Net sales grew to $6.4 billion in 1997 from $4.1 billion in 1996. The 57.2% increase in net sales during the year was primarily the result of increasing unit sales of LAN switching products such as the Catalyst® 5000, high-end routers such as the Cisco 7500 product family, modular access routers such as the Cisco 4700, and growth in the sales of add-on boards that provide increased functionality. These increases were partially offset by decreasing unit sales of the Company's older product lines, consisting of the Cisco 7000 and Cisco 4000. The sales growth rate for lower-priced access and switching products targeted toward small and medium-sized businesses has increased faster than that of the Company's high-end core router products. These products typically carry lower average selling prices, thereby contributing to the slowdown in the Company's overall growth rate in 1997 versus 1996. Additionally, some of the Company's more established product lines, such as the Cisco 2500 series, have experienced decelerating growth rates. Sales to international customers decreased to 43.5% of net sales in 1997 from 48.2% for 1996. The decrease reflects slower sales growth in certain international markets, particularly Japan, France, and Germany. Sales growth in these markets has been impacted by certain factors including weaker economic conditions, delayed government spending, a stronger dollar versus the local currencies, and slower adoption of networking technologies.

Sales and marketing expenses increased by $434 million in fiscal 1997 over fiscal 1996, an increase to 18.0% of net sales in 1997 from 17.7% in fiscal 1996. The increase in these expenses resulted from an increase in the size of the Company's direct sales force and related commissions, additional marketing programs to support the launch of new products, the entry into new markets, and expanding distribution channels.

General and administrative expenses rose by $45 million in fiscal 1997 over fiscal 1996, a decrease to 3.2% from 3.9% of net sales. The dollar increase reflects increased personnel costs necessary to support the Company's business infrastructure, including those associated with its new European Logistics Center, as well as the further development of its information systems. The percentage decrease reflects management's continued efforts to control discretionary spending. It is management's intent to keep general and administrative costs relatively constant as a percentage of net sales; however, this goal is dependent upon the level of acquisition activity, among other factors.

The amount expensed to purchased research and development in fiscal 1997 arose from the acquisitions of Telebit Corporation, Netsys Technologies, Skystone Systems Corporation, Ardent Communications, and Global Internet Software Group see Note 3.

Interest and other income, net, was $109 million in 1997 and $64 million in 1996. Interest income rose as a result of additional investment income on the Company's increasing investment balances. The Company currently holds approximately .3 million shares of common stock in a publicly traded company with a cost basis significantly below its current market value. Beginning in fiscal year 1997, the Company began selling its equity stake in this company. Also in 1997, the Company established the Cisco Systems Foundation ("the Foundation"). As part of this initiative, the Company donated a portion of this investment, along with other equity securities, with a combined cost basis of approximately $2 million and an approximate market value of $72 million at July 26, 1997, to the Foundation. The realized gains on the sale of this investment, net of the amounts donated to the Foundation, were $153 million in fiscal 1997. The Company expects to sell its remaining stake in the publicly traded company in fiscal year 1998 and will realize additional gains, based on an established hedge on this investment (see Note 5).

Net sales grew to $4.1 billion in 1996 from $2.2 billion in 1995. The 83.5% increase in net sales during the year was primarily a result of increasing unit sales of the Cisco 7500 series; continued strong sales of Access business unit products, including the Cisco 4500 and Cisco 2500 series; and continued market acceptance of the Company's Workgroup business unit products, particularly the Catalyst 5000. In connection with the acquisition of StrataCom, Inc., the Company formed the WAN business unit, which consists of the IPX®, BPX®, IGX™, and AXIS product lines. Sales of these products increased from 1995 levels primarily because of an increase in demand for Asynchronous Transfer Mode (ATM) cell switching products by public carrier customers. These increases were partially offset by decreasing unit sales of the Company's older product lines, comprising mainly the Cisco 7000 series. Sales to international customers were 48.2% of net sales in 1996 compared with 41.7% in 1995. This increase was attributed to continued expansion into new geographic markets, as well as growth in existing European and Japanese markets. Sales growth between 1996 and 1995 increased more substantially in Japan than in other geographical markets.

Gross margins decreased to 65.6% of net sales in 1996 from 66.7% in 1995. Gross margins were affected by several factors, including higher material costs as a result of certain component shortages and the continued shift in revenue mix to the Company's lower-margin products consisting primarily of products in the Access and Workgroup business units.

