Cisco Systems 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the quarterly period ended May 1, 2010
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 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 May 20, 2010, 5,711,151,107 shares of the registrants common stock were outstanding.
FORM 10-Q for the Quarter Ended May 1, 2010
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 EQUITY
In September 2001, the Companys Board of Directors authorized a stock repurchase program. As of May 1, 2010, the Companys Board of Directors had authorized an aggregate repurchase of up to $72 billion of common stock under this program with no termination date. For additional information regarding stock repurchases, see Note 12 to the Consolidated Financial Statements. The stock repurchases since the inception of this program and the related impact on Cisco shareholders equity are summarized in the table below (in millions):
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 2010 is a 53-week fiscal year and fiscal 2009 was a 52-week fiscal year. The third quarter of fiscal 2010 consisted of 14 weeks, one week more than a typical quarter. 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.
The accompanying financial data as of May 1, 2010 and for the three and nine months ended May 1, 2010 and April 25, 2009 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 generally accepted accounting principles in the United States (GAAP) have been condensed or omitted pursuant to such rules and regulations. The July 25, 2009 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 25, 2009.
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 May 1, 2010, and results of operations for the three and nine months ended May 1, 2010 and April 25, 2009, cash flows, and equity for the nine months ended May 1, 2010 and April 25, 2009, as applicable, have been made. The results of operations for the three and nine months ended May 1, 2010 are not necessarily indicative of the operating results for the full fiscal year or any future periods.
The Company has made certain reclassifications to prior period amounts relating to net sales for similar groups of products, and gross margin by theater, 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.
The Company has evaluated subsequent events through the date that the financial statements were issued based on the accounting guidance for subsequent events.
(a) New Accounting Standards Recently Adopted
Revenue Recognition for Arrangements with Multiple Deliverables
In October 2009, the Financial Accounting Standards Board (FASB) amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance, tangible products containing software components and nonsoftware components that function together to deliver the products essential functionality. In October 2009, the FASB also amended the accounting standards for multiple-deliverable revenue arrangements to:
The Company elected to early adopt this accounting guidance at the beginning of its first quarter of fiscal 2010 on a prospective basis for applicable transactions originating or materially modified after July 25, 2009.
This guidance does not generally change the units of accounting for the Companys revenue transactions. Most products and services qualify as separate units of accounting. Products are typically considered delivered upon shipment. 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. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which is typically from one to three years. Consulting services for specific customer networking needs, which the Company refers to as advanced services, are recognized upon delivery or completion of performance. Advanced service arrangements are typically short term in nature and are largely completed within 90 days from the start of service. The Companys arrangements generally do not include any provisions for cancellation, termination, or refunds that would significantly impact recognized revenue.
Many of the Companys products have both software and nonsoftware components that function together to deliver the products essential functionality. The Companys product offerings fall into the following categories: routing, switching, advanced technologies, and other products, which include emerging technologies. In addition to its product offerings, the Company provides a broad range of technical support and advanced services, as discussed above. The Company has a broad customer base that encompasses virtually all types of public and private entities, including enterprise businesses, service providers, commercial customers, and consumers. The Company and its sales force are not organized by product divisions and all of the above described products and services can be sold standalone or together in various combinations across the Companys geographic segments or customer markets. For example, service provider arrangements are typically larger in scale with longer deployment schedules and involve the delivery of a variety of product technologies, including high-end routing, video and network management software, among others, along with technical support and advanced services. The Companys enterprise and commercial arrangements are typically unique for each customer and smaller in scale and may include network infrastructure products such as routers and switches or collaboration technologies such as Unified Communications and Cisco TelePresence systems along with technical support services. Consumer products, including Linksys wireless routers and Pure Digital video recorders, are sold in standalone arrangements directly to distributors and retailers without support, as customers generally only require repair or replacement of defective products or parts under warranty.
The Company enters into revenue arrangements that may consist of multiple deliverables of its product and service offerings due to the needs of its customers. For example, a customer may purchase routing products along with a contract for technical support services. This arrangement would consist of multiple elements, with the products delivered in one reporting period and the technical support services delivered across multiple reporting periods. Another customer may purchase networking products along with advanced service offerings, in which all the elements are delivered within the same reporting period. In addition, distributors and retail partners purchase products or services on a standalone basis for the purpose of stocking for resale to an end user, and these transactions would not result in a multiple element arrangement.
