Feature Story

Chairman and CEO John Chambers and CFO Frank Calderoni Discuss Cisco Second Quarter Fiscal Year 2010 Performance

February 3, 2010

Cisco announced second quarter fiscal year 2010 financial results. John Chambers, chairman and CEO, and Frank Calderoni, CFO, had the following to say regarding the company's results and business outlook.

What are some of the key financial highlights of the quarter?

John Chambers: From a financial perspective, the quarter was very strong, well exceeding even our own optimistic expectations. In our opinion, the second quarter marked the second phase of the recovery, with additional across-the-board acceleration in almost all of our geographies and market segments.

Revenues of $9.8 billion, increasing 8 percent year-over-year, were dramatically above the high end of our expectations of an increase of 1 percent to 4 percent. Second-quarter revenues showed a 9 percent sequential increase over our first-quarter revenues, the highest fiscal first quarter-to-second quarter sequential increase I've seen in the last decade.

Cash generated from operations in the second quarter was approximately $2.5 billion, and we repurchased $1.5 billion of stock during the quarter under our repurchase program.

Product book to bill was approximately 1.

Services continued its strong growth, with year-over-year revenue growth of approximately 6 percent.

How would you characterize the customer segments and geographies?

John Chambers: On a global basis, our total product orders year-over-year were up 11 percent. This was a major improvement from the first quarter, when year-over-year total product orders were down in the high single digits; the improvement was even greater when compared to product orders in fiscal year 2009's fourth quarter, which were down year-over-year in the low 20s.

Product orders for Service Provider business on a global basis in the second quarter were up 11 percent year-over-year. Commercial was up 10 percent year-over year, Enterprise (including Public Sector) was up approximately 7 percent year-over-year, and Consumer (including our Pure Digital acquisition) was up over 80 percent year-over-year.

To put this in perspective, in the first quarter of the fiscal year Enterprise was down slightly year-over-year, Consumer was up approximately 20 percent year-over-year, and Service Provider and Commercial were down in the low double digits year-over-year. This is obviously an inflection point in the market in all customer segments.

Looking at our geographies, the U.S. had a very strong second quarter in order growth from both a year-over-year perspective and in sequential improvement from the first quarter of fiscal 2010. Order growth was approximately 17 percent year-over-year compared to the first quarter's year-over-year order growth, which was approximately flat. Balance in the U.S. was good across industry segments, with Enterprise growing approximately 10 percent, Public Sector growing 2 percent, Commercial growing in the mid teens and Service Provider growing in the low 20s, each from a year-over-year order growth perspective.

I would like to comment specifically on the Service Provider market where orders just two quarters ago were down over 30 percent year-over-year and just last quarter were down in the high single digits year-over-year. This is one of the most robust positive turnarounds I've seen in my career.

Our business in Japan, despite the very challenging economy, continued to show solid improvements, with order growth in the high teens year-over-year.

Asia Pacific, which was down in the low single digits year-over-year in the first quarter, grew in the low double digits year-over-year in the second quarter, with both India and China each starting to take off with order growth, respectively, in the low 20s and high teens on a year-over-year basis.

We also saw the Emerging Markets start to turn around, improving from the first quarter's negative order growth year-over-year in the high 20s to this quarter's flat growth year-over-year. This was led by Brazil, with year-over-year order growth of approximately 30 percent. As you would expect, in some very challenged economies we experienced negative order growth, such as in Mexico where order growth year-over-year declined in the mid-teens.

We continue to see improvement in Europe. Our European orders were up approximately 4 percent year-over-year, although the results vary dramatically among large European countries: orders in France grew year-over-year in low double digits; UK order growth was approximately flat year-over-year; Italy order growth was down in the mid-single digits; and order growth in Spain was down in the low double digits.

How has the company's new collaborative model contributed to its success in the marketplace?

John Chambers: In an area that we have not discussed since the start of the downturn for obvious reasons, productivity has increased dramatically two quarters in a row. In the first quarter, revenue per employee was $558,000, which was up approximately 8 percent over the fourth quarter of fiscal 2009. Second-quarter revenue per employee was $606,000, approximately a 9 percent increase over the first quarter of fiscal 2010.

