Cisco Systems 10-Q 2009
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended January 24, 2009
For the transition period from to
Commission file number 0-18225
CISCO SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
170 West Tasman Drive
San Jose, California 95134
(Address of principal executive office and zip code)
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES ¨ NO x
As of February 12, 2009, 5,837,016,965 shares of the registrants common stock were outstanding.
FORM 10-Q for the Quarter Ended January 24, 2009
CONSOLIDATED BALANCE SHEETS
(in millions, except par value)
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except per-share amounts)
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fiscal year for Cisco Systems, Inc. (the Company or Cisco) is the 52 or 53 weeks ending on the last Saturday in July. Fiscal 2009 and 2008 are 52-week fiscal years. The Consolidated Financial Statements include the accounts of Cisco and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. The Company conducts business globally and is primarily managed on a geographic basis in the following theaters: United States and Canada; European Markets; Emerging Markets; Asia Pacific; and Japan. The Emerging Markets theater consists of Eastern Europe, Latin America, the Middle East and Africa, and Russia and the Commonwealth of Independent States (CIS).
The accompanying financial data as of January 24, 2009 and for the three and six months ended January 24, 2009 and January 26, 2008 has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. The July 26, 2008 Consolidated Balance Sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto, included in the Companys Annual Report on Form 10-K for the fiscal year ended July 26, 2008.
In the opinion of management, all adjustments (which include normal recurring adjustments, except as disclosed herein) necessary to present fairly the statement of financial position as of January 24, 2009, and results of operations for the three months and six months ended January 24, 2009 and January 26, 2008, cash flows, and shareholders equity for the six months ended January 24, 2009 and January 26, 2008, as applicable, have been made. The results of operations for the three and six months ended January 24, 2009 are not necessarily indicative of the operating results for the full fiscal year or any future periods.
During the first quarter of fiscal 2009, the Company began to allocate certain costs, which had previously been recorded in general and administrative expenses (related to information technology, financing business, and human resources), to sales and marketing, research and development, and cost of sales, as applicable. These changes also resulted in reclassifications to prior period gross margin by theater amounts. In addition, the Company has made certain reclassifications to prior period amounts relating to net sales by theater and net sales for similar groups of products due to refinement of the respective categories. The Company has made certain other reclassifications to prior period amounts in order to conform to the current periods presentation.
(a) Fair Value Measures
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value, and enhances fair value measurement disclosure. In October 2008, the FASB issued FSP 157-3 Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP 157-3). FSP 157-3 clarifies the application of SFAS No. 157 in a market that is not active, and provides guidance on the key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. Effective July 27, 2008, the Company adopted the measurement and disclosure requirements related to financial assets and financial liabilities. The adoption of SFAS 157 for financial assets and financial liabilities did not have a material impact on the Companys results of operations or the fair values of its financial assets and liabilities.
FASB Staff Position 157-2, Effective Date of FASB Statement No. 157, (FSP 157-2) delayed the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of fiscal 2010. The Company is currently assessing the impact that the application of SFAS 157 to nonfinancial assets and liabilities will have on its results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115 (SFAS 159). Under SFAS 159, a company may choose, at specified election dates, to measure eligible items at fair value and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Effective July 27, 2008, the Company adopted SFAS 159, but the Company has not elected the fair value option for any eligible financial instruments as of January 24, 2009.
(b) Recent Accounting Pronouncements
SFAS 141(R) and SFAS 160
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (SFAS 141(R)) and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB No. 51 (SFAS 160). SFAS 141(R) will significantly change current practices regarding business combinations. Among the more significant changes, SFAS 141(R) expands the definition of a business and a business combination; requires the acquirer to recognize the assets acquired, liabilities assumed and noncontrolling interests (including goodwill), measured at fair value at the acquisition date; requires acquisition-related expenses and restructuring costs to be recognized separately from the business combination; requires assets acquired and liabilities assumed from contractual and noncontractual contingencies to be recognized at their acquisition-date fair values with subsequent changes recognized in earnings; and requires in-process research and development to be capitalized at fair value as an indefinite-lived intangible asset. SFAS 160 will change the accounting and reporting for minority interests, reporting them as equity separate from the parent entitys equity, as well as requiring expanded disclosures. SFAS 141(R) and SFAS 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company is currently assessing the impact that SFAS 141(R) and SFAS 160 will have on its results of operations and financial position.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities an amendment of FASB Statement No. 133 (SFAS 161), which requires additional disclosures about the objectives of using derivative instruments, the method by which the derivative instruments and related hedged items are accounted for under FASB Statement No. 133 and its related interpretations, and the effect of derivative instruments and related hedged items on financial position, financial performance, and cash flows. SFAS 161 also requires disclosure of the fair values of derivative instruments and their gains and losses in a tabular format. SFAS 161 is effective for the Company in the third quarter of fiscal 2009. The Company is currently assessing the impact that the adoption of SFAS 161 will have on its financial statement disclosures.
(a) Purchase Acquisitions
A summary of the purchase acquisitions for the six months ended January 24, 2009 is as follows (in millions):
Under the terms of the definitive agreements related to the Companys purchase acquisitions completed during the six months ended January 24, 2009, the purchase consideration consisted of cash and fully vested share-based awards assumed. The purchase consideration for the Companys purchase acquisitions is also allocated to tangible assets acquired and liabilities assumed.
The Consolidated Financial Statements include the operating results of each business from the date of acquisition. Pro forma results of operations for the acquisitions completed during the six months ended January 24, 2009 have not been presented because the effects of the acquisitions, individually or in the aggregate, were not material to the Companys financial results.
(b) Compensation Expense Related to Acquisitions and Investments
The following table presents the compensation expense related to acquisitions and investments (in millions):
Share-Based Compensation Expense
As of January 24, 2009, the remaining balance of share-based compensation related to acquisitions and investments to be recognized over the vesting periods was approximately $213 million.
Cash Compensation Expense
In connection with the Companys purchase acquisitions, asset purchases, and acquisitions of variable interest entities, the Company has agreed to pay certain additional amounts contingent upon the achievement of certain agreed-upon technology, development, product, or other milestones, or the continued employment with the Company of certain employees of the acquired entities. In each case, any additional amounts paid will be recorded as compensation expense. As of January 24, 2009, the Company may be required to recognize future compensation expense pursuant to these agreements of up to $417 million, which includes the remaining potential amount of additional compensation expense related to Nuova Systems, Inc., as discussed below.
Nuova Systems, Inc.
During fiscal 2008, the Company purchased the remaining interests in Nuova Systems, Inc. (Nuova Systems) not previously held by the Company, representing approximately 20% of Nuova Systems. Under the terms of the merger agreement, the former minority interest holders of Nuova Systems are eligible to receive up to three milestone payments based on agreed-upon formulas. During the first six months of fiscal 2009, the Company recorded $40 million of compensation expense, and through January 24, 2009, the Company has recorded aggregate compensation expense of $317 million related to the fair value of amounts that are expected to be earned by the minority interest holders pursuant to a vesting schedule. Actual amounts payable to the former minority interest holders of Nuova Systems will depend upon achievement under the agreed-upon formulas.
