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Financial Review - Management's Discussion and Analysis - Annual Report 2001


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 2001 AND 2000
The net sales and gross margin for fiscal 2001 and 2000 were as follows (in millions, except percentages):



Net product revenue in fiscal 2001 increased by 15.0% from fiscal 2000. The increase in net product revenue was primarily a result of increased unit sales of router and switch products; growth in the sales of add-on boards that provide increased functionality; and optical transport products (see Note 13 to the Consolidated Financial Statements).

Product gross margin in fiscal 2001 decreased to 47.9% from 64.9% in fiscal 2000 primarily due to an additional excess inventory charge as discussed below. The decrease in product gross margin was also due to lower shipment volumes and related manufacturing overhead; shifts in product mix; higher production-related costs; and the pricing pressure seen from competitors in certain product areas. We recorded a provision for inventory, including purchase commitments, totaling $2.77 billion in fiscal 2001, which included an additional excess inventory charge. The excess inventory charge recorded in the third quarter of fiscal 2001 was $2.25 billion. This excess inventory charge was subsequently reduced in the fourth quarter of fiscal 2001 by a $187 million benefit primarily related to lower settlement charges for purchase commitments. As of July 28, 2001, $572 million of the excess inventory reserve has been used. The provision for inventory in fiscal 2000 was $339 million. The following is a summary of the usage and the remaining excess inventory reserve as of July 28, 2001 (in millions):



Inventory purchases and commitments are based upon future demand forecasts. To mitigate the component supply constraints that have existed in the past, we built inventory levels for certain components with long lead times and entered into commitments for certain components. Due to a sudden and significant decrease in demand for our products, inventory levels exceeded our estimated requirements based on demand forecasts. This additional excess inventory charge was calculated in accordance with our accounting policy. We do not currently anticipate the excess inventory subject to this provision will be used at a later date based on our current demand forecast.

Net service revenue in fiscal 2001 increased by 42.0% from fiscal 2000. Service revenue is generally deferred and, in most cases, recognized ratably over the service period obligations, which are typically one to three years. The increase in net service revenue was primarily related to an increase in product sales and installed base of equipment needing maintenance support. The increase in service gross margin was primarily due to increased cost efficiencies in our technical assistance centers.

We manage our business based on four geographic theaters: the Americas; Europe, the Middle East, and Africa ("EMEA"); Asia Pacific; and Japan. Financial information by theater for fiscal 2001 and 2000 is summarized in the following table (in millions, except percentages):



The following table shows the standard margins for each theater and the total gross margin (in millions, except percentages):



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, cost of sales adjustments, production overhead, and manufacturing variances and other related costs to the theaters. Sales adjustments primarily relate to reserves for leases and structured loans, deferred revenue, two-tier distribution, and other timing differences.

Standard margins remained relatively constant for all geographic theaters as compared with fiscal 2000. Standard margins vary due to a number of reasons including, but not limited to, shifts in product mix, sales discounts, and sales channels.

We expect gross margin may be adversely affected by increases in material or labor costs, higher inventory balances, obsolescence charges, loss of cost savings, price competition, and changes in channels of distribution or in the mix of products sold, in particular, optical and access products. If product or related warranty costs associated with our products are greater than we have experienced, gross margin may also be adversely affected. Our gross margin may also be adversely affected 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. These distribution channels are generally given privileges to return inventory. 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.

Research and development ("R&D"), sales and marketing, and general and administrative ("G&A") expenses are summarized in the following table (in millions, except percentages):



R&D, sales and marketing, and G&A expenses as a percentage of net sales for fiscal 2001 have increased compared with the prior fiscal year primarily due to the decline in net sales during the second half of fiscal 2001.

R&D expenses in fiscal 2001 increased by 45.0% from fiscal 2000. The increase reflected R&D efforts in a wide variety of areas such as data, voice, and video over IP; wireless access; dial access; enterprise switching; optical transport; storage networking; content networking; security; network management; advanced routing and switching technologies; digital subscriber line ("DSL") technologies; cable; and other broadband 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 have been expensed as incurred.

Sales and marketing expenses in fiscal 2001 increased by 34.2% from fiscal 2000. The increase in sales and marketing expenses was principally due to an increase in the size of our direct sales force and related commissions, additional marketing and advertising investments associated with existing and new product introductions, the expansion of distribution channels and markets, 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.

G&A expenses in fiscal 2001 increased by 22.9% from fiscal 2000. The increase in G&A expenses was primarily related to the addition of new personnel and investments in infrastructure.

Amortization of goodwill and purchased intangible assets included in operating expenses was $1.05 billion in fiscal 2001, compared with $291 million in fiscal 2000. Amortization of goodwill and purchased intangible assets primarily relates to various purchase acquisitions (see Note 3 and Note 5 to the Consolidated Financial Statements). In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS142"). SFAS142 requires goodwill to be tested for impairment under certain circumstances, and written off when impaired, rather than being amortized as previous standards required. We are currently assessing the impact of SFAS 142 on our operating results and financial condition. We expect the amortization of identifiable purchased intangible assets to increase if we continue to acquire companies and technologies.