For transactions entered into prior to the first quarter of fiscal 2010, the Company primarily recognized revenue based on software revenue recognition guidance. For the vast majority of the Companys arrangements involving multiple deliverables, such as sales of products with services, the entire fee from the arrangement was allocated to each respective element based on its relative selling price, using VSOE. In the limited circumstances when the Company was not able to determine VSOE for all of the deliverables of the arrangement, but was able to obtain VSOE for any undelivered elements, revenue was allocated using the residual method. Under the residual method, the amount of revenue allocated to delivered elements equaled the total arrangement consideration less the aggregate selling price of any undelivered elements, and no revenue was recognized until all elements without VSOE had been delivered. If VSOE of any undelivered items did not exist, revenue from the entire arrangement was initially deferred and recognized at the earlier of (i) delivery of those elements for which VSOE did not exist or (ii) when VSOE can be established. However, in limited cases where technical support services were the only undelivered element without VSOE, the entire arrangement fee was recognized ratably as a single unit of accounting over the technical services contractual period. The residual and ratable revenue recognition methods were generally used in a limited number of arrangements containing advanced and emerging technologies, such as Cisco TelePresence systems. Several of these technologies are sold as solution offerings whereby products or services are not sold on a standalone basis.
In many instances, products are sold separately in standalone arrangements as customers may support the products themselves or purchase support on a time and materials basis. Advanced services are sold in standalone engagements such as general consulting, network management, or security advisory projects. Also, technical support services are sold separately through renewals of annual contracts. As a result, for substantially all of the arrangements with multiple deliverables pertaining to routing and switching products and related services, as well as most arrangements containing advanced and emerging technologies, the Company has used and intends to continue using VSOE to allocate the selling price to each deliverable. Consistent with its methodology under previous accounting guidance, the Company determines VSOE based on its normal pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, the Company requires that a substantial majority of the selling prices for a product or service fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical standalone transactions falling within plus or minus 15% of the median rates. In addition, the Company considers the geographies in which the products or services are sold, major product and service groups and customer classifications, and other environmental or marketing variables in determining VSOE.
In certain limited instances, the Company is not able to establish VSOE for all deliverables in an arrangement with multiple elements. This may be due to the Company infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. When VSOE cannot be established, the Company attempts to establish selling price of each element based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, the Companys go-to-market strategy differs from that of its peers and its offerings contain a significant level of customization and differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor products selling prices are on a standalone basis. Therefore, the Company is typically not able to determine TPE.
When the Company is unable to establish selling price using VSOE or TPE, the Company uses ESP in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a standalone basis. ESP is generally used for new or highly customized offerings and solutions or offerings not priced within a narrow range, and it applies to a small proportion of the Companys arrangements with multiple deliverables.
The Company determines ESP for a product or service by considering multiple factors, including, but not limited to, geographies, market conditions, competitive landscape, internal costs, gross margin objectives, and pricing practices. The determination of ESP is made through consultation with and formal approval by the Companys management, taking into consideration the go-to-market strategy.
The Company regularly reviews VSOE, TPE, and ESP and maintains internal controls over the establishment and updates of these estimates. There were no material impacts during the quarter nor does the Company currently expect a material impact in the near term from changes in VSOE, TPE, or ESP.
Net sales as reported and the Companys estimate of the pro forma net sales that would have been reported during the three and nine months ended May 1, 2010, if the transaction entered into or materially modified after July 25, 2009 were subject to previous accounting guidance, are shown in the following table (in millions):
The estimated impact to net sales of the accounting standard was primarily to net product sales.
The new accounting standards for revenue recognition if applied in the same manner to the year ended July 25, 2009 would not have had a material impact on net sales for that fiscal year. In terms of the timing and pattern of revenue recognition, the new accounting guidance for revenue recognition is not expected to have a significant effect on net sales in periods after the initial adoption when applied to multiple-element arrangements based on current go-to-market strategies due to the existence of VSOE across most of the Companys product and service offerings. However, the Company expects that this new accounting guidance will facilitate the Companys efforts to optimize its offerings due to better alignment between the economics of an arrangement and the accounting. This may lead to the Company engaging in new go-to-market practices in the future. In particular, the Company expects that the new accounting standards will enable it to better integrate products and services without VSOE into existing offerings and solutions. As these go-to-market strategies evolve, the Company may modify its pricing practices in the future, which could result in changes in selling prices, including both VSOE and ESP. As a result, the Companys future revenue recognition for multiple-element arrangements could differ materially from the results in the current period. The Company is currently unable to determine the impact that the newly adopted accounting guidance could have on its revenue as these go-to-market strategies evolve.