Subsequent changes to the fair value of the amounts probable of being earned and the continued vesting will result in adjustments to the recorded compensation expense. The potential amount that could be recorded as compensation expense may be up to a maximum of $678 million, including the $317 million that has been expensed as of January 24, 2009. The compensation is expected to be paid during fiscal 2010 through fiscal 2012.
The following table presents the changes in goodwill allocated to the Companys reportable segments during the six months ended January 24, 2009 (in millions):
In the table above, Other primarily includes foreign currency translation and purchase accounting adjustments.
(b) Purchased Intangible Assets
The following table presents details of the purchased intangible assets acquired through business combinations during the six months ended January 24, 2009 (in millions, except years):
The following tables present details of the Companys purchased intangible assets (in millions):
The following table presents the amortization of purchased intangible assets (in millions):
During the second quarter of fiscal 2009, the Company recorded an impairment charge of $23 million from write-downs of purchased intangible assets related to certain technologies due to reductions in expected future cash flows, and the amount was recorded as amortization of purchased intangible assets.
The estimated future amortization expense of purchased intangible assets as of January 24, 2009 is as follows (in millions):
The following tables provide details of selected balance sheet items (in millions):
(a) Lease Receivables
Lease receivables represent sales-type and direct-financing leases resulting from the sale of the Companys and complementary third-party products. These lease arrangements typically have terms from two to three years and are generally collateralized by a security interest in the underlying assets. The net lease receivables are summarized as follows (in millions):
Contractual maturities of the gross lease receivables at January 24, 2009 were $390 million in the remaining six months of fiscal 2009, $597 million in fiscal 2010, $432 million in fiscal 2011, $242 million in fiscal 2012, and $128 million in fiscal 2013 and thereafter. Actual cash collections may differ from the contractual maturities due to early customer buyouts, refinancings, or defaults.
(b) Financed Service Contracts
Financed service contracts are summarized as follows (in millions):
The revenue related to financed service contracts, which primarily relates to technical support services, is deferred and included in deferred service revenue. The revenue is recognized ratably over the period during which the related services are to be performed, which is typically from one to three years.
(c) Loan Receivables
Loan receivables are summarized as follows (in millions):
A portion of the revenue related to loan receivables is deferred and included in deferred product revenue based on revenue recognition criteria.
(d) Financing Guarantees
In the ordinary course of business, the Company provides financing guarantees, which are generally for various third-party financing arrangements extended to channel partners and other customers.
Channel Financing Guarantees
The Company facilitates financing arrangements for third-party financing extended to channel partners, consisting of revolving short-term financing, generally with payment terms ranging from 60 to 90 days. The Company receives a payment from the third-party financing organizations based on the Companys standard payment terms. These financing arrangements facilitate the working capital requirements of the channel partners and, in some cases, the Company guarantees a portion of these arrangements. During the three and six months ended January 24, 2009, the volume of channel partner financing was $3.5 billion and $7.6 billion, respectively, compared with $3.5 billion and $6.8 billion for the three and six months ended January 26, 2008, respectively. As of January 24, 2009 and July 26, 2008, the balance of the channel partner financing subject to guarantees was $1.4 billion and $1.7 billion, respectively.
Customer Financing Guarantees
The Company also provides financing guarantees for third-party financing arrangements extended to customers related to leases and loans, which typically have terms of three years. During the three and six months ended January 24, 2009, the volume of financing provided by third parties for leases and loans on which the Company has provided guarantees was $246 million and $644 million, respectively, compared with $272 million and $572 million for the three and six months ended January 26, 2008, respectively.
The aggregate amount of guarantees outstanding at January 24, 2009 and July 26, 2008, representing the total maximum potential future payments under financing arrangements with third parties, and the related revenue deferred in accordance with revenue recognition policies and FIN 45 are summarized below (in millions):
(a) Summary of Investments
The following tables summarize the Companys investments (in millions):
The Companys management has determined that the unrealized losses on its investment securities at January 24, 2009 are temporary in nature. The Company reviews its investments to identify and evaluate investments that have indications of possible impairment. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and the Companys intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.
(b) Gains and Losses on Investments
The following table summarizes the realized net gains (losses) associated with the Companys investments (in millions):
For the second quarter and first six months of fiscal 2009, net losses on fixed income securities included impairment charges of $19 million and $202 million, respectively, and net gains and losses on publicly traded equity securities included impairment charges of $18 million and $35 million, respectively. The impairment charges in both periods were due to a decline in the fair value of the investments below their cost basis that were judged to be other-than-temporary and were recorded as a reduction to the amortized cost of the respective investments. There were no impairments of fixed income securities or publicly traded equity securities during the first six months of fiscal 2008.
(c) Maturities of Fixed Income Securities
The following table summarizes the maturities of the Companys fixed income securities at January 24, 2009 (in millions):
Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.
SFAS 157 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.
(a) Fair Value Hierarchy
SFAS 157 requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. SFAS 157 establishes a fair value hierarchy based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instruments categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. SFAS 157 prioritizes the inputs into three levels that may be used to measure fair value:
Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.
Level 2 applies to assets or liabilities for which there are inputs other than quoted prices that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.
Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.
(b) Assets and Liabilities Measured at Fair Value on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis as of January 24, 2009 were as follows (in millions):
Level 2 fixed income securities are priced using quoted market prices for similar instruments, non-binding market prices that are corroborated by observable market data, or discounted cash flow techniques. The Companys derivative instruments are classified as Level 2 as they are not actively traded and are valued using pricing models that use observable market inputs. Level 3 assets include asset-backed securities whose values are determined based on discounted cash flow models using inputs that the Company could not corroborate with market quotes.
Assets and liabilities measured at fair value on a recurring basis were presented on the Companys consolidated balance sheet as of January 24, 2009 as follows (in millions):
The following table presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the indicated periods (in millions):
(c) Assets Measured at Fair Value on a Nonrecurring Basis
The following table presents the Companys assets that were measured at fair value on a nonrecurring basis during the six months ended January 24, 2009 and the losses recorded to other income (loss), net during the three and six months ended January 24, 2009 on those assets (in millions):
The above assets, all still held as of January 24, 2009, were measured at fair value during the first six months of fiscal 2009 due to events or circumstances the Company identified that significantly impacted the fair value of these investments. The Company measured fair value using financial metrics, comparison to other private and public companies, analysis of the financial condition and near-term prospects of the investees, including recent financing activities and their capital structure as well as other economic variables. These investments were classified as Level 3 assets because the Company used unobservable inputs to value them, reflecting the Companys assumptions about the assumptions market participants would use in pricing these investments due to the absence of quoted market prices and inherent lack of liquidity.
