Cisco Systems, Inc. — Q3 FY2011 Form 10-Q
Reporting period: Quarter ended April 30, 2011; results are unaudited. The quarter had 13 weeks, compared with 14 weeks in Q3 FY2010, affecting comparability. Unless stated otherwise, amounts are in millions of dollars.
Financial performance
| Metric | Q3 FY2011 | Q3 FY2010 | First 9 months FY2011 | First 9 months FY2010 |
|---|---|---|---|---|
| Net sales | $10,866 | $10,368 | $32,023 | $29,204 |
| Gross margin | $6,659; 61.3% | $6,630; 63.9% | $19,675; 61.4% | $18,850; 64.5% |
| Operating income | $2,183 | $2,345 | $6,218 | $6,839 |
| Net income | $1,807 | $2,192 | $5,258 | $5,832 |
| Diluted EPS | $0.33 | $0.37 | $0.94 | $0.99 |
| Cash from operations | $3.0 billion | Not stated for quarter | $7,255 | $6,941 |
- Quarterly sales grew 4.8% year over year; product revenue rose 2.8% and services 13.7%. Nine-month sales grew 9.7%, with product revenue up 8.4% and services up 14.8%.
- Q3 operating margin was 20.1%, versus 22.6%; net margin was 16.6%, versus 21.1%. Nine-month operating margin was 19.4%, versus 23.4%; net margin was 16.4%, versus 20.0%.
- Q3 effective tax rate was 18.0%, compared with 8.8%, which included a prior-year $158 million nonrecurring tax benefit. Nine-month rates were 17.3% and 16.6%.
- At April 30, cash and cash equivalents were $6.635 billion and investments were $36.732 billion, totaling $43.367 billion. Current assets were $55.204 billion and current liabilities $16.110 billion.
- Total debt was approximately $16.749 billion ($581 million short-term and $16.168 billion long-term), compared with $15.284 billion at July 31, 2010. Cisco issued $4.0 billion of notes in March and repaid $3.0 billion of notes at maturity in February. A $3.0 billion revolving credit facility was undrawn; debt covenants were met.
- Nine-month cash uses included $5.564 billion of share repurchases, $930 million of capital expenditures, and $329 million of dividends. Cisco initiated its first quarterly dividend, $0.06 per share.
- Deferred revenue was $11.699 billion, up from $11.083 billion at July 31, 2010. Accounts receivable was $4.413 billion; days sales outstanding improved to 37 from 41. Inventory was $1.442 billion, up from $1.327 billion; annualized inventory turns fell to 11.1 from 12.6.
Material changes and business drivers
- Profitability weakened despite sales growth: Q3 net income fell 17.6% and diluted EPS fell 10.8%; nine-month net income declined 9.8% and diluted EPS 5.1%.
- Management attributed margin pressure to higher discounts and unfavorable pricing, product mix, restructuring costs, and—in the nine-month period—higher acquired-intangible amortization and impairment. Switching revenue fell 9% in Q3 amid product transitions and competition; public-sector product sales declined 6%.
- Growth areas included Q3 New Products (+15%), collaboration (+39%), data center (+31%), and services (+14%). Emerging Markets revenue grew 11%. The comparison in collaboration includes Tandberg acquisition contribution.
- Cisco recorded $151 million of Q3 restructuring and other charges, primarily related to its consumer business and exit from Flip Video. Nine-month purchased-intangible impairment charges were $164 million, primarily tied to lower expected cash flows from consumer products and the Flip exit.
- Cash and investments increased $3.506 billion from fiscal year-end, primarily from operating cash flow and net debt issuance, partly offset by buybacks, capital expenditures, and dividends. $38.8 billion of cash and investments was held outside the United States; repatriation could trigger additional taxes.
Outlook, risks, and contingencies
- For Q4 FY2011, Cisco expected revenue to be relatively flat year over year, total gross margin excluding restructuring to be slightly below Q3, operating expenses as a percentage of revenue to rise year over year, and operating income, net income, and EPS likely to continue declining year over year.
- Management expected cost-reduction actions to lower the annualized operating-expense run rate by about $1 billion, using Q4 FY2011 expense as the baseline, with the target expected to be achieved in FY2012. A voluntary early-retirement program was expected to generate a $0.5–$1.1 billion pretax charge in Q4; further restructuring charges were not yet quantifiable. Sales, services, and engineering realignment was expected to be completed in FY2012.
- Key risks include intense competition and pricing pressure, continuing switching and public-sector weakness, uncertain customer spending, product transitions, supply constraints and component availability following the Japan earthquake, and potential excess inventory or purchase commitments. Management cited some manufacturing-cost benefits in Q3 as nonrecurring.
- Brazilian authorities asserted claims against Cisco’s subsidiary of approximately $515 million in import taxes, $650 million in interest, and $2.4 billion in penalties. Cisco disputes liability, intends to defend the matter, and said it could not assess the likelihood of an unfavorable outcome or reasonably estimate a loss range; a final judicial determination was not expected for several years.
- Two purported securities class actions and shareholder derivative lawsuits were disclosed; Cisco said it considers the claims without merit. The filing does not provide a clear estimate of potential losses for these cases.
- Financing receivables, net, were $6.144 billion, with a $372 million credit-loss allowance. Management described historical losses as immaterial, but customer credit deterioration could increase provisions. Outstanding financing guarantees had $590 million of maximum potential payments, offset by $460 million of associated deferred revenue.
Important facts for investors to verify
- Whether revenue and margin trends—especially switching, public-sector, and product-pricing performance—improved after the reported quarter.
- Whether the Q4 revenue, margin, earnings, and $1 billion annualized expense-reduction outlook was achieved, and the actual retirement-program and restructuring charges.
- The quality and liquidity of the $43.4 billion cash-and-investments balance, including the tax implications of the substantial offshore balance.
- Developments in the Brazilian tax dispute and shareholder litigation, including any change in Cisco’s ability to estimate potential losses.
- Whether supply constraints, inventory levels, financing-receivable growth, and related credit allowances or guarantees created additional costs or risk.