Part of the increase was due to just raw revenue growth, but we believe an equal amount was due to our new organization structures and use of our own collaborative products. We were very pleased with this when one considers that out of the 30-plus market adjacencies we are moving into, many do not have material revenue contribution at this time, even though we have allocated a large amount of headcount to these new market adjacencies. In other words, we believe our real productivity was well above the numbers I just mentioned.

What impact has the company's organizational structure of councils, boards and working groups had on its ability to manage in the downturn?

John Chambers: As discussed in the last few calls, this structure is operating very effectively and has been an important part of managing through the recent downturn and then positioning us for the acceleration of results achieved during the last two quarters. We believe that these structures allow speed, scale, flexibility and rapid replication in the operation of our business and help expand our ability to take advantage of new market opportunities. We plan to continue to move into additional market adjacencies, which are currently at 30-plus.

Of perhaps equal importance, many of our leading customers now understand how this highly innovative management structure and new business models can launch both as many product families as we currently have, as well as movement into new market adjacencies, while still maintaining revenue growth and market share gains in our traditional areas. Moreover, I believe that more of our customers are beginning to understand our view that the market adjacencies are inter-related--at first loosely connected but then tightly be coupled together from both a technology and business architectural perspective enabled by the common theme of the network as the platform for all forms of communications and IT. If the market adjacencies play out the way we expect, it will be very similar to what we saw years ago with the original Cisco advanced technologies being initially viewed as "standalone," and then over time becoming loosely and then tightly viewed as integrated.

Now that the recovery appears to be underway, what can we expect in terms of the company's expenses?

John Chambers: As we said in prior quarters' conference calls, we are going to continue to be very aggressive to position ourselves in response to our optimistic view of global economic growth, while continuing to maintain tight financial management in aligning our resources to new opportunities.

Given our belief that the market is beginning to accelerate, and given our productivity growth in terms of revenue per headcount of approximately 17 percent in just two quarters, it is probably not a surprise to anyone that we are planning to grow our expenses at a faster pace, as we continue to expand in our traditional business areas and move into these 30-plus market adjacencies.

While the continued strength of the recovery and eventual job creation may still be in question, we clearly are basing our decisions and investments upon an optimistic belief about the positive direction of the economy.

If we get surprised, we will adjust. And we have a proven track record of being able to do so when appropriate.


Frank Calderoni on Cisco's Second Quarter Financial Position

What is your view of the second quarter overall from a financial perspective?

Frank Calderoni: I am pleased with our very strong results for the second quarter of fiscal year 2010, which demonstrates our ability to execute on our innovation and operational excellence priorities within our business model.

Our ongoing efforts to improve efficiency and productivity have allowed us to deliver strong performance in the second quarter, but also in our view position us well for the future.

What are some of the key financial specifics for the second quarter?

Frank Calderoni: Total revenue for the second quarter was $9.8 billion, an increase of approximately 8 percent year-over-year, well above our guidance provided last quarter of 1 percent to 4 percent year-over-year. Total service revenue was $1.8 billion, up approximately 6 percent year-over-year. Total product revenue was $8 billion, up 9 percent year-over-year. Our results include the contribution of our acquisitions of Starent and Scansafe, which each closed during the quarter.

Switching revenue was $3.4 billion, an increase of 13 percent year-over-year. Modular switching revenue was up approximately 12 percent year-over-year, while fixed switching revenue increased 14 percent year-over-year. With sequential revenue growth of 19 percent, this reflects the highest first-to-second quarter sequential switching revenue growth in over a decade.

Routing revenue was $1.6 billion, up 2 percent year-over-year, representing an increase of 12 percent year-over-year in high end, a decrease of 14 percent in mid range and a decrease of 11 percent in low end.

Advanced Technologies revenue totaled $2.4 billion, representing an increase of 1 percent year-over-year. We saw increases in Unified Communications of 17 percent and Wireless of 9 percent on a year over year basis. We saw a year-over-year decline in Video Systems of 12 percent, and Security was flat year-over-year.

Other product revenue totaled $604 million, an increase of 46 percent year-over-year. Growth year-over-year was driven primarily by the inclusion of our acquisition of Pure Digital, which we closed late last fiscal year, along with continued growth in emerging technologies, which includes TelePresence and Unified Computing Systems, among others.