(a) Long-Term Debt
In February 2006, the Company issued $500 million of senior floating interest rate notes based on the London Interbank Offered Rate (LIBOR) due 2009 (the 2009 Notes), $3.0 billion of 5.25% senior notes due 2011 (the 2011 Notes), and $3.0 billion of 5.50% senior notes due 2016 (the 2016 Notes), for an aggregate principal amount of $6.5 billion. The following table summarizes the Companys long-term debt (in millions, except percentages):
During the third quarter of fiscal 2008, the Company terminated the interest rate swaps entered into in connection with the 2011 Notes and the 2016 Notes and received proceeds of $432 million, net of accrued interest, which was recorded as a hedge accounting adjustment of the carrying amount of the fixed-rate debt and is being amortized as a reduction to interest expense over the remaining terms of the fixed-rate notes. The effective rates for the fixed-rate debt include the interest on the notes, the amortization of the hedge accounting adjustment and the accretion of the discount.
The 2011 Notes and the 2016 Notes are redeemable by the Company at any time, subject to a make-whole premium. Based on market prices, the fair value of the Companys long-term debt, including the current portion of long-term debt, was $6.9 billion as of January 24, 2009. The Company was in compliance with all debt covenants as of January 24, 2009.
Interest is payable quarterly on the 2009 Notes and semi-annually on the 2011 Notes and 2016 Notes. Interest expense and cash paid for interest are summarized as follows (in millions):
(b) Credit Facility
In August 2007, the Company entered into a credit agreement with certain institutional lenders that provides for a $3.0 billion unsecured revolving credit facility that is scheduled to expire on August 17, 2012. Due to the bankruptcy of one of the lenders during the first quarter of fiscal 2009, the Company believes the amount available under the credit facility as of January 24, 2009 may be effectively reduced to $2.9 billion.
Any advances under the credit agreement will accrue interest at rates that are equal to, based on certain conditions, either (i) the higher of the Federal Funds rate plus 0.50% or Bank of Americas prime rate as announced from time to time, or (ii) LIBOR plus a margin that is based on the Companys senior debt credit ratings as published by Standard & Poors Ratings Services and Moodys Investors Service, Inc. The credit agreement requires that the Company maintain an interest coverage ratio as defined in the agreement.
As of January 24, 2009, the Company was in compliance with the required interest coverage ratio, and the Company had not borrowed any funds under the credit facility. The Company may also, upon the agreement of either the then existing lenders or of additional lenders not currently parties to the agreement, increase the commitments under the credit facility up to a total of $5.0 billion and/or extend the expiration date of the credit facility up to August 15, 2014.
The Company uses derivative instruments primarily to manage exposures to foreign currency, interest rate, and equity security price risks. The Companys primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency, interest rates, and equity security prices. The Companys derivatives expose it to credit risk to the extent that the counterparties may be unable to meet the terms of the agreement. The Company seeks to mitigate such risks by limiting its counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.
(a) Foreign Currency Derivatives
The Companys foreign exchange forward and option contracts are summarized as follows (in millions):
The Company conducts business globally in numerous currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. To limit the exposure related to foreign currency changes, the Company enters into foreign currency contracts. The Company does not enter into foreign exchange forward or option contracts for trading purposes.
The Company enters into foreign exchange forward contracts to reduce the short-term effects of foreign currency fluctuations on assets and liabilities such as foreign currency receivables, including long-term customer financings, investments, and payables. Gains and losses on the contracts are included in other income (loss), net, and offset foreign exchange gains and losses from the revaluation of intercompany balances or other current assets, investments, or liabilities denominated in currencies other than the functional currency of the reporting entity. The Companys foreign exchange forward contracts related to current assets and liabilities generally range from one to three months in original maturity. Additionally, the Company has entered into foreign exchange forward contracts with maturities of up to two years related to long-term customer financings. The foreign exchange forward contracts related to investments generally have maturities of less than two years. The Company also hedges certain net investments in its foreign subsidiaries with forward contracts which generally have maturities of less than six months.
The Company hedges certain foreign currency forecasted transactions related to certain operating expenses and service cost of sales with currency options and forward contracts. These currency option and forward contracts, designated as cash flow hedges, generally have maturities of less than 18 months. The effective portion of the derivatives gain or loss is initially reported as a component of accumulated other comprehensive income (loss) and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion, if any, of the gain or loss is reported in earnings immediately. During the six months ended January 24, 2009, and January 26, 2008, there were no significant gains or losses recognized in earnings for hedge ineffectiveness. The Company did not discontinue any hedges during any of the periods presented because it was probable that the original forecasted transaction would not occur.
(b) Interest Rate Derivatives
The Companys interest rate derivatives are summarized as follows (in millions):
The Company maintains a portfolio of publicly traded equity securities that are subject to price risk. The Company may hold equity securities for strategic purposes or to diversify the Companys overall investment portfolio. To manage its exposure to changes in the fair value of certain equity securities, the Company may enter into equity derivatives, including forward sale and option agreements. The gains and losses due to changes in the value of the hedging instruments were included in other income (loss), net, and offset the change in the fair value of the underlying hedged investment. As of January 24, 2009, there were no outstanding forward sale agreements, as the Company terminated all of its previously existing forward sale agreements on publicly traded equity securities designated as fair value hedges during the first quarter of fiscal 2009.
(d) Other Derivative Instruments
The Company has entered into certain other derivative instruments, with immaterial fair market values, which are designed to hedge commodity-related expense items and deferred compensation liabilities.
(a) Operating Leases
The Company leases office space in several U.S. locations. Outside the United States, larger leased sites include sites in Australia, Belgium, China, France, Germany, India, Israel, Italy, Japan, and the United Kingdom. Future annual minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of January 24, 2009 are as follows (in millions):
(b) Purchase Commitments with Contract Manufacturers and Suppliers
The Company purchases components from a variety of suppliers and uses several contract manufacturers to provide manufacturing services for its products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, the Company enters into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by the Company or that establish the parameters defining the Companys requirements. A significant portion of the Companys reported purchase commitments arising from these agreements are firm, noncancelable, and unconditional commitments. In certain instances, these agreements allow the Company the option to cancel, reschedule, and adjust the Companys requirements based on its business needs prior to firm orders being placed. As of January 24, 2009 and July 26, 2008, the Company had total purchase commitments for inventory of $2.7 billion.
In addition, the Company records a liability for firm, noncancelable, and unconditional purchase commitments for quantities in excess of its future demand forecasts consistent with the valuation of the Companys excess and obsolete inventory. As of January 24, 2009 and July 26, 2008, the liability for these purchase commitments was $219 million and $184 million, respectively, and was included in other current liabilities.