The amount expensed to in-process research and development ("in-process R&D") arose from the purchase acquisitions (see Note 3 to the Consolidated Financial Statements). The fair values of the existing purchased technology 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. 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 these technologies into commercially viable products consists principally of planning, designing, experimenting, and testing activities necessary to determine that the technologies 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 key assumptions underlying the valuations for our significant purchase acquisitions completed in fiscal 2001 and 2000 (in millions, except percentages):



Regarding our purchase acquisitions completed in fiscal 2001 and 2000, actual results to date have been consistent, in all material respects, with our assumptions at the time of the acquisitions except for certain purchase acquisitions where goodwill and purchased intangible assets have been impaired as discussed in the section relating to restructuring costs and other special charges. 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 assuming the products have entered the market. 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 may result in impairment charges.

Net gains realized on minority investments were $190 million in fiscal 2001, compared with $531 million in fiscal 2000. The decrease was primarily due to the market price volatility of our publicly traded equity investments.

Interest and other income, net, was $940 million in fiscal 2001, compared with $577 million in fiscal 2000. The increase was primarily due to interest income related to the general increase in cash and investments generated from our operations.

For fiscal 2001, the effective tax rate was (16.0%). The effective tax rate differs from the statutory rate primarily due to the impact of nondeductible in-process R&D, acquisition-related costs, research and experimentation tax credits, and the tax impact of foreign operations. 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.

RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES AND PROVISION FOR INVENTORY
On April 16, 2001, due to macroeconomic and capital spending issues affecting the networking industry, we announced a restructuring program to prioritize our initiatives around high-growth areas of our business, focus on profit contribution, reduce expenses, and improve efficiency. This restructuring program includes a worldwide workforce reduction, consolidation of excess facilities, and restructuring of certain business functions.

As a result of the restructuring program and decline in forecasted revenue, we recorded restructuring costs and other special charges of $1.17 billion classified as operating expenses and an additional excess inventory charge classified as cost of sales. The excess inventory charge recorded in the third quarter of fiscal 2001 was $2.25 billion. This excess inventory charge was subsequently reduced in the fourth quarter of fiscal 2001 by a $187 million benefit primarily related to lower settlement charges for purchase commitments. As a result of the restructuring program, we expect pretax savings in operating expenses will be slightly more than $1 billion on an annualized basis.

The following paragraphs provide detailed information relating to the restructuring costs and other special charges and provision for inventory which were recorded in fiscal 2001.

Worldwide Workforce Reduction
In the third quarter of fiscal 2001, we announced a restructuring program to reduce approximately 6,000 regular employees across all business functions, operating units, and geographic regions. The worldwide workforce reduction started in the third quarter of fiscal 2001 and as of July 28, 2001, approximately 4,700 regular employees have been terminated. We recorded a workforce reduction charge of $397 million primarily relating to severance and fringe benefits of which $336 million has been paid or used as of July 28, 2001. In addition, approximately 1,500 regular employees were reduced through normal attrition. The number of temporary and contract workers employed by us was also reduced.

Consolidation of Excess Facilities and Other Special Charges
We recorded a restructuring charge of $484 million relating to consolidation of excess facilities and other special charges. The consolidation of excess facilities included the closure of certain corporate facilities, sales offices, and operational centers related to business activities that have been exited or restructured. We recorded a restructuring charge of $263 million for excess facilities primarily relating to lease terminations and noncancelable lease costs. Property and equipment that was disposed of or removed from operations resulted in a charge of $141 million and primarily consisted of leasehold improvements; computer equipment and related software; production, engineering, and other equipment; and furniture and fixtures. We also recorded other restructuring costs and special charges of $80 million primarily relating to payments to suppliers and vendors to terminate agreements and professional fees incurred in connection with the restructuring activities.

Impairment of Goodwill and Purchased Intangible Assets
Due to the decline in current business conditions, we restructured certain of our businesses and realigned resources to focus on profit contribution, high-growth markets, and core opportunities. Based upon impairment analyses which indicated that the carrying amount of the goodwill and purchased intangible assets will not be fully recovered through estimated undiscounted future operating cash flows, a charge of $289 million was recorded related to the impairment of goodwill and purchased intangible assets, measured as the amount by which the carrying amount exceeded the present value of the estimated future cash flows for goodwill and purchased intangible assets, as follows (in millions):



The results of operations relating to these businesses were not material on either an individual or aggregate basis.

A summary of the restructuring costs and other special charges is outlined as follows (in millions):



Amounts related to the net lease expense due to the consolidation of facilities will be paid over the respective lease terms through fiscal 2007. We expect to substantially complete implementation of our restructuring program during the first quarter of fiscal 2002.

Provision for Inventory
We recorded a provision for inventory, including purchase commitments, totaling $2.77 billion in fiscal 2001, which included an additional excess inventory charge as previously discussed.

COMPARISON OF FISCAL 2000 AND 1999
Net product revenue in fiscal 2000 was $17.00 billion, compared with $11.09 billion in fiscal 1999, an increase of 53.3%. The increase in net product revenue was primarily a result of increased unit sales of router, switch, and access products; growth in the sales of add-on boards that provide increased functionality; and optical transport products.