Sequentially, our total revenue was up 9 percent quarter-over-quarter. We saw sequential revenue increases across most product categories, with good performance in Fixed Switching, up 21 percent quarter-over-quarter, and Modular Switching, up 18 percent quarter-over-quarter. High end Routing, which includes our Starent acquisition, was up 4 percent quarter-over-quarter, and Video Systems was up 26 percent quarter-over-quarter.

We experienced an increase in total revenue across all geographic segments on a year-over-year basis with the exception of Europe. Year-over-year revenue ranged from a decline of approximately 3 percent in Europe to growth of approximately 16 percent for the Asia Pacific theater. In the U.S. and Canada theater, revenue was up approximately 12 percent year-over-year; in Japan, it was up approximately 12 percent year-over-year, and in Emerging Markets, it was up approximately 1 percent year-over-year.

GAAP net income for the second quarter was $1.9 billion, compared with $1.5 billion in the second quarter of fiscal year 2009. Non-GAAP net income was $2.3 billion, compared with $1.9 billion in the second quarter of fiscal 2009.

GAAP earnings per share on a fully diluted basis for the second quarter were $0.32 versus $0.26 in the same quarter of fiscal year 2009. Non-GAAP earnings per share on a fully diluted basis for the second quarter were $0.40, versus $0.32 in the second quarter of fiscal year 2009, a 25 percent increase year-over-year.



RECONCILIATION OF GAAP TO NON-GAAP NET INCOME

(In millions, except per-share amounts)

Three Months Ended Six Months Ended
January 23, 2010 January 24, 2009 January 23, 2010 January 24, 2009
GAAP net income $ 1,853 $ 1,504 $ 3,640 $ 3,705

Share-based compensation expense (1)

371 298 692 602

Payroll tax on stock option exercises (2)

1

In-process research and development (3)

3

Amortization of acquisition-related intangible assets

192 190 341 356

Other acquisition-related costs (4)

81 37 85 159

Total adjustments to GAAP income before provision for income taxes

644 525 1,118 1,121

Income tax effect

(158) (162) (303) (356)

Effect of retroactive tax legislation (5)

(106)

Total adjustments to GAAP provision for income taxes

(158) (162) (303) (462)
Non-GAAP net income $ 2,339 $ 1,867 $ 4,455 $ 4,364
Diluted net income per share:
GAAP $ 0.32 $ 0.26 $ 0.62 $ 0.63
Non-GAAP $ 0.40 $ 0.32 $ 0.76 $ 0.74
Shares used in diluted net income per share calculation:
GAAP 5,862 5,864 5,866 5,901
Non-GAAP 5,862 5,885 5,866 5,919

(1) Share-based compensation expense for the second quarter and first six months of fiscal 2010 include $26 million and $54 million, respectively, and $22 million and $44 million for the second quarter and first six months of fiscal 2009, respectively, of share-based compensation related to acquisitions.

(2) Effective in the third quarter of fiscal 2009, Cisco no longer excludes payroll tax on stock option exercises for purposes of its non-GAAP financial measures.

(3) Effective in fiscal 2010, Cisco no longer excludes in-process research and development upon acquisition for purposes of its non-GAAP financial measures as it is no longer expensed as a result of new accounting guidance.

(4) Other acquisition-related costs for the second quarter and first six months of fiscal 2010 include $38 million of losses and $4 million of gains, respectively, of mark-to-market impacts related to transactions to hedge a portion of the foreign currency consideration of a pending business combination.

(5) In the first quarter of fiscal 2009, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 reinstated the U.S. federal R&D tax credit, retroactive to January 1, 2008. GAAP net income for the first six months of fiscal 2009 included a $106 million tax benefit related to fiscal 2008 R&D expenses. Non-GAAP net income for the first six months of fiscal 2009 excluded the $106 million tax benefit related to fiscal 2008 R&D expenses.

Certain reclassifications have been made to prior period amounts to conform to the current period's presentation.

Additional reconciliations between GAAP and non-GAAP financial measures are provided in the tables that follow on page 10.

RECONCILIATION OF SHARES USED IN THE GAAP AND NON-GAAP
DILUTED NET INCOME PER SHARE CALCULATION

(In millions)

Three Months Ended Six Months Ended
January 24, 2009 January 24, 2009
Shares used in diluted net income per share calculation - GAAP 5,864 5,901
Effect of share-based compensation expense 21 18
Shares used in diluted net income per share calculation - Non-GAAP 5,885 5,919

Effective for the second quarter and first six months of fiscal 2010, Cisco no longer uses non-GAAP shares in the calculation of non-GAAP net income per share.