(c) Compensation Expense Related to Acquisitions and Investments
In connection with the Companys purchase acquisitions, asset purchases, and acquisitions of variable interest entities, the Company has agreed to pay certain additional amounts contingent upon the achievement of certain agreed-upon technology, development, product, or other milestones or the continued employment with the Company of certain employees of acquired entities. See Note 3.
(d) Other Commitments
The Company also has certain funding commitments primarily related to its investments in privately held companies and venture funds, some of which are based on the achievement of certain agreed-upon milestones, and some of which are required to be funded on demand. The funding commitments were approximately $293 million and $359 million as of January 24, 2009 and July 26, 2008, respectively.
(e) Variable Interest Entities
In the ordinary course of business, the Company has investments in privately held companies and provides financing to certain customers. These privately held companies and customers may be considered to be variable interest entities. The Company has evaluated its investments in these privately held companies and its customer financings and has determined that there were no significant unconsolidated variable interest entities as of January 24, 2009.
(f) Product Warranties and Guarantees
The following table summarizes the activity related to the product warranty liability during the six months ended January 24, 2009 and January 26, 2008 (in millions):
The Company accrues for warranty costs as part of its cost of sales based on associated material product costs, labor costs for technical support staff, and associated overhead. The products sold are generally covered by a warranty for periods ranging from 90 days to five years, and for some products the Company provides a limited lifetime warranty.
In the normal course of business, the Company indemnifies other parties, including customers, lessors, and parties to other transactions with the Company, with respect to certain matters. The Company has agreed to hold the other parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. In addition, the Company has entered into indemnification agreements with its officers and directors, and the Companys bylaws contain similar indemnification obligations to the Companys agents. It is not possible to determine the maximum potential amount under these indemnification agreements due to the Companys limited history with prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on the Companys operating results, financial position, or cash flows.
The Company also provides financing guarantees, which are generally for various third-party financing arrangements to channel partners and other customers. See Note 6. The Companys other arrangements as of January 24, 2009 that were subject to recognition and disclosure requirements under FIN 45 were not material.
(g) Legal Proceedings
Brazilian authorities are investigating the Companys Brazilian subsidiary and certain of its current and former employees, as well as a Brazilian importer of the Companys products, and its affiliates and employees, relating to the allegation of evading import taxes and other alleged improper transactions involving the subsidiary and the importer. The Company is conducting a thorough review of the matter. In December 2008, Brazilian authorities asserted claims against the Company for calendar year 2003 and the Company believes claims may also be asserted for calendar year 2004 through calendar year 2007. The Company believes the asserted claims are without merit and intends to defend the claims vigorously. The Company is unable to determine the likelihood of an unfavorable outcome on any potential further claims against it. While the Company believes there is no legal basis for its alleged liability, due to the complexities and uncertainty surrounding the judicial process in Brazil, and the nature of the claims asserting joint liability with the importer, the Company is unable to reasonably estimate a range of loss, if any. In addition, the Company is investigating the allegations regarding improper transactions, the Company has proactively communicated with United States authorities to provide information and report on its findings, and the United States authorities are currently investigating such allegations.
In addition, the Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations, or cash flows.
(a) Stock Repurchase Program
In September 2001, the Companys Board of Directors authorized a stock repurchase program. As of January 24, 2009, the Companys Board of Directors had authorized an aggregate repurchase of up to $62 billion of common stock under this program and the remaining authorized repurchase amount was $6.8 billion with no termination date. The stock repurchase activity under the stock repurchase program during the first six months of fiscal 2009 is summarized as follows (in millions, except per-share amounts):
The purchase price for the shares of the Companys stock repurchased is reflected as a reduction to shareholders equity. In accordance with Accounting Principles Board Opinion No. 6, Status of Accounting Research Bulletins, the Company is required to allocate the purchase price of the repurchased shares as (i) a reduction to retained earnings until retained earnings are zero and then as an increase to accumulated deficit and (ii) a reduction of common stock and additional paid-in capital. Issuance of common stock and the tax benefit related to employee stock incentive plans are recorded as an increase to common stock and additional paid-in capital.
(b) Other Repurchases of Common Stock
The Company also repurchases shares in settlement of employee tax withholding obligations due upon the vesting of restricted stock or stock units.
(c) Comprehensive Income
The components of comprehensive income are as follows (in millions):
The Company consolidates its investment in a venture fund managed by SOFTBANK Corp. and its affiliates (SOFTBANK) as the Company is the primary beneficiary as defined under FIN 46(R). As a result, SOFTBANKs interest in the change in the unrealized gains and losses on the investments in the venture fund is recorded as a component of accumulated other comprehensive income (loss) and is reflected as a change in minority interest.
(a) Employee Stock Purchase Plan
The Company has an Employee Stock Purchase Plan, which includes its sub-plan, the International Employee Stock Purchase Plan (together, the Purchase Plan), under which 321.4 million shares of the Companys stock have been reserved for issuance. Eligible employees may purchase a limited number of shares of the Companys stock at a discount of up to 15% of the lesser of the market value on the subscription date or the purchase date, which is approximately six months after the subscription date. The Purchase Plan terminates on January 3, 2010. The Company issued 14 million shares and 9 million shares, under the Purchase Plan, during the six months ended January 24, 2009 and January 26, 2008, respectively. As of January 24, 2009, 48 million shares were available for issuance under the Purchase Plan.
(b) Employee Stock Incentive Plans
Stock Incentive Plan Program Description
As of January 24, 2009, the Company had five stock incentive plans: the 2005 Stock Incentive Plan (the 2005 Plan); the 1996 Stock Incentive Plan (the 1996 Plan); the 1997 Supplemental Stock Incentive Plan (the Supplemental Plan); the Cisco Systems, Inc. SA Acquisition Long-Term Incentive Plan (the SA Acquisition Plan); and the Cisco Systems, Inc. WebEx Acquisition Long-Term Incentive Plan (the WebEx Acquisition Plan). In addition, the Company has, in connection with the acquisitions of various companies, assumed the share-based awards granted under stock incentive plans of the acquired companies or issued share-based awards in replacement thereof. Share-based awards are designed to reward employees for their long-term contributions to the Company and provide incentives for them to remain with the Company. The number and frequency of share-based awards are based on competitive practices, operating results of the Company, government regulations, and other factors. Since the inception of the stock incentive plans, the Company has granted share-based awards to a significant percentage of its employees, and the majority has been granted to employees below the vice president level. The Companys primary stock incentive plans are summarized as follows:
As amended on November 15, 2007, the maximum number of shares issuable under the 2005 Plan over its term is 559 million shares plus the amount of any shares underlying awards outstanding on November 15, 2007 under the 1996 Plan, the SA Acquisition Plan and the WebEx Acquisition Plan that are forfeited or are terminated for any other reason before being exercised or settled. However, any shares underlying awards outstanding on November 15, 2007 under the 1996 Plan, the SA Acquisition Plan, and the WebEx Acquisition Plan that expire unexercised at the end of their maximum terms will not be considered to become available for reissuance under the 2005 Plan. If any awards granted under the 2005 Plan are forfeited or are terminated for any other reason before being exercised or settled, then the shares underlying the awards will again be available under the 2005 Plan. The number of shares available for issuance under the 2005 Plan will be reduced by 2.5 shares for each share awarded as stock grants or stock units.