The Companys arrangements with multiple deliverables may have a standalone software deliverable that is subject to the existing software revenue recognition guidance. The revenue for these multiple-element arrangements is allocated to the software deliverable and the nonsoftware deliverables based on the relative selling prices of all of the deliverables in the arrangement using the hierarchy in the new revenue accounting guidance. In the limited circumstances where the Company cannot determine VSOE or TPE of the selling price for all of the deliverables in the arrangement, including the software deliverable, ESP is used for the purposes of performing this allocation.
Fair Value Measures
Effective as of the first quarter of fiscal 2010, the Company adopted revised accounting guidance for the fair value measurement and disclosure of its 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). The adoption of this accounting guidance did not have a material impact on the Companys financial position or results of operations. In January 2010, the FASB issued revised guidance intended to improve disclosures related to fair value measurements. This guidance requires new disclosures as well as clarifies certain existing disclosure requirements. New disclosures under this guidance require separate information about significant transfers in and out of Level 1 and Level 2 fair value measurement categories and the reason for such transfers and also require purchases, sales, issuances, and settlements information for Level 3 measurements to be included in the rollforward of activity on a gross basis. The guidance also clarifies the requirement to determine the level of disaggregation for fair value measurement disclosures and the requirement to disclose valuation techniques and inputs used for both recurring and nonrecurring fair value measurements in either Level 2 or Level 3. This accounting guidance was effective for the Company beginning in the third quarter of fiscal 2010, except for the rollforward of activity on a gross basis for Level 3 fair value measurement, which will be effective for the Company in the first quarter of fiscal 2012. The Company adopted the applicable portions of this guidance beginning in the third quarter of fiscal 2010, and it is currently evaluating the impact that the adoption of the remainder of this guidance might have on its financial statement disclosures in the first quarter of fiscal 2012.
Business Combinations and Noncontrolling Interests
Effective the first quarter of fiscal 2010, the Company adopted the revised accounting guidance for business combinations, which changed its previous accounting practices regarding business combinations. The more significant changes include an expanded definition of a business and a business combination; recognition of assets acquired, liabilities assumed and noncontrolling interests (including goodwill) measured at fair value at the acquisition date; recognition of acquisition-related expenses and restructuring costs separately from the business combination; recognition of assets acquired and liabilities assumed at their acquisition-date fair values with subsequent changes recognized in earnings; and capitalization of in-process research and development (IPR&D) at fair value as an indefinite-lived intangible asset. Such IPR&D will be assessed for impairment until completion and, following completion, will be amortized. The guidance also amends and clarifies the application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. The impact of this accounting guidance and its relevant updates on the Companys results of operations or financial position will vary depending on each specific business combination or asset purchase. See Note 3.
Effective in the first quarter of fiscal 2010, the Company adopted revised accounting guidance which requires noncontrolling interests (formerly minority interest) to be presented as a separate component from the Companys equity in the equity section of the Consolidated Balance Sheets. The net income attributable to the noncontrolling interests was not significant to the Companys consolidated operating results and was not presented separately in the Consolidated Statements of Operations. In accordance with the adoption of this accounting guidance, the Company has expanded disclosures on noncontrolling interests in its consolidated financial statements where applicable, and the relevant presentation and disclosures have been applied retrospectively for all periods presented. The adoption of this accounting guidance had no impact on the Companys results of operations and did not have a material impact on the Companys financial position.
(b) Recent Accounting Standards Not Yet Effective
In June 2009, the FASB issued revised guidance for the accounting of variable interest entities. This revised guidance replaces the quantitative-based risks and rewards approach with a qualitative approach that focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entitys economic performance and has the obligation to absorb losses or the right to receive benefits from the entity that could be potentially significant to the variable interest entity. The accounting guidance also requires an ongoing reassessment of whether an enterprise is the primary beneficiary and requires additional disclosures about an enterprises involvement in variable interest entities. This accounting guidance is effective for the Company beginning in the first quarter of fiscal 2011. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements. In February 2010, the FASB issued amendments to the consolidation requirements for certain investment funds. The amendments specify the attributes that qualify an entity for deferral of the application of Consolidations: Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities. The amendments include guidance on the nature and characteristics, and on the applicable disclosure requirements, for entities that qualify for the deferral. The amendments further provide that if an entity that initially met the deferral requirements ceases to qualify for the deferral as a result of a change in facts and circumstances, the reporting entity shall initially measure the assets, liabilities, and noncontrolling interests of the variable interest entity as of the date the entity ceased to qualify for the deferral. The amendments also clarify that when performing an analysis on whether or not the fees paid to a legal entitys decision maker or service provider are variable interests, a related partys interest should be considered as though it were the reporting entitys own interest. These amendments are effective for the Company beginning in the first quarter of fiscal 2011. The Company is currently evaluating the impact that the adoption of these amendments will have on its consolidated financial statements.
