Cisco Systems, Inc. — Q3 FY2017 Form 10-Q
Reporting period: Quarter ended April 29, 2017; the unaudited filing also reports the nine months ended that date. Q3 FY2017 had 13 weeks, versus 14 weeks in the comparable prior-year quarter, an important factor in year-over-year comparisons.
Financial performance
| Metric | Q3 FY2017 | Q3 FY2016 | Nine months FY2017 | Nine months FY2016 |
|---|---|---|---|---|
| Revenue | $11.94 billion | $12.00 billion | $35.87 billion | $36.61 billion |
| Gross margin | $7.52 billion; 63.0% | $7.72 billion; 64.3% | $22.68 billion; 63.2% | $22.99 billion; 62.8% |
| Operating income | $3.17 billion; 26.5% of revenue | $2.98 billion; 24.9% | $8.94 billion; 24.9% | $9.36 billion; 25.6% |
| Net income | $2.52 billion | $2.35 billion | $7.19 billion | $7.93 billion |
| Diluted EPS | $0.50 | $0.46 | $1.42 | $1.56 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $9.88 billion | $9.75 billion |
Q3 revenue declined 0.5% (reported by management as a 1% decrease); product revenue was nearly flat and service revenue declined 2%. Management estimated the prior-year extra week added about $265 million of revenue, including $200 million from services and $65 million from SaaS and a small amount from product distribution. Nine-month revenue declined 2%; product revenue fell 3.7%, while service revenue grew 3.2%.
Nine-month free cash flow, defined by Cisco as operating cash flow less property and equipment purchases, was $9.12 billion, compared with $8.87 billion. Capital expenditures were $756 million. Cash dividends paid were $4.06 billion, and stock repurchases under the program were $2.51 billion during the nine months.
Financial position and material changes
- At April 29, 2017, cash and cash equivalents were $8.12 billion and investments were $59.86 billion, totaling $67.97 billion. Of this combined amount, $65.1 billion was held by foreign subsidiaries and $2.9 billion was available in the United States; repatriation could result in additional U.S. and foreign withholding taxes.
- Total assets were $125.95 billion; current assets were $79.96 billion and current liabilities were $22.72 billion. Deferred revenue increased to $17.32 billion from $16.47 billion at July 30, 2016, including a 57% increase in deferred product revenue from recurring software and subscription businesses to $4.35 billion.
- Balance-sheet debt was approximately $32.47 billion, comprising $4.25 billion short-term and $28.22 billion long-term. Senior notes had $30.5 billion principal outstanding and Cisco had $2.0 billion of commercial paper outstanding. Cisco repaid $4.15 billion of notes at maturity and issued $6.25 billion of notes in September 2016. Debt covenants were met; revolving credit facilities totaling $5.0 billion were undrawn.
- Product gross margin was 61.7% in Q3, down 2.1 percentage points year over year, primarily due to pricing, a lower supplier-remediation adjustment and product mix. Service gross margin rose to 66.7%. For the nine months, total gross margin improved 0.4 percentage points, partly reflecting the prior-year sale of the lower-margin SP Video CPE business.
- Q3 net income increased 7.1% and diluted EPS increased 8.7%; nine-month net income and diluted EPS fell 9.3% and 9.0%, respectively. The nine-month comparison was affected by a higher effective tax rate (21.1% versus 16.8%); the prior-year period included tax benefits from an IRS settlement and reinstatement of the federal R&D tax credit.
Business trends, outlook and risks
- Management described a challenging, competitive environment, with weakness in service provider demand and emerging markets. It reported Q3 growth in Wireless (13%) and Security (9%), while Data Center, Collaboration, NGN Routing and Service Provider Video declined. For the nine months, Security grew 11.6% and Wireless 4.5%; Service Provider Video fell 51.5%, including the effect of the divested business.
- Cisco said it was continuing to invest in security, IoT, collaboration, next-generation data center, cloud and software, while maintaining its routing, switching and services businesses. It is transitioning toward more software and subscription revenue. Recurring software and subscription deferred product revenue grew 57% year over year, including AppDynamics; excluding AppDynamics it grew 51%.
- The filing gives no clear numerical revenue or earnings guidance for the next quarter or full year. Management expects continued uncertainty in the service provider market and described the overall operating environment as uncertain. It stated that available liquidity, operating cash generation, capital-market access and committed credit lines should meet requirements for at least the next 12 months.
- The FY2017 restructuring plan was extended in May 2017 to cover an additional 1,100 employees and an estimated $150 million of pretax charges. Aggregate estimated charges rose to about $850 million; $614 million had been incurred in the first nine months. The plan was expected to be substantially complete by the end of Q1 FY2018, with savings substantially reinvested in priority areas rather than expected to produce material net cost savings.
- Acquisitions included AppDynamics, completed March 17, 2017, for purchase consideration of $3.26 billion, and CloudLock. A proposed Viptela acquisition for approximately $610 million was announced May 1, 2017 and was expected to close in the second half of calendar 2017.
- Unusual items included $73 million of impairment charges on publicly traded equity securities and $42 million of purchased-intangible impairment charges during the first nine months. Goodwill rose to $29.52 billion, largely due to acquisitions; no goodwill impairment was reported for the period.
- Key exposures include supply constraints and higher component costs, inventory and purchase commitments, competition and pricing pressure, customer and financing-receivable credit risk, investment and interest-rate volatility, taxes on repatriated foreign funds, and the execution and integration risks of acquisitions and restructuring.
Contingencies and legal matters
- Brazilian federal and São Paulo authorities asserted claims against Cisco’s subsidiary for alleged import-tax matters: $255 million in taxes, $1.5 billion in interest and $1.2 billion in penalties. Cisco disputed the claims, but said it could not assess the likelihood of an adverse outcome or reasonably estimate any loss; resolution could take several years.
- In a Sprint patent case, a jury awarded $139.8 million against Time Warner Cable; Cisco may have partial indemnification exposure if the judgment is upheld. Cisco could not estimate its ultimate obligation and said it did not anticipate a material final obligation. A separate SRI patent jury verdict awarded $23.7 million; post-trial proceedings and a planned appeal remained pending. In an SSL case, the PTAB found the asserted patent claims unpatentable, subject to appeal.
- Other commitments include $4.72 billion of inventory purchase commitments, $1.16 billion of future minimum operating-lease payments, and up to $222 million of estimated future acquisition-related cash compensation. Cisco also disclosed $170 million of funding commitments to unconsolidated variable-interest entities.
Important facts for investors to verify
- Assess whether reported growth and margin comparisons remain favorable after accounting for the prior-year extra week and the SP Video CPE divestiture.
- Track product pricing, service provider and emerging-market demand, and whether growth in Security, Wireless and subscription offerings offsets weakness elsewhere.
- Monitor deferred subscription revenue conversion, cash generation, foreign-held liquidity and the practical cost of accessing offshore funds.
- Review debt levels and maturities alongside continued dividends, repurchases, acquisition spending and the planned Viptela transaction.
- Follow restructuring charges and execution, component availability and purchase commitments, and the outcomes or developments in the Brazil and patent matters.