FOOL CONFERENCE CALL SYNOPSIS*
By Greg Markus (TMF Boring)

Cisco Systems
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170 W. Tasman Dr.
San Jose, CA 95134
(408) 526-4000
http://www.cisco.com

ANN ARBOR, Mich. (May 6, 1997) /FOOLWIRE/ -- Cisco Systems today reported results for its fiscal third quarter ending April 26, 1997. Net sales increased 52% over the year-ago period, to $1.65 billion. Net income, excluding a one-time gain of three cents from sale of a portion of a minority stock investment, was $358.0 million, or $0.52 per share. The EPS figure represented a 41% increase over the $0.37 of last year's third quarter.

MARGINS. Chief Financial Officer Larry Carter provided some additional detail regarding the company's earnings statement and balance sheet. Revenue from training, service, and support was $115 million versus $97 million in Q2. Gross margin held steady sequentially at 65.3%, as cost reductions from Cisco's value-engineering activities offset a slightly negative product mix. Pricing on components has stabilized generally, although Cisco has begun to see some upward movement in memory prices. Net margin, excluding the gain from sale of a minority stock investment, was 21.7% of sales compared to 22.1% last quarter on a comparable basis.

EXPENSES. Total operating expenses increased to 32.6% of sales versus 31.9% for Q2 on a comparable basis. Last quarter, Cisco discussed a plan to lower the sequential growth rate of total operating expenses. This was achieved by growing total operating expenses approximately 6% sequentially this quarter versus 13% and 14% sequentially in the first two quarters, respectively, of this fiscal year. R&D increased as a percentage of revenues to 11.1% from 10.5% in Q2. This was due primarily to Cisco's hiring focus in engineering. Tax provision remained constant at 37%, which the company believes will be constant for the remainder of this year.

HEADCOUNT. In Q3, total headcount grew by 246 to 10,451 employees. Over 500 employees were hired during the quarter. Voluntary turnover rate remained constant as compared with past quarters, while the involuntary turnover rate more than doubled as the company terminated some underperforming employees.

ACCOUNTS RECEIVABLE. Accounts receivable increased from Q2 by $114 million to $1.1 billion. Days sales outstanding (DSO) increased to 63 days from 59 days at the end of Q2. The increase was primarily due to the nonlinearity of shipments during the quarter; although orders were fairly linear throughout April, shipments were not, and hence the increase in DSO. The quality of the accounts receivable is excellent, and depending on linearity of orders and shipments in the current quarter, management would expect an improvement in DSO going forward.

INVENTORY. Inventory was approximately $234 million, an increase of $30 million sequentially (as Cisco said they would do at the end of the last quarter) due to shortening of lead times. Quarterly inventory turns were 10.4 versus 9.9 last quarter and 5.3 a year ago.

SHARE REPURCHASE PLAN. Cisco's Board of Directors has approved a plan authorizing the repurchase of 5.0 million shares of Cisco stock, which the company intends to execute within a short period of time. The schedufor a pooling-of-interest accounting on future acquisitions.

CHAMBERS'S COMMENTS ON Q3. President and CEO John Chambers said the company was satisfied with its third quarter results, given the seasonal challenges Cisco typically faces in that quarter and the industry-wide challenges. Sequential revenue growth was 3% and year-over-year revenue growth was 52%, which is above the 30% to 50% range that industry pundits project for the networking industry as a whole. There have not been any fundamental changes in the technology or business drivers of the market that would cause Cisco to call into question that industry projection. However, the service provider market and certain countries that continue to experience slower economic growth continue to be a challenge. Based on Cisco's analysis, the company continues to grow faster than many of its competitors by continuing to gain share in many of its markets.

ORDER FLOW. Book to bill was 1.0 again as the company continues to bring the lead time between order and sales to the 1-3 week range in most areas, which customers require. Short lead times can result in increased quarter to quarter volatility in results. In terms of bookings flow, February and March were slower and more back-end loaded than Cisco would have liked; April, however, was solid and linear across all products, customer segments, and geographies. The company will need to see how the next few months proceed in order to know whether the April experience was indicative of a trend.

GEOGRAPHIC MARKETS. Business remains good in China, U.K., U.S., and Canada. Japan, Germany, and France continued weak, and some softness in Korea, as well. Japan and Germany may be bottoming out at last, but there is no firm evidence of that yet. The U.S./Canada market was very consistent, although service provider sales were weaker than Cisco would have preferred. The U.S. accounted for approximately 50% of product bookings in the quarter.