The 2005 Plan permits the granting of stock options, stock, stock units, and stock appreciation rights to employees (including employee directors and officers) and consultants of the Company and its subsidiaries and affiliates, and non-employee directors of the Company. Stock options granted under the 2005 Plan have an exercise price of at least 100% of the fair market value of the underlying stock on the grant date and expire no later than nine years from the grant date. The stock options will generally become exercisable for 20% or 25% of the option shares one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Stock grants and stock units will generally vest with respect to 20% or 25% of the shares covered by the grant on each of the first through fifth or fourth anniversaries of the date of the grant, respectively. The Compensation and Management Development Committee of the Board of Directors has the discretion to use different vesting schedules. Stock appreciation rights may be awarded in combination with stock options or stock grants and such awards shall provide that the stock appreciation rights will not be exercisable unless the related stock options or stock grants are forfeited. Stock grants may be awarded in combination with non-statutory stock options, and such awards may provide that the stock grants will be forfeited in the event that the related non-statutory stock options are exercised.
The 1996 Plan expired on December 31, 2006, and the Company can no longer make equity awards under the 1996 Plan. The maximum number of shares issuable over the term of the 1996 Plan was 2.5 billion shares. Stock options granted under the 1996 Plan have an exercise price of at least 100% of the fair market value of the underlying stock on the grant date and expire no later than nine years from the grant date. The stock options generally become exercisable for 20% or 25% of the option shares one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Certain other grants have utilized a 60-month ratable vesting schedule. In addition, the Board of Directors, or other committees administering the plan, have the discretion to use a different vesting schedule and have done so from time to time.
The Supplemental Plan expired on December 31, 2007, and the Company can no longer make equity awards under the Supplemental Plan. Officers and members of the Companys Board of Directors were not eligible to participate in the Supplemental Plan. Nine million shares were reserved for issuance under the Supplemental Plan.
In connection with the Companys acquisitions of Scientific-Atlanta, Inc. (Scientific-Atlanta) and WebEx Communications, Inc. (WebEx), the Company adopted the SA Acquisition Plan and the WebEx Acquisition Plan, respectively, each effective upon completion of the applicable acquisition. These plans constitute assumptions, amendments, restatements, and renamings of the 2003 Long-Term Incentive Plan of Scientific-Atlanta and the WebEx Communications, Inc. Amended and Restated 2000 Stock Incentive Plan, respectively. The plans permit the grant of stock options, stock, stock units, and stock appreciation rights to certain employees of the Company and its subsidiaries and affiliates who had been employed by Scientific-Atlanta or its subsidiaries or WebEx or its subsidiaries, as applicable. As a result of the shareholder approval of the amendment and extension of the 2005 Plan, as of November 15, 2007, the Company will no longer make stock option grants or direct share issuances under either the SA Acquisition Plan or the WebEx Acquisition Plan.
General Share-Based Award Information
Stock Option Awards
A summary of the stock option activity is as follows (in millions, except per-share amounts):
The following table summarizes significant ranges of outstanding and exercisable stock options as of January 24, 2009 (in millions, except years and share prices):
The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Companys closing stock price of $15.89 as of January 23, 2009, which would have been received by the option holders had those option holders exercised their stock options as of that date. The total number of in-the-money stock options exercisable as of January 24, 2009 was 88 million. As of July 26, 2008, 795 million outstanding stock options were exercisable and the weighted-average exercise price was $29.53.
Restricted Stock and Stock Unit Awards
A summary of the restricted stock and stock unit activity is as follows (in millions, except per-share amounts):
Certain of the restricted stock units are awarded contingent on the future achievement of financial performance metrics.
Share-Based Awards Available for Grant
A summary of share-based awards available for grant are as follows (in millions):
As reflected in the table above, for each share awarded as restricted stock or subject to a restricted stock unit award under the 2005 Plan subsequent to November 15, 2007, an equivalent of 2.5 shares is deducted from the available share-based award balance.
Valuation and Expense Information Under SFAS 123(R)
Share-based compensation expense recognized under SFAS 123(R) consists primarily of expenses for stock options, stock purchase rights, restricted stock, and restricted stock units granted to employees. The following table summarizes employee share-based compensation expense (in millions):
As of January 24, 2009, total compensation cost related to unvested share-based awards, including share-based compensation relating to acquisitions and investments, not yet recognized was $3.3 billion, which is expected to be recognized over approximately 3.2 years on a weighted-average basis. The income tax benefit for employee share-based compensation expense was $73 million and $150 million for the three and six months ended January 24, 2009, respectively, and $86 million and $160 million for the three and six months ended January 26, 2008, respectively.
Valuation of Employee Stock Options and Employee Stock Purchase Rights
Upon adoption of SFAS 123(R) at the beginning of fiscal 2006, the Company began estimating the value of employee stock options and employee stock purchase rights on the date of grant using a lattice-binomial option-pricing model. The Companys employee stock options have vesting provisions and various restrictions including restrictions on transfer and hedging, among others, and are often exercised prior to their contractual maturity. Lattice-binomial models are more capable of incorporating the features of the Companys employee stock options than closed-form models such as the Black-Scholes model. The use of a lattice-binomial model requires extensive actual employee exercise behavior data and a number of complex assumptions including expected volatility, risk-free interest rate, expected dividends, kurtosis, and skewness.
The valuation of employee stock options is summarized as follows:
The valuation of employee stock purchase rights is summarized as follows:
The determination of the fair value of share-based payment awards on the date of grant using the lattice-binomial model is impacted by the Companys stock price as well as assumptions regarding a number of highly complex and subjective variables. The weighted-average assumptions were determined as follows:
The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. The expected life of employee stock options is impacted by all of the underlying assumptions and calibration of the Companys model. The lattice-binomial model assumes that employees exercise behavior is a function of the options remaining vested life and the extent to which the option is in-the-money. The lattice-binomial model estimates the probability of exercise as a function of these two variables based on the entire history of exercises and cancellations on all past option grants made by the Company.