Net service revenue in fiscal 2000 was $1.93 billion, compared with $1.08 billion in fiscal 1999, an increase of 78.2%. The increase in net service revenue was primarily related to an increase in product sales and installed base of equipment needing maintenance support.

Gross margin in fiscal 2000 was 64.4%, compared with 65.0% in fiscal 1999. The decrease in the gross margin was primarily due to a continued shift in revenue mix toward our lower-margin products and pricing pressure seen from competitors in certain product areas.

R&D, sales and marketing, and G&A expenses are summarized in the following table (in millions, except percentages):



R&D expenses in fiscal 2000 increased by 62.6% from fiscal 1999. The increase reflected our ongoing R&D efforts in a wide variety of areas. 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 2000 increased by 60.1% from 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.

G&A expenses in fiscal 2000 increased by 66.1% from fiscal 1999. The increase in G&A expenses was primarily related to the addition of new personnel and investments in infrastructure.

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 increased as we acquired companies and technologies.

Net gains realized on minority investments were $531 million in fiscal 2000. There were no gains realized on minority investments in fiscal 1999.

Interest and other income, net, in fiscal 2000 was $577 million, compared with $330 million in fiscal 1999. The increase was primarily due to interest income related to the general increase in cash and investments generated from our operations.

RECENT ACCOUNTING PRONOUNCEMENTS
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141") and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). SFAS 141 requires all business combinations to be accounted for using the purchase method of accounting and is effective for all business combinations initiated after June 30, 2001. SFAS 142 requires goodwill to be tested for impairment under certain circumstances, and written off when impaired, rather than being amortized as previous standards required. SFAS 142 is effective for fiscal years beginning after December 15, 2001. Early application is permitted for entities with fiscal years beginning after March 15, 2001 provided that the first interim period financial statements have not been previously issued. The adoption of SFAS 141 did not have a material effect on our operating results or financial condition. We are currently assessing the impact of SFAS 142 on our operating results and financial condition.

LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents and total investments were $18.52 billion at July 28, 2001, a decrease of $1.98 billion from July 29, 2000. The decrease was primarily a result of a decrease in our net unrealized gains on publicly held investments of $5.76 billion and cash used in investing activities, primarily relating to $2.27 billion in capital expenditures and $1.16 billion in purchases of minority investments, offset by cash provided by operating activities of $6.39 billion and financing activities of $1.25 billion.

Accounts receivable decreased 36.2% during fiscal 2001. Days sales outstanding in receivables decreased to 31 days at July 28, 2001, from 37 days at July 29, 2000. The decrease in accounts receivable and days sales outstanding was primarily due to shipment linearity and process improvements surrounding billings and collections.

Inventories increased 36.7% during fiscal 2001. Inventory turns were 4.1 for the fourth quarter of fiscal 2001 and 7.8 for the fourth quarter of fiscal 2000. Inventory turns, excluding the excess inventory benefit of $187 million, were 4.6 for the fourth quarter of fiscal 2001. The inventory levels and inventory turns reflected the decrease in demand of products due to certain unfavorable economic conditions, combined with purchases of certain components with long lead times. Inventory management remains an area of focus as we balance 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 28, 2001, we had a line of credit totaling $500 million, which expires in July 2002. There have been no borrowings under this agreement (see Note 8 to the Consolidated Financial Statements).

We have entered into several agreements to lease sites in San Jose, California (where our headquarters are established) and surrounding areas; Boxborough, Massachusetts; Salem, New Hampshire; Richardson, Texas; and Research Triangle Park, North Carolina, where we have pledged $1.26 billion of our investments as collateral for certain obligations of the leases. We anticipate that we may 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 9 to Consolidated Financial Statements). We also lease office space in other U.S. locations, as well as locations in the Americas, EMEA, Asia Pacific, and Japan.

In addition, during the past couple of years, we have entered into several agreements to purchase or construct real estate, subject to the satisfaction of certain conditions. As of July 28, 2001, the total amount of commitments, if certain conditions are met, was approximately $1 billion.

We lend certain fixed income securities to enhance investment income. During fiscal 2001, we entered into various agreements to loan up to $500 million of our fixed income securities on an overnight basis. Under these securities lending agreements, the value of the collateral is equal to 102% of the fair market value of the loaned securities. The collateral is generally cash, U.S. government-backed securities, or guaranteed securities. At July 28, 2001, there were no outstanding securities lending transactions.

In fiscal 2001, we entered into an agreement to fund $1.05 billion in the SOFTBANK Asia Infrastructure Fund, which is payable upon demand by the general partner. As of July 28, 2001, we have invested $100 million toward this investment fund.

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 needs (including restructuring liabilities), capital expenditures, investment requirements, and commitments (see Note 9 to the Consolidated Financial Statements) through at least the next 12 months. Remaining cash expenditures relating to workforce reductions and termination of agreements will be substantially paid in the first quarter of fiscal 2002. Amounts related to the net lease expense due to the consolidation of facilities will be paid over the respective lease terms through fiscal 2007.

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