Annual Report 2000

Financial Review - Management's Discussion and Analysis


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Management's Discussion and Analysis...

All historical financial information has been restated to reflect the acquisitions that were accounted for as poolings of interests (see Note 3 to the Consolidated Financial Statements).

FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report, including, without limitation, statements containing the words "believes," "anticipates," "estimates," "expects," "projections," and words of similar import, constitute "forward-looking statements." You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including risks faced by us described in the Risk Factors sections, among others, included in the documents we file with the Securities and Exchange Commission ("SEC"), including our most recent reports on Form 10-K, Form 8-K, and Form 10-Q, and amendments thereto.

COMPARISON OF FISCAL 2000 AND FISCAL 1999
Net sales in fiscal 2000 were $18.93 billion, compared with $12.17 billion in fiscal 1999, an increase of 55.5%. The increase in net sales was primarily a result of increased unit sales of switch, router, and access products; growth in the sales of add-on boards that provide increased functionality; optical transport products; and maintenance, service, and support sales (see Note 12 to the Consolidated Financial Statements).

We manage our business on four geographic theaters: the Americas; Europe, the Middle East, and Africa ("EMEA"); Asia Pacific; and Japan. Summarized financial information by theater for fiscal 2000 and 1999 is presented in the following table (in millions):



The revenue growth for each theater was primarily driven by market demand and the deployment of Internet technologies and business solutions.

Gross margin in fiscal 2000 was 64.4%, compared with 65.0% in fiscal 1999. The following table shows the standard margins for each theater:



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The net sales and standard margins by geographic theater differ from the amounts recognized under generally accepted accounting principles because we do not allocate certain sales adjustments, production overhead, and manufacturing variances and other related costs to the theaters. Sales adjustments relate to revenue deferrals and reserves, credit memos, returns, and other timing differences.

Standard margins increased for all geographic theaters as compared with fiscal 1999. The decrease in the overall gross margin was primarily due to shifts in product mix, introduction of new products, which generally have lower margins when first released, higher production-related costs, the continued pricing pressure seen from competitors in certain product areas, and the above-mentioned sales adjustments, which were not included in the standard margins.

We expect gross margin may be adversely affected by increases in material or labor costs, heightened price competition, increasing levels of services, higher inventory balances, introduction of new products for new high-growth markets, and changes in channels of distribution or in the mix of products sold. We believe gross margin may additionally be impacted due to constraints relating to certain component shortages that currently exist in the supply chain. We may also experience a lower gross margin as the product mix for access and optical product volume grows.

We have recently introduced several new products, with additional new products scheduled to be released in the future. Increase in demand would result in increased manufacturing capacity, which in turn would result in higher inventory balances. In addition, our vendor base is capacity-constrained, and this could result in increased cost pressure on certain components. If product or related warranty costs associated with these new products are greater than we have experienced, gross margin may be adversely affected. Our gross margin may also be impacted by geographic mix, as well as the mix of configurations within each product group. We continue to expand into third-party or indirect-distribution channels, which generally results in a lower gross margin. In addition, increasing third-party and indirect-distribution channels generally results in greater difficulty in forecasting the mix of our product, and to a certain degree, the timing of orders from our customers. Downward pressures on our gross margin may be further impacted by other factors, such as increased percentage of revenue from service provider markets, which may have lower margins or an increase in product costs, which could adversely affect our future operating results.

Research and development ("R&D") expenses in fiscal 2000 were $2.70 billion, compared with $1.66 billion in fiscal 1999, an increase of 62.6%. R&D expenses, as a percentage of net sales, increased to 14.3% in fiscal 2000, compared with 13.7% in fiscal 1999. The increase reflected our ongoing R&D efforts in a wide variety of areas such as data, voice, and video integration, digital subscriber line ("DSL") technologies, cable modem technology, wireless access, dial access, enterprise switching, optical transport, security, network management, and
high-end routing technologies, among others. A significant portion of the increase was due to the addition of new personnel, partly through acquisitions, as well as higher expenditures on prototypes and depreciation on additional lab equipment. We also continued to purchase technology in order to bring a broad range of products to the market in a timely fashion. If we believe that we are unable to enter a particular market in a timely manner with internally developed products, we may license technology from other businesses or acquire businesses as an alternative to internal R&D. All of our R&D costs are expensed as incurred. We currently expect that R&D expenses will continue to increase in absolute dollars as we continue to invest in technology to address potential market opportunities.