Accuracy of Fair Value Estimates
The Company uses third-party analyses to assist in developing the assumptions used in, as well as calibrating, its lattice-binomial model. The Company is responsible for determining the assumptions used in estimating the fair value of its share-based payment awards. The Companys determination of the fair value of share-based payment awards is affected by assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Companys expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because the Companys employee stock options have certain characteristics that are significantly different from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in managements opinion, the existing valuation models may not provide an accurate measure of the fair value of the Companys employee stock options. Although the fair value of employee stock options is determined in accordance with SFAS 123(R) and SAB 107 using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
The following table provides details of income taxes (in millions, except percentages):
The effective tax rate for the six months ended January 24, 2009 reflected a $106 million tax benefit recorded in the first quarter of fiscal 2009 as a result of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, which reinstated the U.S. federal R&D tax credit retroactive to January 1, 2008. The effective tax rate for the first six months of fiscal 2008 reflected a net tax benefit of $162 million recorded in the first quarter of fiscal 2008 from the settlement of certain tax matters with the Internal Revenue Service (IRS).
The amount of unrecognized tax benefits was determined in accordance with Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48). The Company had $2.6 billion of unrecognized tax benefits as of January 24, 2009, of which $2.2 billion, if recognized, would favorably impact the effective tax rate at January 24, 2009. Although timing of the resolution of audits is highly uncertain, the Company does not believe it is reasonably possible that the total amount of unrecognized tax benefits as of January 24, 2009 will materially change in the next 12 months.
The Companys operations involve the design, development, manufacturing, marketing, and technical support of networking and other products and services related to the communications and information technology industry. Cisco products include routers, switches, advanced technologies, and other products. These products, primarily integrated by Cisco IOS Software, link geographically dispersed local-area networks (LANs), metropolitan-area networks (MANs) and wide-area networks (WANs).
(a) Net Sales and Gross Margin by Theater
The Company conducts business globally and is primarily managed on a geographic basis. The Companys management makes financial decisions and allocates resources based on the information it receives from its internal management system. Sales are attributed to a geographic theater based on the ordering location of the customer.
The Company does not allocate research and development, sales and marketing, or general and administrative expenses to its geographic theaters in this internal management system because management does not include the information in its measurement of the performance of the operating segments. In addition, the Company does not allocate amortization of acquisition-related intangible assets, share-based compensation expense, and the effects of purchase accounting adjustments to inventory to the gross margin for each theater because management does not include this information in its measurement of the performance of the operating segments.
Summarized financial information by theater for the three and six months ended January 24, 2009 and January 26, 2008, based on the Companys internal management system and as utilized by the Companys Chief Operating Decision Maker (CODM), is as follows (in millions):
(b) Net Sales for Groups of Similar Products and Services
The following table presents net sales for groups of similar products and services (in millions):
The Company refers to some of its products and technologies as advanced technologies. As of January 24, 2009, the Company had identified the following advanced technologies for particular focus: application networking services, home networking, security, storage area networking, unified communications, video systems, and wireless technology. The Company continues to identify additional advanced technologies for focus and investment in the future, and the Companys investments in some previously identified advanced technologies may be curtailed or eliminated depending on market developments.
(c) Other Segment Information
The majority of the Companys assets, excluding cash and cash equivalents and investments, as of January 24, 2009 and July 26, 2008 were attributable to its U.S. operations. The Companys total cash and cash equivalents and investments held outside of the United States in various foreign subsidiaries was $26.3 billion as of January 24, 2009, and the remaining $3.2 billion was held in the United States. For the three months and six months ended January 24, 2009 and January 26, 2008, no single customer accounted for 10% or more of the Companys net sales.
Property and equipment information is based on the physical location of the assets. The following table presents property and equipment information for geographic areas (in millions):
SFAS No. 128, Earnings per Share, requires that employee equity share options, unvested shares, and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per share. Diluted shares outstanding include the dilutive effect of in-the-money options and nonvested restricted stock and stock units, which is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. The following table presents the calculation of basic and diluted net income per share (in millions, except per-share amounts):
On February 9, 2009 the Company filed a Form S-3 Registration Statement with the Securities and Exchange Commission to offer debt securities, subject to market conditions. On February 9, 2009, the Company also entered into an underwriting agreement to issue senior unsecured notes in aggregate principal amount of $4.0 billion under the Registration Statement. Of these notes, $2.0 billion will mature in 2019 and bear interest at a fixed rate of 4.95% per annum and $2.0 billion will mature in 2039 and bear interest at a fixed rate of 5.90% per annum. This offering is expected to be completed in February 2009, subject to customary closing conditions. The Company intends to use the proceeds from the offering for general corporate purposes and to repay its floating rate notes due in February 2009, in the aggregate principal amount of $500 million.
This Quarterly Report on Form 10-Q, including this Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as expects, anticipates, targets, goals, projects, intends, plans, believes, seeks, estimates, continues, endeavors, may, variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, under Part II, Item 1A. Risk Factors, and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.
In the second quarter of fiscal 2009, our results reflected a 7.5% decrease in net sales compared with the second quarter of fiscal 2008. Net sales were relatively flat during the first six months of fiscal 2009 compared with the first six months of fiscal 2008. As the second quarter of fiscal 2009 progressed, we saw our markets becoming increasingly affected by the continuing global macroeconomic downturn, especially in January 2009, the final month of the quarter. Compared with the corresponding periods of fiscal 2008, net income decreased by 27% and 13% in the second quarter and the first six months of fiscal 2009, respectively, as a result of the lower revenue and lower gross margins. We have undertaken initiatives to reduce our operating expenses, which are expected to have a further impact in future periods. Lower interest and other income during the second quarter and the first six months of fiscal 2009 also contributed to the decrease in net income. Net income per diluted share decreased by 21% and 7% in the second quarter and the first six months of fiscal 2009, respectively, compared with the corresponding periods of fiscal 2008.
The downturn which first started in the United States clearly has spread to customers in our other geographic theaters. During the second quarter and first six months of fiscal 2009, the declines in the enterprise and service provider markets were the most significant and were characterized by cautious spending by customers in those markets. During the second quarter of fiscal 2009, we experienced stronger sales to the public sector relative to our other customer markets. We believe it is likely that this economic downturn will persist; however, we cannot predict its severity or duration.
Strategy and Focus Areas
Drawing from our experience from managing through economic downturns in the past, we have developed a multifaceted strategy for addressing the current economic downturn that involves the following:
As we have done in the past, we will attempt to use the current economic downturn as an opportunity to expand our share of our customers information technology spending and to continue moving into product markets similar, related, or adjacent to those in which we currently are active, which we refer to as product adjacencies. Our approach of aiming to achieve balance across products and services, customer markets and geographic theaters has contributed to the growth we experienced in the past. We have delivered several new products recently, and we are pleased with the breadth and depth of our innovation across all aspects of our business and the impact that we believe this innovation will have on our long-term prospects. We believe that our strategy and our ability to innovate and execute may enable us to improve our relative competitive position in difficult business conditions and may continue to provide us with long-term growth opportunities.
For the second quarter of fiscal 2009, revenue in three of our geographic theaters decreased year over year, while revenue grew by 1% in our European Markets and Japan theaters compared with the second quarter of fiscal 2008. For the first six months of fiscal 2009, total revenue growth was relatively flat compared with the first six months of fiscal 2008, with the revenue increases in our Emerging Markets, Japan and European Markets theaters being offset by the revenue decreases in the United States and Canada and Asia Pacific theaters.