In June 2009, the FASB issued revised guidance for the accounting of transfers of financial assets. This guidance eliminates the concept of a qualifying special-purpose entity, removes the scope exception for qualifying special-purpose entities when applying the accounting guidance related to the consolidation of variable interest entities, changes the requirements for derecognizing financial assets, and requires enhanced disclosure. This accounting guidance is effective for the Company beginning in the first quarter of fiscal 2011. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements.
(a) Business Combinations Completed During the Period
A summary of the business combinations completed during the nine months ended May 1, 2010 is as follows (in millions):
The Company continues to evaluate certain assets and liabilities related to business combinations completed during the period. Additional information, which existed as of the acquisition date but was at that time unknown to the Company, may become known to the Company during the remainder of the measurement period, a period not to exceed 12 months from the acquisition date. Changes to amounts recorded as assets or liabilities may result in a corresponding adjustment to goodwill.
The total purchase consideration related to the Companys business combinations completed during the nine months ended May 1, 2010, consisted of approximately $6.0 billion in cash and $82 million in vested share-based awards assumed. For the April 2010 acquisition of Tandberg, of the total consideration of $3.3 billion, approximately $281 million (based on exchange rates in effect as of May 1, 2010) relating to the compulsory acquisition of non-tendered shares is expected to be paid during the fourth quarter of fiscal 2010.
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 nine months ended May 1, 2010 have not been presented because the effects of the acquisitions, individually and in the aggregate, were not material to the Companys financial results. For the three and nine months ended May 1, 2010, the Company recorded business combination-related transaction costs of $10 million and $33 million, respectively, within general and administrative expenses.
(b) Cash Compensation Expense Related to Acquisitions and Investments
In connection with the Companys business combinations and asset purchases, the Company has agreed to pay certain 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.
The following table presents the cash compensation expense related to acquisitions and investments (in millions):
The Company may be required to recognize future compensation expense pursuant to these agreements of up to $206 million, which includes the remaining potential amount of compensation expense related to Nuova Systems, Inc., as discussed below.
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 noncontrolling interest holders of Nuova Systems are eligible to receive up to three milestone payments based on agreed-upon formulas totaling up to a maximum of $678 million. During the first nine months of fiscal 2010, the Company recorded $65 million of compensation expense, and through May 1, 2010, the Company has recorded aggregate compensation expense of $487 million related to the fair value of amounts that are expected to be earned by the former noncontrolling interest holders pursuant to a vesting schedule. Of this compensation, approximately $261 million was paid during the third quarter of fiscal 2010, and the remainder is expected to be paid primarily in fiscal 2011 and fiscal 2012. Actual amounts payable to the former noncontrolling interest holders of Nuova Systems will depend upon achievement under the agreed-upon formulas and vesting.
The following table presents the goodwill allocated to the Companys reportable segments as of and during the nine months ended May 1, 2010 (in millions):
In the table above, Other primarily includes foreign currency translation.
(b) Purchased Intangible Assets
The following table presents details of the Companys purchased intangible assets acquired through business combinations during the nine months ended May 1, 2010 (in millions, except years):
The following tables present details of the Companys purchased intangible assets (in millions):
Purchased intangible assets include technology intangible assets acquired through business combinations as well as through technology licenses.
Effective the first quarter of fiscal 2010, with the adoption of revised accounting guidance for business combinations, IPR&D has been capitalized at fair value as an intangible asset with an indefinite life and will be assessed for impairment thereafter. Upon completion of the development of the underlying marketable products, the capitalized IPR&D asset will be amortized over its estimated useful life. Prior to the adoption of the revised accounting guidance, IPR&D was expensed upon acquisition if it had no alternative future use.
The following table presents the amortization of purchased intangible assets (in millions):
The Company recorded impairment charges of $5 million and $13 million during the three and nine months ended May 1, 2010, respectively, and $11 million and $34 million during the three and nine months ended April 25, 2009, respectively. These impairment charges were due to reductions in expected future cash flows related to certain technologies and were recorded as amortization of purchased intangible assets.