Sales and marketing expenses in fiscal 2000 were $3.95 billion, compared with $2.46 billion in fiscal 1999, an increase of 60.1%. Sales and marketing expenses, as a percentage of net sales, increased to 20.8% in fiscal 2000, compared with 20.2% in fiscal 1999. The increase was principally due to an increase in the size of our direct sales force and related commissions, additional marketing and advertising investments associated with the introduction of new products, the expansion of distribution channels, and general corporate branding. The increase also reflected our efforts to invest in certain key areas, such as expansion of our end-to-end networking strategy and service provider coverage, in order to be positioned to take advantage of future market opportunities. We currently expect that sales and marketing expenses will continue to increase in absolute dollars.

General and administrative ("G&A") expenses in fiscal 2000 were $633 million, compared with $381 million in fiscal 1999, an increase of 66.1%. G&A expenses, as a percentage of net sales, increased to 3.3% in fiscal 2000, compared with 3.1% in fiscal 1999. G&A expenses for fiscal 2000 and 1999 included
acquisition-related costs of approximately $62 million and $16 million, respectively. Excluding the acquisition-related costs, the increase in G&A expenses was primarily related to the addition of new personnel and investments in infrastructure. We intend to keep G&A expenses relatively constant as a percentage of net sales; however, this depends on the level of acquisition activity and our growth, among other factors.

Amortization of goodwill and purchased intangible assets included in operating expenses was $291 million in fiscal 2000, compared with $61 million in fiscal 1999. Amortization of goodwill and purchased intangible assets primarily relates to various purchase acquisitions (see Note 3 and Note 4 to the Consolidated Financial Statements). Amortization of goodwill and purchased intangible assets will continue to increase as we acquire companies and technologies.

The amount expensed to in-process research and development ("in-process R&D") arose from the purchase acquisitions completed in fiscal 2000 (see Note 3 to the Consolidated Financial Statements).

The fair values of the existing products and patents, as well as the technology currently under development, were determined using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations were typically derived from a weighted-average cost of capital analysis and venture capital surveys, adjusted upward to reflect additional risks inherent in the development life cycle. These risk factors have increased the overall discount rate for acquisitions in the current year. We consider the pricing model for products related to these acquisitions to be standard within the high-technology communications equipment industry. However, we do not expect to achieve a material amount of expense reductions or synergies as a result of integrating the acquired in-process technology. Therefore, the valuation assumptions do not include significant anticipated cost savings.

The development of these technologies remains a significant risk due to the remaining effort to achieve technical viability, rapidly changing customer markets, uncertain standards for new products, and significant competitive threats from numerous companies. The nature of the efforts to develop the acquired technologies into commercially viable products consists principally of planning, designing, and testing activities necessary to determine that the products can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets and could have a material adverse impact on our business and operating results.

The following table summarizes the significant assumptions underlying the valuations for our significant purchase acquisitions completed in fiscal 2000 and 1999 (in millions, except percentages):



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Regarding our purchase acquisitions completed in fiscal 2000 and 1999, actual results to date have been consistent, in all material respects, with our assumptions at the time of the acquisitions. The assumptions primarily consist of an expected completion date for the in-process projects, estimated costs to complete the projects, and revenue and expense projections once the products have entered the market. Shipment volumes of products from the above-acquired technologies are not material to our overall financial results at the present time. Therefore, it is difficult to determine the accuracy of overall revenue projections early in the technology or product life cycle. Failure to achieve the expected levels of revenue and net income from these products will negatively impact the return on investment expected at the time that the acquisitions were completed and potentially result in impairment of any other assets related to the development activities.

Interest and other income, net, was $577 million in fiscal 2000, compared with $330 million in fiscal 1999. The increase was primarily due to interest income related to the general increase in cash and investments, which was generated from our operations. Net gains realized on minority investments were $531 million in fiscal 2000. The net gains realized on minority investments were not material in fiscal 1999.

Our pro forma effective tax rate for fiscal 2000 was 30.0%. The actual effective tax rate was 38.6%, which included the impact of nondeductible in-process R&D and acquisition-related costs. Our future effective tax rates could be adversely affected if earnings are lower than anticipated in countries where we have lower effective rates or by unfavorable changes in tax laws and regulations. Additionally, we have provided a valuation allowance on certain of our deferred tax assets because of uncertainty regarding their realizability due to expectation of future employee stock option exercises (see Note 11 to the Consolidated Financial Statements).

COMPARISON OF FISCAL 1999 AND FISCAL 1998
Net sales in fiscal 1999 were $12.17 billion, compared with $8.49 billion in fiscal 1998, an increase of 43.4%. The increase in net sales was primarily a result of increased unit sales of LAN switching products, access servers, high-performance WAN switching and routing products, and maintenance service contracts.

Gross margin in fiscal 1999 was 65.0%, compared with 65.6% in fiscal 1998. The decrease in the overall gross margin was primarily due to our continued shift in revenue mix toward our lower-margin products and the continued pricing pressure seen from competitors in certain product areas.