In the second quarter and first six months of fiscal 2009, our net service revenue increased by approximately 10% compared with the corresponding periods of fiscal 2008. Our service and support strategy seeks to capitalize on increased globalization, and we believe this strategy, along with our architectural approach, has the potential to further differentiate us from competitors. Among our product categories, only the advanced technologies category achieved year-over-year revenue growth in the second quarter, with growth in the second quarter and the first six months of fiscal 2009 of 1% and 9%, respectively. The increase in our sales of advanced technologies reflects our balanced product portfolio and our efforts to constantly innovate and evolve into new markets and product adjacencies. Categories within our advanced technologies that showed relative strength during the second quarter of fiscal 2009 were video systems and security products.
In the second quarter and the first six months of fiscal 2009, our revenue from routing products declined by 23% and 11%, respectively compared with the corresponding periods of fiscal 2008, as revenue from high-end, midrange and low-end routers decreased. In the second quarter and the first six months of fiscal 2009, our revenue from switching products declined by 11% and 1%, respectively, compared with the corresponding periods of fiscal 2008.
In view of the decline in our business that we began to experience in the first quarter of fiscal 2009, a decline that continued throughout the second quarter of fiscal 2009 with particular weakness in January 2009, we anticipate that our revenue will continue to decline on a year-over-year basis in the third quarter of fiscal 2009.
In the second quarter and the first six months of fiscal 2009, our gross margin percentage decreased compared with the corresponding periods of fiscal 2008. The decrease was driven by lower product gross margin, which was due to higher sales discounts and rebates, product mix, product pricing, and lower shipment volume, partially offset by lower manufacturing costs. If our shipment volumes, product mix, pricing or other significant factors that impact our gross margin continue to be adversely affected by the economic downturn or market factors, our gross margin could continue to be adversely affected. The decrease in our product margin during the second quarter and first six months of fiscal 2009 was partially offset by higher service margins.
Operating expenses in the second quarter and the first six months of fiscal 2009 increased in both absolute dollars and as a percentage of revenue compared with the corresponding periods of fiscal 2008. For the second quarter and first six months of fiscal 2009, the increase was primarily a result of acquisition-related milestone payments and, for the first six months of fiscal 2009, higher headcount-related expenses also contributed to the increase. In the near term, we anticipate that despite the efforts to reduce operating expenses, operating expenses will continue to increase as a percentage of total revenue, as the anticipated cost savings may not keep pace with expected revenue declines.
Other Financial Highlights
The following is a summary of other financial highlights for the second quarter and first six months of fiscal 2009:
We believe that our strong cash position, our solid balance sheet, our visibility into our supply chain, our strong investment portfolio management, and our financing capabilities together provide a key competitive advantage and collectively enable us to be well positioned to manage our business through the current economic downturn.
Critical Accounting Estimates
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended July 26, 2008 describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements.
The accounting policies described below are significantly affected by critical accounting estimates. Such accounting policies require significant judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies.
Our products are generally integrated with software that is essential to the functionality of the equipment. Additionally, we provide unspecified software upgrades and enhancements related to the equipment through our maintenance contracts for most of our products. Accordingly, we account for revenue in accordance with Statement of Position No. 97-2, Software Revenue Recognition, and all related interpretations. For sales of products where software is incidental to the equipment, or in hosting arrangements, we apply the provisions of Staff Accounting Bulletin No. 104, Revenue Recognition, and all related interpretations. Revenue is recognized when all of the following criteria have been met:
In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. When a sale involves multiple elements, such as sales of products that include services, the entire fee from the arrangement is allocated to each respective element based on its relative fair value and recognized when revenue recognition criteria for each element are met. The amount of product and service revenue recognized is affected by our judgment as to whether an arrangement includes multiple elements and, if so, whether vendor-specific objective evidence of fair value exists. Changes to the elements in an arrangement and our ability to establish vendor-specific objective evidence for those elements could affect the timing of the revenue recognition.
Revenue deferrals relate to the timing of revenue recognition for specific transactions based on financing arrangements, service, support, and other factors. Financing arrangements may include sales-type, direct-financing, and operating leases, loans, and guarantees of third-party financing. Our total deferred revenue for products was $3.2 billion and $2.7 billion as of January 24, 2009 and July 26, 2008, respectively. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which typically ranges from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our total deferred revenue for services was $6.1 billion as of January 24, 2009 and July 26, 2008.
We make sales to distributors and retail partners and recognize revenue based on a sell-through method using information provided by them. Our distributors and retail partners participate in various cooperative marketing and other programs, and we maintain estimated accruals and allowances for these programs. If actual credits received by our distributors and retail partners under these programs were to deviate significantly from our estimates, which are based on historical experience, our revenue could be adversely affected.
Allowance for Doubtful Accounts and Sales Returns
Our accounts receivable balance, net of allowance for doubtful accounts, was $2.9 billion and $3.8 billion as of January 24, 2009 and July 26, 2008, respectively. The allowance for doubtful accounts was $230 million, or 7.4% of the gross accounts receivable balance, as of January 24, 2009, and $177 million, or 4.4% of the gross accounts receivable balance, as of July 26, 2008. The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customers ability to pay.
Our provision for doubtful accounts was $59 million and $29 million for the first six months of fiscal 2009 and 2008, respectively. If a major customers creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our revenue.
A reserve for future sales returns is established based on historical trends in product return rates. The reserve for future sales returns as of January 24, 2009 and July 26, 2008 was $98 million and $103 million, respectively, and was recorded as a reduction of our accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected.
Inventory Valuation and Liability for Purchase Commitments with Contract Manufacturers and Suppliers
Our inventory balance was $1.1 billion and $1.2 billion as of January 24, 2009 and July 26, 2008, respectively. Inventory is written down based on excess and obsolete inventories determined primarily by future demand forecasts. Inventory write-downs are measured as the difference between the cost of the inventory and market based upon assumptions about future demand and are charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.
We record a liability for firm, noncancelable, and unconditional purchase commitments with contract manufacturers and suppliers for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory. As of January 24, 2009, the liability for these purchase commitments was $219 million, compared with $184 million as of July 26, 2008 and was included in other current liabilities.
Our provision for inventory was $25 million and $70 million for the first six months of fiscal 2009 and 2008, respectively. The provision for the liability related to purchase commitments with contract manufacturers and suppliers was $79 million and $37 million for the first six months of fiscal 2009 and 2008, respectively. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory write-downs and our liability for purchase commitments with contract manufacturers and suppliers and gross margin could be adversely affected. Inventory and supply chain management remain areas of focus as we balance the need to maintain supply chain flexibility to help ensure competitive lead times with the risk of inventory obsolescence.
