CEO John Chambers and CFO Dennis Powell Discuss Cisco's Q4 and Fiscal Year 2003 Results

August 5, 2003

Cisco has announced its Q4 and Fiscal Year 2003 financial results. John Chambers, Cisco CEO and president and Dennis Powell, Cisco CFO and senior vice president, had this to say regarding the company's performance and what went well this quarter.

How would you characterize this quarter?

More Information Release: Cisco Systems Reports Fourth Quarter & Fiscal Year 2003 Earnings Fact Sheet: Customer Highlights and Technology Innovations: Fourth Quarter, FY 2003 Fiscal Year 2003 Video: John Chambers discusses Cisco's Q4 FY03 Earnings on CNBC's Business Center Q&A: Dennis Powell Comments on Cisco's Q4 Financial Position Can you give an update on the company's financial position? Dennis Powell: I believe the company's solid financial performance reflects our ongoing focus on operational excellence. For over a year, our quarterly pro forma net income has consistently exceeded $1 billion and our profit has exceeded 20 percent of revenue. In Q4, Cisco generated approximately $1.5 billion in cash flow from operations. During the quarter we repurchased $1.4 billion of common stock. We exited the quarter with over $20B in cash, cash equivalents, and marketable investments, which was an increase over Q3 of more than $300 million even after the $1.4B stock repurchase. Our financial performance and cash position speaks to our financial strength, which is what our customers are looking for when they choose a company in a challenging market. Have you improved price/performance or price reductions this past quarter? Dennis Powell: We continue to dramatically improve our price/performance and price reductions in almost all product areas over the last year, while maintaining solid gross margins. In Q4 we had over eight product areas achieving these types of improvements for our customers. These price/performance improvements included the Catalyst 4000, 2900 mid-range routers, 10000 edge services router, storage and voice products, technology trade-in programs for end-user customers and continued focus on channel profitability with additional discounts on select Catalyst 2950 and 3550 switches. This balance between customer price/performance advantages and profit contribution to Cisco may be one of our best accomplishments as a company-our continued balance of both profits and customer success. This quarter, Cisco closed the acquisition of the business of The Linksys Group, Inc. What was the impact in terms of both market and financial momentum? Dennis Powell: Cisco completed the acquisition of Linksys on May 31, 2003. As a reminder, Cisco recognizes two-tier revenue on a sell through basis using information from distributors. We applied this revenue recognition methodology to Linksys on the date of acquisition-therefore only products shipped and sold through to the end user are recognized in revenue in the current quarter. In Q4, Linksys increased Cisco's revenue by approximately $20M, had a negative mix impact of 0.3% on gross margins and did not change earnings per share. In July, Linksys announced a new wireless multimedia product, the Wireless-B Media Adapter, that bridges the analog and digital worlds using 802.11b wireless networking to deliver digital content to conventional TVs and home stereos. This is the first in a line of new wireless home products from Linksys. Also in July, Intel and Linksys established a technology and marketing program, designed to improve the experience of setting up and operating wireless networks in homes and small offices using Linksys wireless routers and access points and Intel Centrino mobile technology. Over the past quarter, several companies including Microsoft have changed their position and programs surrounding stock options. Can investors expect the same from Cisco? Dennis Powell: As we have said, we remain opposed to expensing stock options and have no plans to offer restricted stock in lieu of stock options. Expensing options would prevent many rank-and-file workers from receiving options and have little impact on executive compensation plans. If expensed, the people who will suffer are middle management and rank-and-file employees-all of whom receive options at Cisco today. We clearly agree that there are fundamental changes that have to be made in stock options governance and we support meaningful reform in the areas of disclosure, corporate governance and enforcement, additional disclosures with respect to dilution, ways to improve quality and quantity of information regarding dilution, strong enforcement and shareholder approval of stock option plans for officers and directors. We believe that employee stock options best align the interests of employees with those of the shareholders. Broad-based employee option plans are vital to the growth, innovation and future of the technology industry

John Chambers: In what continues to be a challenging environment for a number of companies in the IT industry, we have achieved some of the top financial measurements in our company's history, including net income, gross margins, profitable market share gains, focused profit contribution, geographic balance and momentum in Advanced Technology markets. Our market position is strong and the strategies and investments made two to three years ago are beginning to show a real return on investment, but more importantly, position Cisco for the future.

Looking forward, where will Cisco be looking to grow in the coming fiscal year?

John Chambers: When we talk about areas for potential growth, we have segmented those areas into three very broad groups including our core technologies, routing and switching; the service provider market; and Advanced Technology markets. Additionally, we have made major investments over the last several years in the U.S. federal government business and Advanced Services, which are yielding some initial positive results.

When do you feel that your customers will begin to spend again?

John Chambers: Today's economy continues to be a "show-me" economy meaning that CEOs will wait to spend until they see their own revenues and profits pick up. But for the first time in a long time, we are seeing a number of potentially positive signs of economic recovery, business improvements, and CEO confidence, and therefore potential capex spending in our area. Having said that, there were a number of projections in calendar 2001 and 2002 that indicated stronger second-half economic recoveries which, for a variety of reasons, did not develop. The obvious concern here is that, while things are starting to look better, it is still fragile and may not develop to the level we desire.