R&D expenses in fiscal 1999 were $1.66 billion, compared with $1.05 billion in fiscal 1998, an increase of 58.1%. R&D expenses, as a percentage of net sales, increased to 13.7% in fiscal 1999, compared with 12.4% in fiscal 1998. The increase reflected our ongoing R&D efforts in a wide variety of areas such as data, voice, and video integration, DSL technologies, cable modem technology, wireless access, dial access, enterprise switching, security, network management, and high-end routing technologies, among others. A significant portion of the increase was due to the addition of new personnel, partly through acquisitions, as well as higher expenditures on prototypes and depreciation on additional lab equipment.

Sales and marketing expenses in fiscal 1999 were $2.46 billion, compared with $1.58 billion in fiscal 1998, an increase of 56.1%. Sales and marketing expenses, as a percentage of net sales, increased to 20.2% in fiscal 1999, compared with 18.6% in fiscal 1998. The increase was principally due to an increase in the size of our direct sales force and related commissions, television advertising campaigns to build brand awareness, additional marketing and advertising costs associated with the introduction of new products, and the expansion of distribution channels. The increase also reflected our efforts to invest in certain key areas, such as expansion of our end-to-end networking strategy and service provider coverage, in order to be positioned to take advantage of future market opportunities.

G&A expenses in fiscal 1999 were $381 million, compared with $247 million in fiscal 1998, an increase of 54.3%. G&A expenses, as a percentage of net sales, increased to 3.1% in fiscal 1999, compared with 2.9% in fiscal 1998. The increase was primarily related to additional personnel and acquisition-related costs of $16 million.

Amortization of goodwill and purchased intangible assets included in operating expenses was $61 million in fiscal 1999, compared with $23 million in fiscal 1998. Amortization of goodwill and purchased intangible assets increased as we acquired companies and technologies.

Interest and other income, net, in fiscal 1999 was $330 million, compared with $196 million in fiscal 1998. Interest income rose primarily as a result of additional investment income on our increased investment balances.

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RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133, as amended, establishes accounting and reporting standards for derivative instruments and hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. We do not expect the initial adoption of SFAS 133 to have a material effect on our operations or financial position. We are required to adopt SFAS 133 in the first quarter of fiscal 2001.

In September 1999, the FASB issued Emerging Issues Task Force Topic No. D-83, "Accounting for Payroll Taxes Associated with Stock Option Exercises" ("EITF D-83"). EITF D-83 requires that payroll tax paid on the difference between the exercise price and the fair value of acquired stock in association with an employee's exercise of stock options be recorded as operating expenses. Payroll tax on stock option exercises of $51 million was expensed in fiscal 2000.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101, as amended, summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. At this time, we do not expect the adoption of SAB 101 to have a material effect on our operations or financial position; however, the SEC's final guidance for implementation has not been released to date. We are required to adopt SAB 101 in the fourth quarter of fiscal 2001.

LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents, short-term investments, and investments were $20.50 billion at July 29, 2000, an increase of $10.28 billion from July 31, 1999. The increase was primarily a result of $5.00 billion of net unrealized gains on publicly held investments and $7.70 billion of cash generated by operating and financing activities partially offset by investing activities, including net capital expenditures of $1.09 billion, purchases of technology licenses of $444 million, and investments in lease receivables of $535 million.

Accounts receivable increased 83.9% during fiscal 2000. Days sales outstanding in receivables increased to 37 days for fiscal 2000, from 32 days for fiscal 1999. The increase in accounts receivable and days sales outstanding was due, in part, to growth in total net sales combined with conditions in a number of markets, resulting in longer payment terms.

Inventories increased 87.2% during fiscal 2000; however, inventory turns remained constant at 7.8 times. The increase in inventory levels reflected new product introductions, continued growth in our two-tier distribution system, and increased purchases to secure the supply of certain components. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times with the risk of inventory obsolescence due to rapidly changing technology and customer requirements.

At July 29, 2000, we had a line of credit totaling $500 million, which expires in July 2002. There have been no borrowings under this agreement (see Note 7 to the Consolidated Financial Statements).

We have entered into several agreements to lease 448 acres of land located in San Jose, California, where our headquarters operations are established, and 759 acres of land located in Boxborough, Massachusetts; Salem, New Hampshire; Richardson, Texas; and Research Triangle Park, North Carolina, where we have expanded certain R&D and customer-support activities. In connection with these transactions, we have pledged $1.29 billion of our investments as collateral for certain obligations of the leases. We anticipate that we will occupy more leased property in the future that will require similar pledged securities; however, we do not expect the impact of this activity to be material to our liquidity position (see Note 8 to the Consolidated Financial Statements).

We believe that our current cash and cash equivalents, short-term investments, line of credit, and cash generated from operations will satisfy our expected working capital, capital expenditure, and investment requirements through at least the next 12 months.

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