BUSINESS REALIGNMENT

Cisco devotes a portion of each quarter's conference call to a presentation on a specific topic. This time, Chambers described Cisco's recent realignment of its business around three key customer lines: enterprise, service providers, and small/medium businesses. The argument Chambers presented was that Cisco's former product-oriented focus was very useful for getting the company to where it is now but that a reorientation directed toward customer needs, which may span a variety of products, is more compatible with Cisco's emphasis on providing market-specific end-to-end solutions.

ENTERPRISE SEGMENT. This business line, led by Mario Mazzola, will provide Cisco's large corporate and institutional customers with end-to-end, scalable networking solutions that leverage the convergence of switching and routing technologies, plus comprehensive network management, security and support for multi-service applications. This line continues to provide the majority of Cisco's business, and industry analysts estimate that it will continue to grow strongly well into the year 2005. According to those analysts, Cisco is #1 in high-end LAN switching, with a 45% market share in 1996, up from 22% in 1995. LAN switching is making a key transition from hub/router based technology to switch/router-based solutions.

SERVICE PROVIDER. Headed by Don Listwin, this business line will provide end-to-end networking systems for telecommunication carriers, Internet service providers (ISPs), and cable and wireless companies. Its emphasis will be on delivering next-generation services of particular interest to service providers, such as tag-switching and quality of service (QoS). The major strategic relationship with GTE (discussed below) is an example of a service provider recognizing the advantage of Cisco's end-to-end solutions. In its press release, GTE said that its joint effort with Cisco to dramatically ramp up GTE's network offerings for customers could bring as much as $1 billion in business to Cisco over the next five years. Cisco continues to make strides in offering dial solutions to ISPs and Regional Bell Operating Companies (RBOCs). For example, bookings for Cisco's AS5200 access server were up in excess of 40% sequentially. Cisco also announced a free 56K upgrade for AS5200 customers, and will be investing heavily in upgrading product offerings and performance in the dial market. On the ATM and frame relay front, Cisco continues to achieve major wins. For example, Telecom Italia selected Cisco for Europe's largest ATM and frame relay network. Cisco has also just announced a new product line for voice and data integration, the Cisco 3800 series, and the company expects to make perhaps 10-12 announcements in this area during calendar 1997. Cisco is also offering high-speed DSL solutions through its acquisition of Telesend.

SMALL/MEDIUM BUSINESS. This line is led by Howard Charney. It will deliver end-to-end networking solutions for small to medium-sized customers, with a focus on easy-to-use, integrated solutions that combine software and multiple products. This is one of the fastest-growing segments of the networking market. Cisco's web-server solution for small businesses is an example of unique offerings in this segment.

At present, roughly 60% of Cisco's business is enterprise, 30% is service providers, and perhaps 10% small/medium business. Cisco's position in the enterprise segment is very strong. It's good in the service provider segment, but not as strong as Cisco would like to see. Cisco believes that it now has the right products, but particularly in the small/medium business segment needs to do better in terms of its selling channels, where some competitors have done better to date.

STRATEGIC PARTNERSHIPS

Another key theme of the conference call was the growing importance of strategic partnerships -- such as ones already announced with such partners as INTEL, MICROSOFT, and HEWLETT-PACKARD, and the one just announced with GTE. Chambers said that strategic partnerships will be as important to Cisco's future growth as acquisitions were to its past.

For multimedia, Cisco, Intel and Microsoft announced the formation of the Networked Multimedia Connection, a cooperative program to facilitate the widespread adoption of networked multimedia applications in businesses using intranets and the Internet. In the security arena, an area of increasing importance to customers, Cisco announced the Enterprise Security Alliance, the industry's first security initiative to provide a multi-technology framework through a single, secure routing and switching fabric for end-to-end network security. Among the members in this program are Microsoft, Hewlett-Packard and Oracle.

Cisco believes that if they execute properly, Intel and Microsoft will be long-term strategic partners with Cisco, and those organizations would say the same thing. Sales, support, and service in the networking market -- particularly in terms of expectations that high-end enterprise and service providers' have for their vendors -- is a very different model from that for other kinds of markets. So the advantages for Cisco and its partners to approach those accounts jointly rather than individually are very good.

The emphasis on partnerships should not be taken to imply that Cisco will be slowing its buying binge noticeably. Guidance was to expect 8 to 12 acquisitions this year.

NEW PRODUCTS

Cisco announced approximately 20 new product innovations the quarter. Key product announcements include Cisco's expansion of its Catalyst 5000 family with the addition of the Catalyst 5500 and the Catalyst 5002. Approximately 2000 Catalyst 5500 units were ordered in its first month. Cisco also launched the industry's first multiservice access concentrator to integrate voice, data and IP routing: the Cisco 3800.