The estimated future amortization expense of purchased intangible assets with finite lives as of May 1, 2010 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 of up 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 May 1, 2010 are as follows (in millions):
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 that are generally for various third-party financing arrangements extended to channel partners and end-user customers.
Channel Partner Financing Guarantees
The Company facilitates 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. 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 nine months ended May 1, 2010, the volume of channel partner financing was $4.4 billion and $12.3 billion, respectively, compared with $3.0 billion and $10.7 billion for the three and nine months ended April 25, 2009, respectively. As of May 1, 2010 and July 25, 2009, the balance of the channel partner financing subject to guarantees was $1.4 billion and $1.1 billion, respectively.
End-User Financing Guarantees
The Company also provides financing guarantees for third-party financing arrangements extended to end-user customers related to leases and loans that typically have terms of up to three years. During the three and nine months ended May 1, 2010, the volume of financing provided by third parties for leases and loans on which the Company has provided guarantees was $215 million and $625 million, respectively, compared with $316 million and $960 million for the three and nine months ended April 25, 2009, respectively.
Financing Guarantee Summary
The aggregate amount of financing guarantees outstanding at May 1, 2010 and July 25, 2009, representing the total maximum potential future payments under financing arrangements with third parties and the related deferred revenue, are summarized in the following table (in millions):
(a) Summary of Available-for-Sale Investments
The following tables summarize the Companys available-for-sale investments (in millions):
(b) Gains and Losses on Available-for-Sale Investments
The following table summarizes the realized net gains (losses) associated with the Companys available-for-sale investments (in millions):
There were no impairment charges on investments in fixed income securities and publicly traded equity securities during the third quarter and first nine months of fiscal 2010. For the third quarter and first nine months of fiscal 2009, net gains (losses) on investments in fixed income securities included impairment charges of $17 million and $219 million, respectively, and net gains (losses) on investments in publicly traded equity securities included impairment charges of $4 million and $39 million, respectively. All such impairment charges 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.
The following table summarizes the activity related to credit losses for fixed income securities (in millions):
The following tables present the breakdown of the available-for-sale investments with gross unrealized losses and the duration that those losses have been unrealized at May 1, 2010 and July 25, 2009 (in millions):
For fixed income securities that have unrealized losses as of May 1, 2010, the Company has determined that (i) it does not have the intent to sell any of these investments, and (ii) it is not more likely than not that it will be required to sell any of these investments before recovery of the entire amortized cost basis. In addition, as of May 1, 2010, the Company anticipates that it will recover the entire amortized cost basis of such fixed income securities and has determined that no other-than-temporary impairments associated with credit losses were required to be recognized during the three and nine months ended May 1, 2010.
The Company has evaluated its publicly traded equity securities as of May 1, 2010 and has determined that there were no unrealized losses that indicate an other-than-temporary impairment. This determination was based on several factors, which include the length of time and extent to which fair value has been less than the cost basis and the financial condition and near-term prospects of the issuer, and the Companys intent and ability to hold the publicly traded equity securities for a period of time sufficient to allow for any anticipated recovery in market value.
(c) Maturities of Fixed Income Securities
The following table summarizes the maturities of the Companys fixed income securities at May 1, 2010 (in millions):
Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.
Pursuant to the accounting guidance for fair value measurements and its subsequent updates, fair value is defined 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
The accounting guidance for fair value measurement also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard 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. The fair value hierarchy is as follows:
Level 1 Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.
Level 2 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 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 May 1, 2010 and July 25, 2009 were as follows (in millions):
Government securities, government agency securities and corporate debt securities include an aggregate of $328 million and $409 million of cash equivalents as of May 1, 2010 and July 25, 2009, respectively.
Level 2 fixed income securities are priced using quoted market prices for similar instruments, nonbinding market prices that are corroborated by observable market data, or in limited circumstances, discounted cash flow techniques. The Company uses inputs such as actual trade data, benchmark yields, broker/dealer quotes, and other similar data, which are obtained from quoted market prices, independent pricing vendors, or other sources, to determine the ultimate fair value of these assets and liabilities. The Company uses such pricing data as the primary inputs to make its assessments and determinations as to the ultimate valuation of its investment portfolio and has not made, during the periods presented, any material adjustments to such inputs. The Company is ultimately responsible for the financial statements and underlying estimates. The Companys derivative instruments are primarily classified as Level 2, as they are not actively traded and are valued using pricing models that use observable market inputs. The Company did not have any transfers between Level 1 and Level 2 fair value measurements during the three or nine months ended May 1, 2010.
