Cisco Systems, Inc. — Q2 FY2012 Form 10-Q
Reporting period: Three and six months ended January 28, 2012. Financial statements are unaudited. Fiscal 2012 is a 52-week year. Unless noted otherwise, amounts are in U.S. dollars.
Financial performance
| Metric | Q2 FY2012 | Q2 FY2011 | Six months FY2012 | Six months FY2011 |
|---|---|---|---|---|
| Net sales | $11.527B | $10.407B | $22.783B | $21.157B |
| Gross margin | $7.065B; 61.3% | $6.261B; 60.2% | $13.955B; 61.3% | $13.016B; 61.5% |
| Operating income | $2.734B; 23.7% margin | $1.684B; 16.2% margin | $4.944B; 21.7% margin | $4.035B; 19.1% margin |
| Net income | $2.182B | $1.521B | $3.959B | $3.451B |
| Diluted EPS | $0.40 | $0.27 | $0.73 | $0.61 |
| Operating cash flow | $3.1B, per MD&A | Not stated for Q2 | $5.434B | $4.276B |
Q2 sales rose 10.8% year over year; product sales increased 10.7% and service revenue 11.0%. For the first six months, sales grew 7.7%, with product up 6.7% and service up 11.7%. Q2 effective tax rate was 20.6% versus 12.1%; the six-month rate was 20.7% versus 16.9%.
Liquidity, debt and capital allocation
- At January 28, cash and cash equivalents were $8.561B and investments were $38.181B, totaling $46.742B, compared with $44.585B at July 30, 2011. Management said $41.7B of cash and investments was held by foreign subsidiaries; repatriation could incur additional U.S. and foreign taxes.
- Current assets were $59.298B and current liabilities $17.598B. Total debt was approximately $16.904B: $605M short-term and $16.299B long-term. Long-term debt principal was $16.0B; its disclosed fair value was $18.3B. Cisco reported compliance with debt covenants.
- Operating cash flow for the first six months was $5.434B. Investing activities used $2.085B and financing activities used $2.450B; cash and cash equivalents increased $899M.
- Cisco repurchased 126M shares for $2.010B in the first six months; $8.2B remained authorized under the repurchase program. It paid $644M in dividends during the period. A quarterly dividend of $0.08 per share was declared in February, up from $0.06.
- After quarter-end, Cisco entered into a new $3.0B unsecured revolving credit facility, scheduled to expire in 2017; it had not been drawn as of February 21, 2012.
Material changes and business drivers
- Q2 operating margin improved 7.5 percentage points and diluted EPS rose 48% year over year. Management attributed the performance to higher sales, lower manufacturing costs, expense reductions and the absence of prior-year intangible-asset impairment charges. The prior-year six-month period included approximately $155M of such impairment charges.
- For the first six months, gross margin declined 0.2 percentage points, principally reflecting discounts, unfavorable pricing and product mix, partly offset by lower manufacturing costs and lower amortization/impairment charges. Lower-margin Data Center and Service Provider Video products affected product mix.
- Q2 sales increased across all geographic segments: Americas 9%, EMEA 15%, and APJC 11%. Product growth was particularly strong in Data Center (88% in Q2; 96% for six months), Service Provider Video (23%; 18%), Wireless (25%; 17%), and Security (24%; 17%). “Other” product sales declined, primarily following Cisco’s exit from consumer product lines.
- Management said it achieved its target to reduce the annualized operating expense run rate by approximately $1B—measured against Q4 FY2011—one quarter ahead of schedule. Cisco remained focused on core routing, switching and services, as well as collaboration, data center/cloud, video and business-transformation architectures.
- Restructuring charges were $205M for the first six months, including $179M for employee severance and $26M for other costs. Cumulative charges under the July 2011 restructuring actions were $926M; management expected total pretax charges of approximately $1B, with remaining charges expected in the second half of FY2012.
Outlook, risks and contingencies
The filing provides no specific numerical revenue or earnings guidance. Management said available cash, investments, operating cash generation and access to capital were expected to meet liquidity needs for at least the next 12 months. It expected DSO to range from 30 to 40 days. Management described continued momentum across geographic segments and product priorities, while cautioning that global macroeconomic conditions, Europe, public-sector weakness and cautious customer IT spending could weigh on results. It also noted that new products and lower-margin sales could pressure product margins.
- Supply chain and demand: Component constraints tied to Japan’s earthquake and Thailand’s flooding could continue for several quarters. Purchase commitments were $4.192B; inventory was $1.590B. Lower-than-forecast demand or product obsolescence could cause write-downs and margin pressure.
- Customer and financing exposure: Net financing receivables were $7.019B. Financing guarantees had maximum potential payments of $600M, or $136M net of associated deferred revenue. Management said historical losses on financing receivables had been immaterial, but customer credit deterioration could increase losses.
- Legal matters: Brazilian tax authorities asserted claims totaling approximately $464M in taxes, $1.0B in interest and $2.2B in penalties. Cisco disputed liability, but could not estimate the likelihood or range of loss; a final judicial decision was not expected for several years. Securities class-action and derivative litigation was also pending; Cisco said it could not estimate a loss range for the class action.
- Tax and unusual items: The prior-year effective tax rate benefited from retroactive reinstatement of the U.S. R&D tax credit, which expired December 31, 2011. Cisco disclosed $3.0B of unrecognized tax benefits and said this balance could decrease by about $0.4B over the next 12 months.
- Other risks highlighted include intense competition and pricing pressure, volatility in service-provider orders, product transitions and execution, warranty costs, foreign exchange and investment-value changes, and the possibility that restructuring or strategic investments may not deliver expected benefits.
Most important facts for investors to verify
- Whether revenue growth and the Q2 margin improvement persist, particularly given first-half product-margin pressure from pricing and mix.
- Whether expense reductions are sustainable and the restructuring reaches the expected approximately $1B total cost, including the timing of remaining charges.
- Whether supply disruptions, purchase commitments and inventory levels create further cost, delivery or obsolescence risks.
- The location and accessibility of overseas liquidity, and the tax consequences of any repatriation.
- Developments in the Brazilian tax claims and shareholder litigation, for which Cisco could not estimate potential losses.
- Growth and credit quality of financing receivables, guarantees and the VCE investment, including expected further funding and losses.