Cisco Systems, Inc. — FY2017 Form 10-K
Reporting period: Fiscal year ended July 29, 2017; the fourth quarter ended the same date. FY2017 comprised 52 weeks versus 53 weeks in FY2016. Amounts are U.S. dollars unless stated otherwise.
Business context
Cisco designs and sells networking, security, collaboration, data-center, wireless, service-provider video, and related products and services worldwide. It reports three geographic segments: Americas, EMEA, and APJC. Management’s strategy emphasizes intent-based networking, security, cloud, software, and subscription offerings, while maintaining its core routing and switching businesses.
Financial performance
| Metric | FY2017 | FY2016 | Change |
|---|---|---|---|
| Revenue | $48.005 billion | $49.247 billion | Down 2.5% |
| Product revenue | $35.705 billion | $37.254 billion | Down 4.2% |
| Service revenue | $12.300 billion | $11.993 billion | Up 2.6% |
| Gross margin | $30.224 billion; 63.0% | $30.960 billion; 62.9% | Margin up 0.1 percentage point |
| Operating income | $11.973 billion; 24.9% of revenue | $12.660 billion; 25.7% | Down 5%; margin down 0.8 point |
| Net income | $9.609 billion | $10.739 billion | Down 10.5% |
| Diluted EPS | $1.90 | $2.11 | Down 10.0% |
| Operating cash flow | $13.876 billion | $13.570 billion | Up $306 million |
| Free cash flow* | $12.912 billion | $12.424 billion | Up $488 million |
Q4 FY2017: Revenue was $12.133 billion, down 4% year over year; gross margin was 62.2%, down 0.9 percentage point; operating margin was 25.0%, down 1.1 points; net income was $2.424 billion, down 13.8%; and diluted EPS was $0.48, down 14.3%.
Liquidity and debt: Cash, cash equivalents, and investments totaled $70.492 billion, up from $65.756 billion. Total debt was approximately $33.7 billion, including $30.5 billion in senior notes and $3.2 billion in commercial paper; FY2016 total debt was $28.6 billion. Cash and investments held by foreign subsidiaries were $67.5 billion, versus $3.0 billion available in the United States. Cisco reported $18.494 billion in deferred revenue, up 12%. Management said available liquidity, operating cash generation, capital-market access, and credit facilities should meet requirements for at least the next 12 months.
Capital returns: Cisco paid $5.511 billion in dividends and repurchased $3.706 billion of shares under its repurchase program in FY2017. The annual dividend declared per share rose to $1.10 from $0.94. The company’s stated capital-allocation policy is to return at least 50% of annual free cash flow to shareholders through dividends and repurchases.
Material changes and drivers
- Reported revenue fell 2.5%; management said the decline was about 2% excluding FY2016 SP Video CPE revenue. FY2017 also had one fewer week; Cisco estimated the extra FY2016 week contributed about $265 million in revenue.
- Product revenue fell, while service revenue grew. Switching declined 5.1%, NGN Routing 3.7%, Data Center 4.1%, Collaboration 1.7%, and Service Provider Video 45.4%. Security grew 9.3% and Wireless 4.8%.
- Weakness in service-provider spending, emerging markets, and the competitive environment weighed on results. Americas revenue declined 3.5%, EMEA declined 2.4%, and APJC grew 1.3%.
- Overall gross margin was nearly flat year over year, but product gross margin slipped to 61.6% from 62.0%, reflecting pricing and mix pressures and higher memory-component costs. Service gross margin improved to 66.8% from 65.6%.
- Net income and EPS were also affected by the higher effective tax rate: 21.8% versus 16.9%. FY2016 included $593 million of tax benefits, including an IRS settlement and the reinstated federal R&D tax credit.
- Deferred revenue from recurring software and subscription offers increased 50% to $4.971 billion. Total deferred revenue increased by $2.022 billion, supporting the shift toward recurring revenue.
- Inventory rose 33% to $1.616 billion; purchase commitments with contract manufacturers and suppliers rose 19% to $4.640 billion. Cisco cited efforts to secure constrained memory supply; annualized inventory turns fell to 12.3 from 14.6.
Outlook, commentary, risks, and unusual items
- Outlook: The filing provides no specific numerical revenue or earnings guidance. Management described the operating environment as challenging and uncertain, particularly for service providers and emerging markets, and said higher memory-component costs were expected to affect productivity in the near term. Cisco intends to reinvest substantially all expected savings from its restructuring in priority areas, so material net cost savings are not expected.
- Restructuring: The FY2017 plan could affect up to 6,600 employees and carries estimated pretax charges of about $850 million. Cisco recorded $756 million in FY2017 and expected the plan to be substantially completed by the end of FY2018’s first quarter.
- Product remediation: Cisco recorded a $125 million FY2017 charge for anticipated failures of a widely used third-party component. It also reduced a prior supplier-component remediation liability by $141 million; related liabilities totaled $174 million at year-end.
- Acquisitions: FY2017 included seven acquisitions, with total purchase consideration of $3.637 billion, notably AppDynamics ($3.258 billion), CloudLock, and MindMeld. Cisco completed its Viptela acquisition for approximately $610 million on July 31, 2017, after fiscal year-end.
- Contingencies: Brazilian tax authorities asserted claims totaling $258 million in taxes, $1.5 billion in interest, and $1.2 billion in penalties. Cisco disputes the claims, but said it could not determine the likelihood or estimate a loss range; resolution may take several years. Cisco also disclosed patent and other litigation, generally stating it did not expect material adverse effects, while noting uncertainty in outcomes.
- Key risks: Demand and quarterly revenue variability; service-provider and emerging-market weakness; intense price and technology competition; transition to software and subscriptions; supply constraints and inventory exposure; cybersecurity and product-quality issues; foreign exchange and geopolitical risks; acquisition execution; tax uncertainty; and debt obligations. Cisco had $71.1 billion of foreign subsidiary earnings intended for indefinite reinvestment; repatriation could trigger additional taxes.
- Accounting change: Cisco planned to adopt the new revenue-recognition standard in FY2019 using the modified retrospective method. The company expected accelerated recognition for certain term software licenses, enterprise license agreements, and two-tier distributor sales, but did not expect a material impact on total revenue in the adoption year based on its preliminary assessment.
- Audit and controls: PwC issued an unqualified opinion on the consolidated financial statements and concluded internal control over financial reporting was effective as of July 29, 2017.
*Free cash flow is a non-GAAP measure defined by Cisco as operating cash flow less purchases of property and equipment.
Important facts for investors to verify
- Whether the reported revenue decline persists after adjusting for the extra FY2016 week and the sold SP Video CPE business, and whether core switching and routing demand stabilizes.
- Whether security, wireless, subscriptions, and software growth can offset pressure in legacy product categories—and how recurring-revenue growth affects margins and cash conversion.
- Whether memory supply constraints, elevated inventory and purchase commitments, and lower inventory turns create further margin or obsolescence risk.
- How the restructuring’s $850 million estimated charges and reinvestment plan affect operating expenses, execution, and future profitability.
- How Cisco will fund shareholder returns and upcoming debt maturities given rising debt and the concentration of cash and investments offshore.
- Developments in the Brazilian tax dispute, material litigation and indemnification exposures, and the tax consequences of any repatriation or changes in tax incentives.