Level 3 assets include asset-backed securities, certain derivative instruments, and property held for sale, whose values are determined based on discounted cash flow models using inputs that the Company could not corroborate with market data.
The following tables present a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended May 1, 2010 and April 25, 2009 (in millions):
(c) Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
The following table presents the Companys financial instruments and non-financial assets that were measured at fair value on a nonrecurring basis and the losses recorded for the periods presented (in millions):
The following table presents the Companys financial instruments that were measured at fair value on a nonrecurring basis and the losses recorded for the periods presented (in millions):
The losses for the investments in privately held companies were recorded to other income (loss), net, and the losses for purchased intangible assets were included in amortization of purchased intangible assets.
The assets in the preceding tables were measured at fair value due to events or circumstances the Company identified that significantly impacted the fair value of these assets during the periods presented. The Company measured the fair value for investments in privately held companies using financial metrics, comparison to other private and public companies, and analysis of the financial condition and near-term prospects of the issuer, 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 assessment of the assumptions market participants would use in pricing these investments due to the absence of quoted market prices and inherent lack of liquidity. The Company measured the fair value for these purchased intangible assets using discounted cash flow techniques, and these assets were classified as Level 3 assets because the Company used unobservable inputs to value them, reflecting the Companys assessment of the assumptions market participants would use in valuing these purchased intangible assets.
The fair value of certain of the Companys financial instruments that are not measured at fair value, including accounts receivable, accounts payable, accrued compensation, and other current liabilities, approximates the carrying amount because of their short maturities. In addition, the fair value of the Companys loan receivables and financed service contracts also approximates the carrying amount. The fair value of the Companys debt is disclosed in Note 9 and was determined using quoted market prices for those securities.
The following table summarizes the Companys debt (in millions, except percentages):
In November 2009, the Company issued senior unsecured notes in an aggregate principal amount of $5.0 billion. Of these notes, $500 million will mature in 2014 and bear interest at a fixed rate of 2.90% per annum (the 2014 Notes), $2.5 billion will mature in 2020 and bear interest at a fixed rate of 4.45% per annum (the 2020 Notes), and $2.0 billion will mature in 2040 and bear interest at a fixed rate of 5.50% per annum (the 2040 Notes). To achieve its interest rate risk management objectives, during the three months ended May 1, 2010, the Company entered into a $750 million notional amount interest rate swap designated as a fair value hedge of a portion of the 2016 Notes. Subsequent to May 1, 2010, the Company entered into an additional $750 million notional amount interest rate swap, designated as a fair value hedge of an additional portion of the 2016 Notes. In effect, these swaps convert the fixed interest rates of a portion of the 2016 Notes to floating interest rates based on the London InterBank Offered Rate (LIBOR) plus a fixed number of basis points. Gains and losses in the value of the interest rate swaps substantially offset changes in the fair value of the hedged portion of the underlying debt.
The effective rates for the fixed-rate debt include the interest on the notes, the accretion of the discount, and adjustments related to hedging, if applicable. Based on market prices, the fair value of the Companys senior notes was $15.8 billion and $10.5 billion as of May 1, 2010 and July 25, 2009, respectively. Interest is payable semiannually on each class of the senior fixed-rate notes. The notes are redeemable by the Company at any time, subject to a make-whole premium. The Company was in compliance with all debt covenants as of May 1, 2010.
Interest expense and cash paid for interest are summarized as follows (in millions):
(b) Credit Facility
The Company has a credit agreement with certain institutional lenders providing for a $3.0 billion unsecured revolving credit facility that is scheduled to expire on August 17, 2012. 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 comply with certain covenants, including that it maintains an interest coverage ratio as defined in the agreement.
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 by up to an additional $1.9 billion and/or extend the expiration date of the credit facility up to August 15, 2014. As of May 1, 2010, the Company was in compliance with the required interest coverage ratio and the other covenants, and the Company had not borrowed any funds under the credit facility.
Other notes and borrowings include notes and credit facilities with a number of financial institutions that are available to certain foreign subsidiaries of the Company. The amount of borrowings outstanding under these arrangements was $72 million and $2 million at May 1, 2010 and July 25, 2009, respectively.
10. Derivative Instruments
(a) Summary of Derivative Instruments
The Company uses derivative instruments primarily to manage exposures to foreign currency exchange rate, interest rate, and equity 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 exchange rates, interest rates, and equity 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 does, however, seek 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.
