10-QPeriod: Q3 FY2006

CISCO SYSTEMS, INC. Quarterly Report for Q3 Ended Apr 29, 2006

Filed May 25, 2006For Securities:CSCO

Summary

Cisco Systems, Inc. (CSCO) reported solid financial results for the third quarter and first nine months of fiscal year 2006, showcasing growth in net sales and net income compared to the prior year, particularly when accounting for the impact of stock-based compensation. The company's acquisition of Scientific-Atlanta in February 2006 significantly contributed to its top-line growth, adding $407 million in net sales for the quarter and expanding Cisco's presence in the video market. Despite an increase in operating expenses due to higher headcount and the adoption of SFAS 123(R), Cisco demonstrated strong operational execution, with increased switching and router revenues. Financially, Cisco maintained a robust liquidity position with substantial cash and investments, supplemented by a successful $6.5 billion debt offering. The company continued its commitment to shareholder value through significant stock repurchases. Investors should note the slight decrease in gross margins, largely attributed to the lower-margin business model of Scientific-Atlanta, and the ongoing impact of SFAS 123(R) on reported expenses.

Key Highlights

  • 1Net sales increased by 18.3% year-over-year to $7.32 billion for the third quarter of fiscal 2006, driven by strong performance across most geographic segments and product families, as well as the acquisition of Scientific-Atlanta.
  • 2The acquisition of Scientific-Atlanta, completed in February 2006, contributed $407 million in net sales and $88 million in in-process R&D expenses, expanding Cisco's capabilities in the video market.
  • 3Gross margin decreased to 64.5% from 66.8% in the prior year's comparable quarter, primarily due to the lower gross margin profile of Scientific-Atlanta's business and the impact of stock-based compensation expense under SFAS 123(R).
  • 4Operating income saw a slight decrease to $1.65 billion from $1.82 billion, impacted by increased operating expenses, including research and development, sales and marketing, and general and administrative costs, which rose by 26.5%, 30.0%, and 22.1% respectively.
  • 5Net income for the quarter was $1.40 billion, or $0.22 per diluted share, a slight decrease from $1.41 billion, or $0.21 per diluted share in the prior year, but showed growth when considering the pro forma impact of stock-based compensation.
  • 6Cash and cash equivalents and investments totaled $18.18 billion as of April 29, 2006, an increase of $2.13 billion from the prior fiscal year-end, bolstered by operating activities and a $6.5 billion debt issuance.
  • 7Cisco repurchased approximately $1.2 billion of its common stock during the third quarter of fiscal 2006, as part of its ongoing $35 billion stock repurchase program.

Frequently Asked Questions

The acquisition of Scientific-Atlanta, completed in February 2006, significantly boosted Cisco's net sales, contributing $407 million in the third quarter of fiscal 2006. This acquisition expanded Cisco's offerings into the video market and added approximately $310 million to net product sales and $21 million to service revenue. However, it also contributed to a decrease in overall gross margins due to Scientific-Atlanta's lower-margin business model and recognized $88 million in in-process research and development expenses.

Cisco adopted SFAS 123(R) on July 31, 2005. This new accounting standard requires the recognition of stock-based compensation expense for employee stock options and purchases. For the third quarter of fiscal 2006, this resulted in $261 million in stock-based compensation expense related to employee stock options and purchases, impacting cost of sales, R&D, sales & marketing, and G&A expenses. This increased reported expenses compared to prior periods where such expenses were only recognized for acquisitions.

Cisco maintained a strong liquidity position, with cash and cash equivalents and investments totaling $18.18 billion as of April 29, 2006. This was an increase from the prior fiscal year-end, supported by $5.6 billion in cash flow from operations and a $6.5 billion debt issuance. The company also repurchased $1.2 billion of its stock during the quarter, demonstrating its commitment to returning value to shareholders while maintaining sufficient resources for operations, investments, and strategic acquisitions.

The primary driver for the decrease in gross margin was the acquisition of Scientific-Atlanta, whose business model generally operates with lower gross margins compared to Cisco's. Additionally, the impact of stock-based compensation expense under SFAS 123(R), changes in product mix (including sales of certain switching and routing products), and sales discounts also contributed to the decline. These factors were partially offset by lower manufacturing costs and value engineering efforts.