Research and development expenses increased in 1996 by $189 million over 1995 expenditures. This represents an increase to 9.7% of net sales from 9.4% in 1995. The increase reflected the Company's ongoing research and development efforts, including the further development of the CiscoFusion architecture, as well as the acquisition of technologies to bring a broad range of products to the market in a timely fashion. A significant portion of the increase was due to the addition of new personnel, both from hiring and through acquisitions, as well as higher expenditures on prototypes and depreciation on new equipment.

Sales and marketing expenses increased by $326 million in 1996 over 1995, but decreased to 17.7% of net sales in 1996 from 17.9% of net sales in 1995. The dollar increase in these expenses resulted mainly from an increase in the size of the Company's direct sales force and its commissions. Other factors affecting the dollar increase in expenses were additional marketing programs to support the launch of new products; the entry into new markets as noted by the significant percentage increase in business outside the U.S.; and expansion of distribution channels, particularly the two-tier channels associated with the Company's initial efforts to reach the mass market.

General and administrative expenses rose by $75 million in 1996 over 1995, a slight increase to 3.9% from 3.8% of net sales in 1996 versus 1995. The dollar increase reflects increased personnel costs necessary to support the Company's business infrastructure, the amortization of goodwill related to the acquisition of LightStream®, and a one-time write-down of $5 million of LightStream goodwill. There were also nonrecurring costs related to the acquisition of StrataCom that totaled $15 million for fiscal 1996. Excluding the effect of these nonrecurring costs, general and administrative expenses as a percentage of net sales declined to 3.4%, which reflected management's continued controls over discretionary spending.

The amount expensed to purchased research and development in fiscal year 1995 reflects the acquisition of LightStream (see Note 3).

Interest and other income, net, was $64 million in 1996 and $40 million in 1995. Interest income rose as a result of additional investment income on the Company's increasing investment balances.

In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 128, "Earnings per Share" (EPS), which simplifies existing computational guidelines, revises disclosure requirements, and increases the comparability of earnings per share on an international basis. Management has not yet evaluated the effects of this change in computational guidelines on the Company's EPS. SFAS No. 128 is effective for periods ending after December 15, 1997 and requires restatement of all prior period EPS data presented. The Company will adopt SFAS No. 128 in its second quarter of fiscal year 1998.

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components (revenue, expenses, gains, and losses) in a full set of general-purpose financial statements. The Company will adopt SFAS No. 130 in its fiscal year 1999.

In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information," which changes the way public companies report information about operating segments. SFAS No. 131, which is based on the management approach to segment reporting, establishes requirements to report selected segment information quarterly and to report entity-wide disclosures about products and services, major customers, and the material countries in which the entity holds assets and reports revenue. Management has not yet evaluated the effects of this change on its reporting of segment information. The Company will adopt SFAS No. 131 in its fiscal year 1999.

The following discussion about the Company's risk management activities includes "forward-looking statements" that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements.

As a global concern, the Company faces exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on the Company's financial results. Historically, the Company's primary exposures related to nondollar-denominated sales in Japan, Canada, and Australia and nondollar-denominated operating expenses in Europe, Latin America, and Asia where the Company sells primarily in U.S. dollars. The Company has recently expanded its business activities in Europe. As a result, the Company expects to see an increase in exposures related to nondollar-denominated sales in several European currencies. At the present time, the Company hedges only those currency exposures associated with certain assets and liabilities denominated in nonfunctional currencies and does not generally hedge anticipated foreign currency cash flows. The hedging activity undertaken by the Company is intended to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities. The success of this activity depends upon forecasts of transaction activity denominated in various currencies, primarily the Japanese yen, Canadian dollar, Australian dollar, and certain European currencies. To the extent that these forecasts are over- or understated during periods of currency volatility, the Company could experience unanticipated currency gains or losses.

The Company maintains investment portfolio holdings of various issuers, types, and maturities. These securities are generally classified as available for sale, and consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of shareholders' equity. Part of this portfolio includes minority equity investments in several publicly traded companies, the values of which are subject to market price volatility. The Company also has certain real estate lease commitments with payments tied to short-term interest rates. Given the current profile of interest rate exposures, a sharp rise in interest rates could have a material adverse impact on the fair value of the Company's investment portfolio while increasing the costs associated with its lease commitments. The Company does not currently hedge these interest rate exposures.