The fair values of the Companys derivative instruments and the line items on the Consolidated Balance Sheets to which they were recorded are summarized as follows (in millions):
The effect of the Companys cash flow hedging instruments on other comprehensive income (OCI) and the Consolidated Statement of Operations is summarized as follows (in millions):
During the three and nine months ended May 1, 2010 and April 25, 2009, the amounts recognized in earnings on derivative instruments designated as cash flow hedges related to the ineffective portion were not material, and the Company did not exclude any component of the changes in fair value of the derivative instruments from the assessment of hedge effectiveness.
As of May 1, 2010, the Company estimates that approximately $13 million of net derivative losses related to its cash flow hedges included in accumulated other comprehensive income (AOCI) will be reclassified into earnings within the next 12 months.
The effect on the Consolidated Statement of Operations of derivative instruments designated as fair value hedges is summarized as follows (in millions):
The effect on the Consolidated Statement of Operations of derivative instruments not designated as hedges is summarized as follows (in millions):
(b) Foreign Currency Exchange Risk
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 such contracts for trading purposes.
The Company hedges 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 Company assesses effectiveness based on changes in total fair value of the derivatives. The effective portion of the derivative instruments gain or loss is initially reported as a component of AOCI 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. 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.
The Company enters into foreign exchange forward and option 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. These derivatives are not designated as hedging instruments. Gains and losses on the contracts are included in other income (loss), net, and substantially offset foreign exchange gains and losses from the remeasurement of intercompany balances or other current assets, investments, or liabilities denominated in currencies other than the functional currency of the reporting entity.
During the nine months ended May 1, 2010, the Company entered into foreign exchange forward and options contracts denominated in Norwegian kroner to hedge against a portion of the foreign currency exchange risk associated with the purchase consideration for the acquisition of Tandberg. These contracts were not designated as hedging instruments. Gains and losses on such contracts are included in other income (loss), net. The Company recognized net losses of $14 million and $10 million for the third quarter and first nine months of fiscal 2010, respectively, relating to such contracts denominated in Norwegian kroner.
The Company hedges certain net investments in its foreign subsidiaries with forward contracts, which generally have maturities of up to six months. The Company recognized a loss of $4 million in OCI for the effective portion of its net investment hedges for the nine months ended May 1, 2010. The Companys net investment hedges are not included in the preceding tables.
The notional amounts of the Companys foreign currency derivatives are summarized as follows (in millions):
(c) Interest Rate Risk
Interest Rate Derivatives, Investments
The Companys primary objective for holding fixed income securities is to achieve an appropriate investment return consistent with preserving principal and managing risk. To realize these objectives, the Company may utilize interest rate swaps or other derivatives designated as fair value or cash flow hedges. As of May 1, 2010 and July 25, 2009, the Company did not have any outstanding interest rate derivatives related to its fixed income securities.
Interest Rate Derivatives, Long-Term Debt
During the nine months ended May 1, 2010, the Company entered into $3.7 billion of interest rate derivatives designated as cash flow hedges to hedge against interest rate movements in connection with the anticipated issuance of senior notes in November 2009. The effective portion of these hedges was recorded to AOCI, net of tax, and is being amortized to interest expense over the respective lives of the notes. These derivative instruments were settled in connection with the actual issuance of the senior notes in November 2009.
During the third quarter of fiscal 2010, the Company entered into a $750 million notional amount interest rate swap designated as a fair value hedge of a portion of the 2016 Notes. Subsequent to May 1, 2010, the Company entered into an additional $750 million notional amount interest rate swap, designated as a fair value hedge of an additional portion of the 2016 Notes. Under these interest rate swap contracts, the Company receives fixed-rate interest payments and makes interest payments based on LIBOR plus a fixed number of basis points. The effect of these swaps is to convert fixed-rate interest expense on a portion of the 2016 Notes to a floating rate interest expense. The gains and losses related to changes in the fair value of the interest rate swaps are included in interest expense in the Consolidated Statements of Operations and substantially offset changes in the fair value of the hedged portion of the underlying hedged debt. As of May 1, 2010 the fair value of the interest rate swaps was $1 million and was reflected in other assets in the Consolidated Balance Sheet.
(d) Equity Price Risk
The Company may hold equity securities for strategic purposes or to diversify its overall investment portfolio. The publicly traded equity securities in the Companys portfolio are subject to price risk. To manage its exposure to changes in the fair value of certain equity securities, the Company may enter into equity derivatives that are designated as fair value or cash flow hedges. The changes in the value of the hedging instruments are included in other income (loss), net, and offset the change in the fair value of the underlying hedged investment. The Company did not have any equity derivatives outstanding as of May 1, 2010 and July 25, 2009.
