Why did Cisco's reported profit swing from a loss to a gain in fiscal 2002?

Fiscal 2001 included a $2.2 billion excess inventory charge, $1.2 billion in restructuring costs and other special charges, and $690 million in goodwill amortization, which together produced a $1.0 billion net loss. Fiscal 2002 had no goodwill amortization because the company early-adopted SFAS 142, and restructuring charges were absent, so net income returned to $1.9 billion even though sales fell 15%. Fiscal 2002 did include an $858 million impairment on equity investments, which partly offset these gains.

Is Cisco's improved gross margin sustainable?

Part of the improvement is a comparison effect: the 47.9% prior-year product margin was depressed by the inventory charge. The underlying improvement was modest, from 58.4% to 58.9% excluding that charge and related benefits. Cisco itself warns that margins may fall due to price competition, mix shifts, excess inventory, warranty costs, and channel changes. Service margin rose to 69.6%, supported by higher service revenue and efficiency gains.

What is the main risk to Cisco's revenue outlook?

The filing identifies service provider spending as the central risk. Service providers accounted for a large share of the decline, particularly among incumbent local exchange carriers and interexchange carriers in the Americas and China-related service provider demand in Asia Pacific. Management does not expect lower service provider capital spending to reverse in the near term. Cisco also says its revenue is difficult to predict due to shipment linearity, distributor ordering patterns, and reduced backlog, which fell to about $1.4 billion from $2.0 billion a year earlier.

What is the Andiamo acquisition and why does it matter?

On August 19, 2002, Cisco agreed to acquire the remaining equity of privately held Andiamo Systems, which it had previously funded with $63 million of an $84 million commitment and had expensed as R&D. The price will be paid in Cisco stock, based on a revenue multiple with a cap of about $2.5 billion, and closing is expected by mid-2004. Because the price depends on Cisco's market capitalization and revenue, the final cost and dilution to shareholders are uncertain, and the filing notes the purchase price cannot be determined at this time.

What legal and capital-return matters should investors watch?

Consolidated securities class action lawsuits filed in 2001 allege misleading statements between August 1999 and February 2001, and related shareholder derivative suits are pending. Cisco says it believes the claims lack merit and that the outcome is not currently determinable, and it does not expect a material adverse effect. On the capital side, Cisco repurchased about 124 million shares for $1.9 billion in fiscal 2002, has $6.1 billion remaining under its buyback authorization, has never paid cash dividends, and carries $948 million in customer financing loan commitments.

CSCO 10-K FY2002 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed September 18, 2002. Cited figures are marked; the original filing is the authoritative source.

Cisco Systems' fiscal 2002 10-K (fiscal year ended July 27, 2002) shows a company under significant strain from the telecom and IT capital spending downturn, but with a healthier profit profile than the prior year.

Net sales fell 15.2% to $18.9 billion^a from $22.3 billion, driven mainly by weak service provider demand in the Americas and EMEA. Net income swung to $1.9 billion (diluted EPS $0.25) from a $1.0 billion loss in fiscal 2001, which had been depressed by a $2.2 billion excess inventory charge and $1.2 billion in restructuring costs. Fiscal 2002 results also included an $858 million pre-tax impairment on publicly traded equity investments and $699 million in amortization of purchased intangibles.

Beneath the headline numbers, operating quality improved meaningfully. Product gross margin rose to 62.3%^b from 47.9%, though much of that reflects the absence of the prior-year inventory charge; excluding it, product margin was roughly 58.9% versus 58.4%. Operating expenses fell sharply, with R&D down 12.1%, sales and marketing down 19.5%, and G&A down 20.6%.

Cash and investments grew to $21.5 billion^c, operating cash flow was $6.6 billion, and inventory was cut nearly in half to $880 million. Service revenue grew 18.7% to $3.2 billion and carries higher margins, which is a meaningful shift in the revenue mix. Management also repurchased about $1.9 billion of stock and raised the buyback authorization to $8 billion.