The liability for product warranties, included in other current liabilities, was $359 million as of January 24, 2009, compared with $399 million as of July 26, 2008. See Note 11 to the Consolidated Financial Statements. Our products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products we provide a limited lifetime warranty. We accrue for warranty costs as part of our cost of sales based on associated material costs, technical support labor costs, and associated overhead. Material cost is estimated based primarily upon historical trends in the volume of product returns within the warranty period and the cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities.
The provision for product warranties issued during the first six months of fiscal 2009 and 2008 was $194 million and $247 million, respectively. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our gross margin could be adversely affected.
Share-Based Compensation Expense
Share-based compensation expense recognized under SFAS 123(R) was as follows (in millions):
The determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the awards and actual and projected employee stock option exercise behaviors. The use of a lattice-binomial model requires extensive actual employee exercise behavior data and a number of complex assumptions including expected volatility, risk-free interest rate, expected dividends, kurtosis, and skewness.
Because share-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, it has been reduced for forfeitures. If factors change and we employ different assumptions in the application of SFAS 123(R) in future periods, the compensation expense that we record under SFAS 123(R) may differ significantly from what we have recorded in the current period.
Fair Value Measurements
Our fixed income and publicly traded equity securities, collectively, are reflected in the Consolidated Balance Sheets at a fair value of $25.3 billion as of January 24, 2009, compared with $21.0 billion as of July 26, 2008. See Note 7 to the Consolidated Financial Statements. We apply SFAS 157 in determining the fair value of our investment securities. As described more fully in Note 8 to the Consolidated Financial Statements, SFAS 157 establishes a valuation hierarchy based on the level of independent, objective evidence available regarding the value of the investments. It establishes three classes of investments: Level 1 consists of securities for which there are quoted prices in active markets for identical securities; Level 2 consists of securities for which inputs other than Level 1 inputs are used, such as prices for similar securities in active markets or for identical securities in inactive markets and model-derived valuations for which the variables are derived from, or corroborated by, observable market data; and Level 3 consists of securities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value.
Our fixed income investment portfolio consists primarily of high quality investment grade securities and as of January 24, 2009 had a weighted-average credit rating exceeding AA. Our Level 2 securities are valued using quoted market prices for similar instruments, non-binding market prices that are corroborated by observable market data, or discounted cash flow techniques in limited circumstances. We use inputs such as actual trade data, benchmark yields, broker/dealer quotes and other similar data which are obtained from independent pricing vendors, quoted market prices or other sources to determine the ultimate fair value of our assets and liabilities. We use such pricing data as the primary input, to which we have not made any material adjustments, to make our assessments and determinations as to the ultimate valuation of our investment portfolio, and we are ultimately responsible for the financial statements and underlying estimates. The fair value and inputs are reviewed for reasonableness, may be further validated by comparison to publicly available information and could be adjusted based on market indices or other information that management deems material to their estimate of fair value.
In the current market environment, the assessment of fair value can be difficult and subjective. However, because of the relative reliability of the inputs we use to value our investment portfolio, and because substantially all of our valuation inputs are obtained using quoted market prices for similar or identical assets, we do not believe that the nature of estimates and assumptions affected by levels of subjectivity and judgment was material to the valuation of the investment portfolio as of January 24, 2009. Level 3 assets do not represent a significant portion of our total investment portfolio as of January 24, 2009.
We recognize an impairment charge when the declines in the fair values of our fixed income or publicly traded equity securities fall below their cost basis and the declines are judged to be other-than-temporary. The ultimate value realized on these securities, to the extent unhedged, is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Our ongoing consideration of these factors could result in additional impairment charges in the future, which could adversely affect our net income. The total impairment charges on investments in fixed income securities and publicly traded equity securities during the first six months of fiscal 2009 were $237 million. There were no impairments of fixed income or publicly traded equity securities during the first six months of fiscal 2008. Our impairment charges on investments in privately held companies were $53 million and $8 million during the first six months of fiscal 2009 and 2008, respectively.
Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques. Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. We perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances for each reporting unit. The goodwill recorded in the Consolidated Balance Sheets as of January 24, 2009 and July 26, 2008 was $12.6 billion and $12.4 billion, respectively. In response to changes in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. There was no impairment of goodwill in the first six months of fiscal 2009 and 2008.
We are subject to income taxes in the United States and numerous foreign jurisdictions. Our effective tax rates differ from the statutory rate primarily due to the tax impact of state taxes, foreign operations, R&D tax credits, tax audit settlements, nondeductible compensation, and international realignments. Our effective tax rate was 19.5% and 21.9% in second quarter of fiscal 2009 and 2008, respectively. The effective tax rate was 17.2% and 18.9% for the first six months of fiscal 2009 and 2008, respectively.
Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest.
Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.
Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in countries that have lower tax rates and higher than anticipated in countries that have higher tax rates; by changes in the valuation of our deferred tax assets and liabilities; by expiration of or lapses in the R&D tax credit laws; by transfer pricing adjustments including the effect of acquisitions on our intercompany R&D cost sharing arrangement and legal structure; by tax effects of nondeductible compensation; by tax costs related to intercompany realignments; or by changes in tax laws, regulations, or accounting principles, including accounting for uncertain tax positions or interpretations thereof. Significant judgment is required to determine the recognition and measurement attribute prescribed in FIN 48. In addition, FIN 48 applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely impact our provision for income taxes or additional paid-in capital. Further, as a result of certain of our ongoing employment and capital investment actions and commitments, our income in certain countries is subject to reduced tax rates and in some cases is wholly exempt from tax. Our failure to meet these commitments could adversely affect our provision for income taxes. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Service and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse impact on our operating results and financial condition.
We are subject to the possibility of various losses arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.
Third parties, including customers, have in the past and may in the future assert claims or initiate litigation related to exclusive patent, copyright, trademark, and other intellectual property rights to technologies and related standards that are relevant to us. These assertions have increased over time as a result of our growth and the general increase in the pace of patent claims assertions, particularly in the United States. If any infringement or other intellectual property claim made against us by any third party is successful, or if we fail to develop non-infringing technology or license the proprietary rights on commercially reasonable terms and conditions, our business, operating results, and financial condition could be materially and adversely affected.
During the first quarter of fiscal 2009, we began to allocate certain costs, which had previously been recorded in general and administrative expenses (related to information technology, financing business, and human resources), to sales and marketing, research and development, and cost of sales, as applicable. These changes also resulted in reclassifications to prior period gross margin by theater amounts. In addition, we have made certain reclassifications to prior period amounts relating to net sales by theater and net sales for similar groups of products due to refinement of the respective categories.
The following table presents the breakdown of net sales between product and service revenue (in millions, except percentages):
In the second quarter of fiscal 2009, we experienced a decline in our business compared with the second quarter of fiscal 2008 due, we believe, to the global economic downturn and the effect it has had on information technology spending. The