In our travels around the world almost all government and business leaders agree that there cannot be a sustained global economic recovery without the U.S. leading the way. And as we have said several times before, in our own view although it may be in the minority we will see this recovery gradually, first in small to medium-sized businesses, second in enterprise businesses, although not in total but in a gradual wave by types of industries and companies within those industries, with industries such as airline and service providers probably being at the back-end of the recovery and capex spending.

What kind of traction did you see during this quarter in your core and Advanced Technology markets?

John Chambers: In our core markets, we saw solid sequential quarter-over-quarter growth in high-end routing and high-end switching. In particular, we were both pleased and pleasantly surprised when our GSR 12000 high-end router orders grew to approximately $200M during Q4, a sequential increase in excess of 25 percent. We also continued to see major acceptance of Gigabit Ethernet, and in Q4 passed an important milestone in booking over 1 million 10/100/1000 ports with similar solid acceptance of Gigabit Ethernet across our modular switching products.

In our Advanced Technology markets, it appears that our strategy in key targeted Advanced Technologies is working reasonably well, as it was another solid quarter in terms of order momentum. Our target is to identify 12 potential Advanced Technologies that could eventually yield $1 billion a year run rates for Cisco if we execute well and the market develops as we expect. Currently, we have identified six Advanced Technology markets-IP telephony, optical, storage, wireless LAN, security, and home networking-which, in Q4, represented approximately 17% product bookings. In total, the six announced markets exceeded 20% sequential quarter growth with IP telephony, storage, and optical growing the fastest sequentially in terms of orders.

In terms of IP telephony, we shipped our two-millionth IP phone in July and have shipped over 13 million voice-over-IP ports to-date. In storage, we increased our number of end user customers from 43 in Q3 to a total to approximately 140 in Q4. We also made a decision to reduce prices by an average of approximately 30-35% with our continued focus on market share and profit contribution. Orders for the MDS 9000 after the pricing reduction grew sequentially by approximately 45%. Finally, we were pleasantly surprised by the growth of our optical business with orders being the best we've seen in almost two years and showing an increase of approximately 40% over Q3.

Cisco's U.S. Federal government sales are on the rise-what are the drivers of this momentum?

John Chambers: Many parts of government, including the civilian side, the Department of Defense and intelligence agencies are upgrading their technology infrastructures to fuel transformational initiatives. The drivers behind these upgrades include improved efficiency and additional bandwidth and memory capacity to drive new applications such as e-learning and employee self-services.

In terms of the Federal Government business, over the last three years we've dramatically expanded our focus to a longer-term investment cycle in terms of people, product development, Advanced Services, security and other issues. In short, we moved more of our focus from a 1-2 year implementation to a 3-5 year investment cycle. The results continue to be very positive. In Q4, our federal business represented approximately 20% of our U.S. enterprise business, up from the single digits several years ago. For the entire fiscal year our orders crossed the $1 billion threshold for the first time

This Q&A may be deemed to contain forward-looking statements, which are subject to the safe harbor provisions of the Private Litigation Reform Act of 1995. These forward-looking statements include, among other things, statements regarding future events and the future financial performance of Cisco that involve risks and uncertainties. Readers are cautioned that these forward-looking statements are only predictions and may differ materially from actual future events or results. Readers are referred to the documents filed by Cisco with the SEC, specifically the most recent reports on Form 10-K and 10-Q, each as it may be amended from time to time, which identify important risk factors that could cause actual results to differ from those contained in the forward-looking statements. Among the important factors or risks that could cause actual results or events to differ materially from those in the forward-looking statements in this Q&A are: business and economic conditions and growth trends in the networking industry in various geographic regions; global economic conditions and uncertainties in the geopolitical environment; overall information technology spending; the growth of the Internet and levels of capital spending on Internet-based systems; variations in customer demand for products and services, including sales to the service provider market; the timing of orders and manufacturing lead times; changes in customer order patterns or customer mix; insufficient, excess or obsolete inventory; variability of component costs; increased price competition; variations in sales channels, product costs, or mix of products sold; the ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; increased competition in the networking industry; dependence on the introduction and market acceptance of new product offerings and standards; rapid technological and market change; manufacturing and sourcing risks; litigation involving patents, intellectual property, antitrust, stockholder and other matters; the ability to recruit and retain key personnel; financial risk management; and potential volatility in operating results, among others. The financial information contained in this Q&A should be read in conjunction with the consolidated financial statements and notes thereto included in Cisco's most recent reports on Form 10-K and Form 10-Q, each as it may be amended from time to time. Cisco's results of operations for the three and twelve months ended July 26, 2003 are not necessarily indicative of Cisco's operating results for any future periods. Any projections in this Q&A are based on limited information currently available to Cisco, which is subject to change. Although any such projections and the factors influencing them will likely change, Cisco will not necessarily update the information, since Cisco will only provide guidance at certain points during the year. Such information speaks only as of the date of this Q&A.