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This executive question and answer may be deemed to contain forward-looking statements, which are subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among other things, statements regarding future events (such as the entry into the second phase of the economic recovery, our momentum and growth in the market, that we are extremely well-positioned, and our ability to continue to focus on growing and capturing market transitions in our industry) 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 due to a variety of factors, including: business and economic conditions and growth trends in the networking industry, our customer markets and various geographic regions; global economic conditions and uncertainties in the geopolitical environment; overall information technology spending; the growth and evolution 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 and other customer markets; the return on our investments in certain market adjacencies and geographical locations; the timing of orders and manufacturing and customer lead times; changes in customer order patterns or customer mix; insufficient, excess or obsolete inventory; variability of component costs; variations in sales channels, product costs or mix of products sold; our ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; increased competition in our product and service markets, including the data center; dependence on the introduction and market acceptance of new product offerings and standards; rapid technological and market change; manufacturing and sourcing risks; product defects and returns; litigation involving patents, intellectual property, antitrust, shareholder and other matters, and governmental investigations; natural catastrophic events; a pandemic or epidemic; our ability to achieve the benefits anticipated from our investments in sales and engineering activities; our ability to recruit and retain key personnel; our ability to manage financial risk, and to manage expenses during economic downturns; risks related to the global nature of our operations, including our operations in emerging markets; currency fluctuations and other international factors, including relating to transactions to hedge foreign currency consideration for acquisitions; changes in provision for income taxes, including changes in tax laws and regulations or adverse outcomes resulting from examinations of our income tax returns; potential volatility in operating results; and other factors listed in Cisco's most recent reports on Form 10-K and Form 10-Q. The financial information contained in this executive question and answer 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, as each may be amended from time to time. Cisco's results of operations for the three and six months ended January 23, 2010 are not necessarily indicative of Cisco's operating results for any future periods. Any projections in this executive question and answer 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 executive question and answer.

This executive question and answer includes non-GAAP net income, non-GAAP net income per share data, and non-GAAP shares used in net income per share calculation. Effective for the second quarter and first six months of fiscal 2010, Cisco no longer uses non-GAAP shares in the calculation of non-GAAP net income per share.

These non-GAAP measures are not in accordance with, or an alternative for measures prepared in accordance with, generally accepted accounting principles and may be different from non-GAAP measures used by other companies. In addition, these non-GAAP measures are not based on any comprehensive set of accounting rules or principles. Cisco believes that non-GAAP measures have limitations in that they do not reflect all of the amounts associated with Cisco's results of operations as determined in accordance with GAAP and that these measures should only be used to evaluate Cisco's results of operations in conjunction with the corresponding GAAP measures.

Cisco believes that the presentation of non-GAAP net income, non-GAAP net income per share data and non-GAAP shares used in net income per share calculation for the periods in which such measures are presented, when shown in conjunction with the corresponding GAAP measures, provides useful information to investors and management regarding financial and business trends relating to its financial condition and results of operations.

For its internal budgeting process, Cisco's management uses financial statements that do not include, when applicable, share-based compensation expense, amortization of acquisition-related intangible assets, other acquisition-related costs, enhanced early retirement benefits, the income tax effects of the foregoing, significant effects of retroactive tax legislation, and significant transfer pricing adjustments related to share-based compensation. Cisco's management also uses the foregoing non-GAAP measures, in addition to the corresponding GAAP measures, in reviewing the financial results of Cisco. In prior periods, Cisco has excluded other items that it no longer excludes for purposes of its non-GAAP financial measures; for example, effective in the third quarter of fiscal 2009, Cisco no longer excludes payroll tax on stock option exercises, and effective in fiscal 2010, Cisco no longer excludes in-process research and development upon acquisition as it is no longer expensed as a result of new accounting guidance. From time to time in the future, there may be other items that Cisco may exclude for purposes of its internal budgeting process and in reviewing its financial results.

For additional information on the items excluded by Cisco from one or more of its non-GAAP financial measures, refer to the Form 8-K regarding Cisco's earnings release furnished today to the Securities and Exchange Commission.

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