The following tables present the hypothetical changes in fair values in the financial instruments held by the Company at July 26, 1997 that are sensitive to changes in interest rates. These instruments are not leveraged and are held for purposes other than trading. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS over six- and twelve-month time horizons. Beginning fair values represent the market principal plus accrued interest, dividends, and certain interest rate-sensitive securities considered cash and equivalents for financial reporting purposes at July 26, 1997. Ending fair values are the market principal plus accrued interest, dividends, and reinvestment income at six- and twelve-month time horizons. This table estimates the fair value of the portfolio at a six-month time horizon (in millions):

The following analysis presents the hypothetical change in fair values of public equity investments held by the Company that are sensitive to changes in the stock market. These equity securities are held for purposes other than trading. The modeling technique used measures the hypothetical change in fair values arising from selected hypothetical changes in each stock's price. Stock price fluctuations of plus or minus 15%, plus or minus 35%, and plus or minus 50% were selected based on the probability of their occurrence.

This table estimates the fair value of the publicly traded corporate equities at a twelve-month time horizon (in millions):

Within the Company's public equity investment portfolio, a 15% movement in the stock price has occurred in 75% of the quarters since the shares were initially offered or in the last three years; a 35% movement in the stock price has occurred in 45% of the quarters since the shares were initially offered or in the last three years; and a 50% movement in the stock price has occurred in 15% of the quarters since the shares were initially offered or in the last three years.

The Company also has interest rate risk associated with leases on its facilities whose payments are tied to the London Interbank Offered rate (LIBOR), and has evaluated the hypothetical change in lease obligations held at July 26, 1997 due to changes in the LIBOR rate. The modeling technique used for analysis measured hypothetical changes in lease obligations arising from selected hypothetical changes in the LIBOR rate. Market changes reflected immediate hypothetical parallel shifts in the LIBOR curve of plus or minus 50 BPS, 100 BPS, and 150 BPS over a six-month and a twelve-month period. The results of this analysis were not material to the Company's financial results.

The Company enters into forward foreign exchange contracts to offset the impact of currency fluctuations on certain nonfunctional currency assets and liabilities, primarily denominated in Japanese, Canadian, Australian, and certain European currencies.

The Company generally enters into forward currency contracts that have original maturities of one to three months, with none having a maturity greater than one year in length. The total notional values of forward contracts purchased and forward contracts sold were $211 million and $268 million, respectively. The net unrealized gain on forward exchange contracts is $.6 million. Management does not expect gains or losses on these contracts to have a material impact on the Company's financial results.

The networking business is highly competitive, and as such, the Company's growth is dependent upon market growth and its ability to enhance its existing products and introduce new products on a timely basis. One of the ways the Company has addressed and will continue to address the need to develop new products is through acquisitions of other companies. Acquisitions involve numerous risks, including difficulties in assimilation of the operations, technologies, and products of the acquired companies; the risk of diverting management's attention from normal daily operations of the business; risks of entering markets in which the Company has no or limited direct prior experience and where competitors in such markets have stronger market positions; and the potential loss of key employees of the acquired company. The Company must also maintain its ability to manage any such growth effectively. Failure to manage growth effectively and successfully integrate acquisitions made by the Company could adversely affect the Company's business and operating results.

The markets for the Company's products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions, and evolving methods of building and operating networks. There can be no assurance that the Company will successfully identify new product opportunities and develop and bring new products to market in a timely manner, or that products and technologies developed by others will not render the Company's products or technologies obsolete or noncompetitive.

The Company expects that in the future, its net sales may grow at a slower rate than was experienced in previous periods, and that on a quarter-to-quarter basis, the Company's growth in net sales may be significantly lower than its historical quarterly growth rate. In the Company's most recent quarters, the sequential sales growth slowed from prior levels, and a disproportionate share of the sales occurred in the last month of the quarter. As a consequence, operating results for a particular quarter are extremely difficult to predict. The Company's ability to meet financial expectations could be hampered if the nonlinear sales pattern continues in future periods. In addition, in response to customer demand, the Company has attempted to reduce its product manufacturing lead times, which may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less predictability in the Company's quarter-to-quarter net sales and operating results going forward. On the other hand, for certain products, lead times are longer than the Company's goal. If the Company cannot reduce manufacturing lead times for such products, the Company's customers may cancel orders or not place further orders if shorter lead times are available from other manufacturers, thus creating additional variability.