Investors should weigh the cautionary signals in the filing. Management stated it does not expect the trend of lower service provider capital spending to reverse in the near term, and the company warned that revenue is hard to predict and that acquisitions, including the pending Andiamo transaction with a potential purchase price of up to $2.5 billion^d in stock, carry integration and valuation risk.

Securities class action and derivative lawsuits from 2001 remain pending. The filing also notes that the company has never paid cash dividends.

02—Key points

Key Highlights

Net sales declined 15.2% to $18.9 billion, with product revenue down 19.9% to $15.7 billion while service revenue grew 18.7% to $3.2 billion.
Net income rebounded to $1.89 billion (diluted EPS $0.25) from a $1.01 billion loss in fiscal 2001, which had included a $2.2 billion excess inventory charge and $1.2 billion in restructuring costs.
Product gross margin improved to 62.3% from 47.9%, though excluding the prior-year inventory charge and subsequent benefits it was 58.9% versus 58.4%.
Operating expenses were cut substantially: R&D fell 12.1% to $3.4 billion, sales and marketing fell 19.5% to $4.3 billion, and G&A fell 20.6% to $618 million.
Cash and investments rose to $21.5 billion, operating cash flow was $6.6 billion, and inventory dropped 47.7% to $880 million; the company repurchased $1.9 billion of stock and expanded its buyback authorization to $8 billion.
A $858 million pre-tax impairment on publicly traded equity investments hit other income, producing a net interest and other loss of $209 million.
Management expects the decline in service provider capital spending to persist near term, and the filing flags the pending Andiamo acquisition (up to about $2.5 billion in stock) and pending securities class action suits as key risks.

03—Questions

Frequently Asked Questions

Why did Cisco's reported profit swing from a loss to a gain in fiscal 2002?
Fiscal 2001 included a $2.2 billion excess inventory charge, $1.2 billion in restructuring costs and other special charges, and $690 million in goodwill amortization, which together produced a $1.0 billion net loss. Fiscal 2002 had no goodwill amortization because the company early-adopted SFAS 142, and restructuring charges were absent, so net income returned to $1.9 billion even though sales fell 15%. Fiscal 2002 did include an $858 million impairment on equity investments, which partly offset these gains.
Is Cisco's improved gross margin sustainable?
Part of the improvement is a comparison effect: the 47.9% prior-year product margin was depressed by the inventory charge. The underlying improvement was modest, from 58.4% to 58.9% excluding that charge and related benefits. Cisco itself warns that margins may fall due to price competition, mix shifts, excess inventory, warranty costs, and channel changes. Service margin rose to 69.6%, supported by higher service revenue and efficiency gains.
What is the main risk to Cisco's revenue outlook?
The filing identifies service provider spending as the central risk. Service providers accounted for a large share of the decline, particularly among incumbent local exchange carriers and interexchange carriers in the Americas and China-related service provider demand in Asia Pacific. Management does not expect lower service provider capital spending to reverse in the near term. Cisco also says its revenue is difficult to predict due to shipment linearity, distributor ordering patterns, and reduced backlog, which fell to about $1.4 billion from $2.0 billion a year earlier.
What is the Andiamo acquisition and why does it matter?
On August 19, 2002, Cisco agreed to acquire the remaining equity of privately held Andiamo Systems, which it had previously funded with $63 million of an $84 million commitment and had expensed as R&D. The price will be paid in Cisco stock, based on a revenue multiple with a cap of about $2.5 billion, and closing is expected by mid-2004. Because the price depends on Cisco's market capitalization and revenue, the final cost and dilution to shareholders are uncertain, and the filing notes the purchase price cannot be determined at this time.
What legal and capital-return matters should investors watch?
Consolidated securities class action lawsuits filed in 2001 allege misleading statements between August 1999 and February 2001, and related shareholder derivative suits are pending. Cisco says it believes the claims lack merit and that the outcome is not currently determinable, and it does not expect a material adverse effect. On the capital side, Cisco repurchased about 124 million shares for $1.9 billion in fiscal 2002, has $6.1 billion remaining under its buyback authorization, has never paid cash dividends, and carries $948 million in customer financing loan commitments.

04—Continue

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