Cisco Systems, Inc. — Q1 Fiscal 2018 Form 10-Q
Reporting period: Three months ended October 28, 2017; comparative period ended October 29, 2016. Financial statements are unaudited. Amounts are in U.S. dollars.
Business context and results
Cisco designs and sells networking, security, collaboration, and cloud-related technology and services. Management reported continued weakness in service-provider demand and emerging markets, while Security and Applications grew. Cisco is transitioning toward software and subscription offerings.
| Metric | Q1 FY2018 | Q1 FY2017 | Change |
|---|---|---|---|
| Revenue | $12.136 billion | $12.352 billion | Down 2% |
| Product revenue | $9.054 billion | $9.302 billion | Down 3% |
| Service revenue | $3.082 billion | $3.050 billion | Up 1% |
| Gross margin | $7.427 billion; 61.2% | $7.884 billion; 63.8% | Down 2.6 percentage points |
| Operating income | $2.756 billion; 22.7% of revenue | $2.877 billion; 23.3% | Down 4% |
| Net income | $2.394 billion | $2.322 billion | Up 3% |
| Diluted EPS | $0.48 | $0.46 | Up 4% |
| Operating cash flow | $3.080 billion | $2.730 billion | Up $350 million |
| Free cash flow | $2.912 billion | $2.455 billion | Up $457 million |
Financial position, liquidity, and capital allocation
- Cash and cash equivalents were $11.043 billion; investments were $60.545 billion, totaling $71.588 billion, up $1.096 billion from July 29, 2017.
- Total debt was approximately $35.923 billion: $10.239 billion short-term and $25.684 billion long-term. Commercial paper outstanding was $5.491 billion. Cisco reported compliance with debt covenants and no borrowings under its revolving credit facilities.
- Cash, cash equivalents, and investments exceeded reported debt by approximately $35.7 billion. However, $69.1 billion of cash and investments were held by foreign subsidiaries; $2.5 billion was available in the United States. Repatriation could trigger additional taxes.
- Current assets were $84.080 billion and current liabilities $29.284 billion. Deferred revenue was $18.565 billion, including $5.213 billion related to recurring software and subscription offers.
- Operating cash flow was $3.080 billion; capital expenditures were $168 million. Cisco returned $3.056 billion through $1.620 billion of stock repurchases and $1.436 billion of dividends. The declared dividend was $0.29 per share, versus $0.26 a year earlier.
Material changes and management commentary
- Infrastructure Platforms revenue fell 4% to $6.970 billion, with most of the decline attributed to routing, service-provider weakness, and slower enterprise routing. Applications rose 6% to $1.203 billion and Security rose 8% to $585 million. Other Products declined 16%.
- Revenue declined across all geographic segments: Americas down 1%, EMEA down 3%, and APJC down 1%. Product revenue declined in service-provider, enterprise, and public-sector markets, partly offset by commercial-market growth.
- Product gross margin fell to 60.1% from 63.4%. Management cited pricing pressure, higher costs for constrained memory components, and a $122 million legal and indemnification settlement charge. Management expected memory-related cost pressure to continue in the near term.
- The effective tax rate declined to 19.2% from 21.4%, primarily reflecting excess tax benefits from share-based compensation. Cisco cautioned that the new accounting treatment may cause quarterly tax-rate variability.
- Operating cash flow and free cash flow increased year over year. Management’s capital allocation policy targets returning at least 50% of annual free cash flow to shareholders.
Outlook, unusual items, risks, and contingencies
- No specific revenue, earnings, or margin guidance for the next quarter or fiscal year is provided in the filing text. Management described the environment as uncertain, with ongoing service-provider and emerging-market weakness, and said it would continue investing in priority areas for long-term profitable growth.
- Cisco extended its fiscal 2017 restructuring plan by an estimated $150 million of pretax charges. Total estimated plan charges were approximately $1.0 billion; $908 million had been incurred, and substantial completion was expected by the end of Q2 FY2018. Management expected to reinvest substantially all savings, so future cost savings were not expected to be material.
- Cisco completed acquisitions of Viptela and Springpath for total purchase consideration of $761 million. A proposed BroadSoft acquisition, for approximately $1.9 billion net of cash and short-term investments, remained subject to customary regulatory reviews.
- Brazilian tax authorities asserted claims totaling $2.95 billion (tax, interest, and penalties). Cisco disputed the claims, but said it could not determine the likelihood of an unfavorable outcome or reasonably estimate any loss; a final judicial determination was not expected for several years.
- Other disclosed litigation included an SRI patent judgment of $57 million plus a 3.5% ongoing royalty through patent expiration in 2018, which Cisco appealed; and a pending HP/DXC contract dispute whose outcome could not be estimated. Cisco recorded the $122 million legal and indemnification settlement charge in product cost of sales during the quarter.
- Key operating risks include intense competition and pricing pressure, dependence on service-provider spending, supply constraints and higher memory-component costs, inventory and purchase-commitment exposure, customer credit and financing risk, foreign currency and interest-rate movements, tax uncertainty, and execution and integration risks from acquisitions and business-model transition.
- For fiscal 2019 adoption of the new revenue-recognition standard, Cisco expected accelerated recognition for certain term software licenses, enterprise license agreements, and two-tier distributor sales, while preliminarily expecting no material impact on total revenue in the adoption year. Actual impact remained dependent on circumstances at adoption.
Important facts for investors to verify
- Whether service-provider and Infrastructure Platforms demand stabilizes, and whether growth in Security, Applications, software, and subscriptions can offset product declines.
- How persistent memory-component constraints and pricing pressure are, and their effect on product gross margin.
- Progress and final costs of the restructuring plan, and whether reinvestment of savings supports profitable growth.
- BroadSoft acquisition closing, financing, integration, and expected contribution.
- Developments in the Brazilian tax claims and other litigation, including any effect beyond recorded charges or management’s current assessments.
- Debt maturities and refinancing needs, the location and tax implications of offshore liquidity, and continued shareholder returns relative to free cash flow.