed to lower operating income and net income.
| Metric | Q1 FY2015 | Q1 FY2014 | Change |
|---|---|---|---|
| Revenue | $12.245 billion | $12.085 billion | +1.3% |
| Product revenue | $9.435 billion | $9.397 billion | +0.4% |
| Service revenue | $2.810 billion | $2.688 billion | +4.5% |
| Gross margin | $7.333 billion; 59.9% | $7.407 billion; 61.3% | Margin down 1.4 points |
| Operating income | $2.342 billion; 19.1% of revenue | $2.455 billion; 20.3% | Down 4.6% |
| Net income | $1.828 billion | $1.996 billion | Down 8.4% |
| Diluted EPS | $0.35 | $0.37 | Down 5.4% |
| Effective tax rate | 22.5% | 21.4% | Up 1.1 points |
Revenue by geography: Americas $7.501 billion (+2.5%); EMEA $3.002 billion (+2.4%); APJC $1.742 billion (−5.1%). Product results were mixed: Security grew 24.7%, Data Center 15.3%, and Wireless 10.6%; Collaboration fell 9.7%, Service Provider Video 11.8%, and NGN Routing 3.8%.
Cash flow, balance sheet, debt, and liquidity
- Operating cash flow was $2.491 billion versus $2.649 billion a year earlier. Capital expenditures were $285 million; company-defined free cash flow was $2.206 billion versus $2.334 billion.
- Cash and cash equivalents were $4.387 billion, while investments were $47.720 billion, for combined cash and investments of $52.107 billion, broadly unchanged from July 26, 2014. About $48.3 billion was held by foreign subsidiaries; repatriation could trigger additional taxes.
- Total debt was approximately $20.972 billion: $1.357 billion short-term and $19.615 billion long-term. The company reported covenant compliance, no commercial paper outstanding, and no borrowings under its $3.0 billion revolving credit facility. It repaid $500 million of notes at maturity on November 17, 2014.
- Current assets were $66.396 billion and current liabilities $20.056 billion. Deferred revenue was $13.744 billion, down $398 million from fiscal year-end. Net accounts receivable fell to $4.375 billion; DSO improved to 33 days from 38.
- Inventory increased to $1.676 billion from $1.591 billion; annualized inventory turns declined to 12.0 from 12.7. Inventory purchase commitments were $4.299 billion.
- Cash dividends paid were $973 million ($0.19 per share), and $1.013 billion of shares were repurchased under the program.
Material changes, outlook, and management commentary
- Management described some improved business momentum but said service-provider spending weakness and challenges in certain emerging countries were expected to persist for at least several quarters. BRICM product revenue declined 7% collectively, with weakness in China and Russia.
- Product gross margin was pressured by pricing (2.5 percentage points) and a $188 million Rockstar patent-portfolio charge (2.0 points); productivity and product mix partly offset these effects. Service gross margin also declined, by 0.7 points.
- The August 2014 workforce restructuring generated $318 million of first-quarter charges. Total pre-tax charges under the plan are not expected to exceed $600 million, with remaining charges expected during the rest of FY2015. Cisco plans to reinvest substantially all resulting savings in growth areas, including data center, software, security, and cloud.
- No specific numerical revenue or earnings guidance is provided in the filing. Management believes available cash, investments, operating cash generation, capital-market access, and credit lines will meet liquidity needs for at least the next 12 months. Its stated capital-allocation policy is to return at least 50% of annual free cash flow to shareholders through dividends and repurchases.
- In October 2014, Cisco agreed to restructure VCE. The planned transaction includes approximately $150 million of payments to Cisco, cancellation of remaining convertible-note principal and accrued interest, and redemption of part of Cisco’s equity; ownership is expected to fall from about 35% to 10%. Closing was expected in Q2 FY2015, subject to approvals. Cisco’s VCE carrying value was $25 million after cumulative equity-method losses of $691 million.
Risks, contingencies, and unusual items
- Brazilian tax authorities asserted claims aggregating approximately $3.1 billion, comprising $348 million in taxes, $1.3 billion in interest, and $1.5 billion in penalties. Cisco disputes the claims, but cannot estimate the likelihood or range of loss; a final determination is not expected for several years.
- Cisco recorded the $188 million Rockstar-related product cost-of-sales charge in connection with a proposed patent-portfolio licensing transaction. Litigation was stayed pending negotiations; the transaction remained subject to closing conditions.
- The company continued investigating alleged potential Foreign Corrupt Practices Act violations involving Russia and certain Commonwealth of Independent States operations at the request of the SEC and Department of Justice. Cisco did not expect a material adverse financial effect; the countries represented less than 2% of revenue.
- The supplier component remediation liability was $639 million, down from $670 million at fiscal year-end, relating to certain products containing components manufactured from 2005 to 2010.
- Other exposures include customer financing and guarantees, supply-chain and inventory risk, product warranties, intellectual-property claims, restructuring execution, and possible volatility in tax provisions. A $2.0 billion unrecognized-tax-benefit balance included $1.7 billion that would favorably affect the tax rate if recognized; Cisco said up to $300 million could be resolved in the next 12 months.
Important facts for investors to verify
- Whether service-provider demand and emerging-market weakness persisted beyond the next several quarters, and whether product transitions improved.
- Whether pricing pressure, mix, and the Rockstar charge continued to affect gross margins, and whether restructuring savings offset related costs.
- Completion and final financial effects of the VCE restructuring, including note cancellation, cash proceeds, and the reduced ownership interest.
- Developments in the Brazilian tax claims, the Russia/CIS investigation, and patent litigation or licensing arrangements.
- Cash generation and shareholder returns alongside debt maturities, foreign-held liquidity and potential repatriation taxes, and financing-receivable credit quality.