In addition, the Company periodically manages the risk of its investment portfolio by entering into equity derivatives that are not designated as accounting hedges. The changes in the fair value of these derivatives were also included in other income (loss), net. The Company is also exposed to variability in compensation charges related to certain deferred compensation obligations to employees. Although not designated as accounting hedges, the Company utilizes equity derivatives to economically hedge this exposure. As of May 1, 2010 and July 25, 2009, the notional amount of the derivative instruments used to hedge such liabilities was $167 million and $91 million, respectively.
(e) Credit-Risk-Related Contingent Features
Certain derivative instruments are executed under agreements that have provisions requiring the Company and counterparty to maintain a specified credit rating from certain credit rating agencies. If the Companys or counterpartys credit rating falls below a specified credit rating, either party has the right to request collateral on the derivatives net liability position. Such provisions did not affect the Companys financial position as of May 1, 2010 and July 25, 2009.
(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. The Company also leases equipment and vehicles. Future minimum lease payments under all noncancelable operating leases with an initial term in excess of one year as of May 1, 2010 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 consists of 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 May 1, 2010 and July 25, 2009, the Company had total purchase commitments for inventory of $4.3 billion and $2.2 billion, respectively.
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 May 1, 2010 and July 25, 2009, the liability for these purchase commitments was $148 million and $175 million, respectively, and was included in other current liabilities.
(c) Other Commitments
In connection with the Companys business combinations and asset purchases, 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.
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 $299 million and $313 million as of May 1, 2010 and July 25, 2009, respectively.
(d) 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 May 1, 2010.
(e) Product Warranties and Guarantees
The following table summarizes the activity related to the product warranty liability during the nine months ended May 1, 2010 and April 25, 2009 (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 Companys products 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 end-user customers. See Note 6. The Companys other guarantee arrangements as of May 1, 2010 and July 25, 2009 that are subject to recognition and disclosure requirements were not material.
(f) Legal Proceedings
Brazilian authorities have investigated 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 alleged evasion of import taxes and alleged improper transactions involving the subsidiary and the importer. Brazilian authorities have assessed claims against the Companys Brazilian subsidiary based on a theory of joint liability with the Brazilian importer for import taxes and related penalties. The claims are for calendar years 2003 through 2007 and aggregate to approximately $190 million for the alleged evasion of import taxes, $85 million for interest, and approximately $1.6 billion for various penalties, all determined using an exchange rate as of May 1, 2010. The Company has completed a thorough review of the matter and believes the asserted tax claims against it are without merit, and the Company intends to defend the claims vigorously. 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 determine the likelihood of an unfavorable outcome against it and is unable to reasonably estimate a range of loss, if any. The Company does not expect a final judicial determination for several years.
The Company has investigated the alleged improper transactions referred to above. The Company communicated with United States authorities to provide information and report on its findings and the United States authorities have investigated such allegations.
The Company and other defendants are also subject to patent claims asserted by Network-1 Security Solutions, Inc. on February 7, 2008 in the Federal District Court for the Eastern District of Texas. Network-1 alleges that various Cisco products implement a method for remotely powering equipment that infringes U.S. Patent No. 6,218,930. Network-1 seeks monetary damages. The trial on these claims is scheduled to begin in July 2010. The Company believes it has strong arguments that its products do not use the technology described in the patent and that the patent is, in any case, invalid. If the jury were to find that Ciscos products infringe this patent and find that the patent is valid, the Company believes damages are not likely to be material given the limited contribution it believes is played by the technology the plaintiff claims is covered by the patent. However, due to the uncertainty surrounding the litigation process, the Company is unable to reasonably estimate the ultimate outcome of this litigation at this time.
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 May 1, 2010, the Companys Board of Directors had authorized an aggregate repurchase of up to $72 billion of common stock under this program and the remaining authorized repurchase amount was $9.3 billion with no termination date. The stock repurchase activity under the stock repurchase program during the nine months ended May 1, 2010 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. 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
For the nine months ended May 1, 2010 and April 25, 2009, the Company repurchased approximately 3.7 million and 0.8 million shares, respectively, 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, net of tax, 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 a result, SOFTBANKs interest in the change in the unrealized gains and losses on the investments in the venture fund is shown as comprehensive income attributable to noncontrolling interests.
The components of AOCI, net of tax, are summarized as follows (in millions):
(a) Employee Stock Purchase Plan
The Company has an Employe