Cisco Systems, Inc. — Q2 FY2017 Form 10-Q
Reporting period: Fiscal quarter and six months ended January 28, 2017. Financial statements are unaudited; comparisons are with the periods ended January 23, 2016.
Business context and financial performance
Cisco designs and sells networking and related technology products and provides associated services. Management described a challenging, competitive market, especially for Switching and next-generation routing, while prioritizing security, IoT, collaboration, data center, cloud and software/subscription offerings.
| Metric | Q2 FY2017 | Q2 FY2016 | Six months FY2017 | Six months FY2016 |
|---|---|---|---|---|
| Revenue | $11.580bn | $11.927bn | $23.932bn | $24.609bn |
| Gross margin | $7.276bn; 62.8% | $7.432bn; 62.3% | $15.160bn; 63.3% | $15.264bn; 62.0% |
| Operating income | $2.893bn; 25.0% margin | $3.294bn; 27.6% margin | $5.770bn; 24.1% margin | $6.373bn; 25.9% margin |
| Net income | $2.348bn | $3.147bn | $4.670bn | $5.577bn |
| Diluted EPS | $0.47 | $0.62 | $0.92 | $1.09 |
| Cash from operations | Not stated for the quarter | Not stated for the quarter | $6.502bn | $6.688bn |
| Free cash flow | Not stated for the quarter | Not stated for the quarter | $5.976bn | $6.112bn |
Q2 product revenue fell 5.5% to $8.491bn, while service revenue rose 4.9% to $3.089bn. For the six months, product revenue declined 5.5% and service revenue increased 6.2%. Cash and investments totaled $71.845bn at quarter-end, including $10.898bn cash and cash equivalents. Deferred revenue was $17.086bn.
Liquidity, debt and capital allocation
At January 28, 2017, current assets were $83.392bn and current liabilities were $22.708bn. Debt carrying amounts were $4.451bn short-term and $30.471bn long-term. Senior-note principal was $34.650bn; Cisco also had $300m of commercial paper outstanding. Debt rose from $28.642bn long-term carrying value at July 30, 2016, principally following a $6.25bn senior-note issuance. Cisco reported compliance with debt covenants and no borrowings on its $3bn revolving credit facility.
For the first six months, Cisco paid $2.612bn in dividends and repurchased $2.002bn of shares under its repurchase program. Management’s policy is to return at least 50% of annual free cash flow to shareholders. A $0.29-per-share dividend was declared after quarter-end. Of cash and investments, $62.3bn was held by foreign subsidiaries; repatriating it could result in additional U.S. and foreign withholding taxes. Management said available liquidity and access to capital were expected to meet requirements for at least the next 12 months.
Material changes and management commentary
- Q2 revenue declined 2.9% year over year (2% excluding the prior-year divested Service Provider Video CPE business); six-month revenue fell 2.8%. Management cited uncertainty in service-provider spending, weakness in emerging markets, competitive pressure and constrained IT spending.
- Security revenue grew 14% in Q2 and 13% for the six months; Collaboration grew 4% in Q2, and Services grew 5%. Switching declined 5% in Q2 and 6% for the six months; NGN Routing declined 10% in Q2. Service Provider Video revenue was also reduced by the prior-year divestiture.
- Q2 net income and EPS were down 25% and 24%, respectively. Management attributed much of the comparison to $519m of prior-year tax benefits and the $286m pretax gain on the SP Video CPE sale. The prior-year tax benefits included an IRS audit settlement and reinstatement of the federal R&D tax credit. The effective tax rate was 20.8% in Q2 versus 4.8% a year earlier; six-month rates were 21.1% and 13.4%.
- Gross margin improved year over year, but operating margin declined. Operating expenses included $133m of Q2 restructuring and other charges and $544m for the six months. The FY2017 restructuring plan may affect up to 5,500 employees; total pretax charges are estimated at about $700m, with substantial completion expected by fiscal year-end. Cisco plans to reinvest substantially all savings in priority areas, so material ongoing net cost savings are not expected.
- Product gross margin faced pricing and product-mix pressure. In Q2, Cisco recorded a $125m charge for expected future remediation of a clock-signal component, partly offset by a $141m reduction in an older memory-component remediation liability.
Outlook, risks and contingencies
The filing provides no specific numerical revenue or earnings guidance. Management expected continued uncertainty in the service-provider market and emerging countries and warned that results may fluctuate. Cisco expected to close its announced AppDynamics acquisition for approximately $3.7bn in cash and assumed equity awards in Q3 FY2017, and expected to repay about $4.2bn of senior notes maturing in that quarter.
Key risks include competition and pricing, technology transitions, supply constraints and memory availability, demand forecasting and inventory obsolescence, customer and financing-receivable credit risk, currency and interest-rate movements, tax uncertainty, acquisition integration, cybersecurity and intellectual-property claims. Inventory purchase commitments were $4.402bn, up from $3.896bn at fiscal year-end; management said approximately half the increase secured constrained memory supply.
Contingencies include Brazilian tax claims aggregating to $258m in asserted taxes, $1.4bn in interest and $1.2bn in penalties; Cisco disputes the claims and cannot estimate the likelihood or range of loss. A patent jury awarded SRI $23.7m, with post-trial proceedings and appeal pending. Cisco said the ultimate outcome of the Brazil matter was uncertain and did not expect the SRI matter to be material. The filing also reports $111m of six-month impairments on investments in privately held companies and $42m of purchased-intangible impairments.
Important facts for investors to verify
- Whether core product trends, particularly Switching and routing, stabilize, and whether growth in Security, Collaboration, Services and subscriptions continues.
- How operating margins and earnings develop after the prior-year divestiture gain and tax benefits, and as restructuring charges continue.
- Funding and timing for the AppDynamics acquisition and the Q3 repayment of approximately $4.2bn of maturing notes; track the effect of higher debt and interest expense.
- Liquidity available in the United States versus foreign-held cash and investments, including any tax implications of repatriation.
- Execution of the restructuring plan, constrained-component supply and the adequacy of inventory and remediation reserves.
- Developments in the Brazilian tax claims, patent litigation and customer-financing exposure.