Many computer systems were not designed to handle any dates beyond the year 1999, and therefore computer hardware and software will need to be modified prior to the year 2000 in order to remain functional. The Company is concerned that many enterprises will be devoting a substantial portion of their information systems spending to resolving this upcoming year 2000 problem. This may result in spending being diverted from networking solutions over the next three years. Additionally, the Company will have to devote resources to providing the year 2000 solution for its own products. The year 2000 issue could lower demand for the Company's products while increasing the Company's costs. These combining factors could have a material adverse impact on the Company's financial results.

The Company also expects that gross margins may be adversely affected by increases in material or labor costs, heightened price competition, and changes in channels of distribution or in the mix of products sold. For example, the Company believes that gross margins may continue to decline over time, because the sales of lower-margin access and switching products targeted toward small to medium-sized customers have continued to grow at a faster rate than the Company's higher-margin router and high-performance switching products targeted toward enterprise and service provider customers. The Company's gross margins may also be impacted by geographic mix, as well as the mix of configurations within each product group. The Company continues to expand into third-party or indirect distribution channels, which generally results in lower gross margins. In addition, increasing third-party and indirect distribution channels generally results in greater difficulty in forecasting the mix of the Company's products, and to a certain degree, the timing of its orders.

The Company's growth and ability to meet customer demands also depend in part on its ability to obtain timely deliveries of parts from its suppliers. The Company has experienced component shortages in the past that have adversely affected its operations. Although the Company works closely with its suppliers to avoid these types of shortages, there can be no assurance that the Company will not encounter these problems in the future.

The Company also expects that its operating margins may decrease as it continues to hire additional personnel and increases other operating expenses to support its business. The Company plans its operating expense levels based primarily on forecasted revenue levels. Because these expenses are relatively fixed in the short term, a shortfall in revenue could lead to operating results being below expectations. The results of operations for 1997 are not necessarily indicative of results to be expected in future periods, and the Company's operating results may be subject to quarterly fluctuations as a result of a number of factors. These factors include the integration of people, operations, and products from acquired businesses and technologies; increased competition in the networking industry; the overall trend toward industry consolidation; the introduction and market acceptance of new technologies, including Gigabit Switch Routing and Tag Switching, currently known as multiprotocol label switching (MPLS); variations in sales channels, product costs, or mix of products sold; the timing of orders and manufacturing lead times; and changes in general economic conditions, any of which could have a material adverse impact on operations and financial results.

The Company's corporate headquarters, including most of its research and development operations and its manufacturing facilities, are located in the Silicon Valley area of Northern California, a region known for seismic activity. Additionally, one of the Company's manufacturing facilities is located near a river that has experienced flooding in the past. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on the Company's financial results.

Accounts receivable increased 87.9% during 1997, while sales grew by 57.2%. Days sales outstanding in receivables increased to 60 days as of July 26, 1997 from 44 days at July 28, 1996. Inventories decreased 15.4% during 1997. Inventory management remains an area of focus as the Company balances the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements.

At July 26, 1997, the Company had a line of credit totaling $500 million, which expires in July 2002. There have been no borrowings under this agreement (see Note 6).

The Company has entered into certain lease arrangements in San Jose, California, and Research Triangle Park, North Carolina, where it has established its headquarters operations and certain research and development and customer support activities, respectively. In connection with these transactions, the Company restricted $363 million of its investments as collateral for certain obligations of the leases. The Company anticipates that it will occupy more leased property in the future that will require similar restricted securities; however, the Company does not expect the impact of this activity to be material to liquidity.

During fiscal 1997, the Company's Board of Directors authorized a stock repurchase program under which 5 million shares of the Company's stock could be reacquired. All 5 million shares were repurchased at an aggregate purchase price of approximately $323 million and subsequently reissued in connection with the Company's stock plans. However, the Company's ability to repurchase shares has been restricted and is expected to continue to be restricted from time to time due to business combinations and limitations under pooling of interests accounting.

The Company's management believes that its current cash and equivalents, short-term investments, line of credit, and cash generated from operations will satisfy its expected working capital and capital expenditure requirements through fiscal 1998.