Cisco will be showing its new Gigabit Switch Router (GSR) and multimedia products at the Las Vegas trade show, which opened today. Tag-switching is being demonstrated in Cisco ATM and router products at Interop, and it's being very well accepted in the IETF standards bodies. A number of Cisco's ISP customers are following the development effort, intend to test tag-switching in their networks, and are headed towards deploying it if Cisco brings it to market, which Cisco says they will.

AREAS OF STRENGTH. Acceptance of a single end-to-end vendor continues to go well, with good results in each product area in terms of market share and in most of Cisco's key markets, with continued improvement in the dial and LAN switching arenas. The business line reorganization is proceeding well. The company continued to hire top engineers in the quarter while at the same time eliminating certain underperforming employees; the latter is difficult but necessary for fast-growth companies. Strategic partnerships are also an area of strength for Cisco.

AREAS FOR IMPROVEMENT. Given Cisco's "normal paranoia," the company always looks closely at areas of concern. Countries with slower economic growth and therefore less technological spending, such as Japan and Germany, may be bottoming out in terms of purchasing network equipment, but Cisco has not yet seen any significant upturns in purchasing there. Service provider spending is still lumpy in terms of orders and on a world-wide basis. Shorter lead-times mean more fluctuations in revenues on a quarterly basis. Cisco also needs to do a better job of challenging competitors' performance claims for certain of their products (see below). Strategic partnering is challenging to implement properly, even more difficult than making acquisitions.

ROUTERS AND ROUTING

Routers do several things: media adaption (such as fast ethernet to gigabit ethernet), policy functions (such as security functions, accounting, QoS, multiprotocol functions -- all the various software functions that are performed as data move through the network), and forwarding, or switching. Cisco sees network performance going up very quickly, but performance is only one-third of the routing function. There are other functions that fundamentally have to be performed somehow, somewhere in software; and that goes against the argument that says that everything will be buried in a single silicon chip, which is an overly simplistic view of the market. People who went through the so-called "ATM wars" a few years ago will appreciate the resiliency of the routing function.

There are two simultaneous trends in the network market: (1) rapidly escalating performance and media bandwidth requirements, but also (2) rapidly escalating demands for value-added services, so that customers and ISPs can deploy services that are economically sound, such as encryption, Internet QoS, and even Internet voice. All those latter functions are present and supported in all parts of the network, including access. The point is that the software function has to be deployed throughout the entire network; and not to pay attention to the software functions that constitute routing is a big mistake.

Furthermore, as voice over IP, streaming video, and other new uses of the network increase, that will require a different kind of QoS than has been common on pure data networks; this further complicates the infrastructure rather than simplifies it. The routing function will thus be with us for a very long time.

That said, routers (as distinct from routing) and shared media hubs are absolutely migrating toward products that have a combination of routing and layer-two switching in them. So you will see routing in Catalyst 5000s and 5500s, and you will see switching in Cisco high-end routers.

HIGH-END ROUTER PRODUCTS

Cisco's high-end router revenues tend to vary from quarter to quarter and are tied to the ISP market. High-end router sales therefore did not grow at the same rate as other segments of Cisco's business, such as LAN switching, and was actually down sequentially. Some customers may have delayed orders while waiting for Cisco's new high-end platform, the GSR, which is in Cisco's booth at Interop+Networld and will be in field trials this summer. That product is focused at the emerging market of Internet applications at rates of OC-12 (622 Mbps) scaling up to OC-48. Cisco will continue to have the 7500 high-end router in the market, and that will be focused on the OC-3 (155 Mbps) market -- which continues to be 80% of the total market.

Many leading-edge service providers are holding their capital expenditures until they can evaluate new technologies for scaling up to OC-12 and OC-48 rates. Right now, there's very little technology to choose from, so those customers are waiting for the GSR. Some competitors are making unrealistic claims for their products -- specifically the Ascend product -- which is confusing customers. So Cisco will press aggressively for independent organizations to evaluate those product claims. A lot of the numbers being postulated are based on completely unrealistic scenarios. Cisco has allowed those claims to overhang the market and needs to address them more aggressively.

SWITCHING PRODUCTS

The carrier business was soft during the last quarter. Cisco did see approximately 30% higher revenue than they've ever seen from the StrataCom line, nevertheless. Over 10,000 LAN switch units were ordered this past quarter, approximately 80% the Catalyst 5000 and 20% the 5500. Overall LAN switching revenues in the quarter were at an annualized run-rate in excess of $1.6 billion.

Price per port will probably decline faster than the 20% per year trend, but at the same time there's a sharp increase in network performance demands. The net result is fairly stable pricing. In fact, gross margins on most of Cisco's LAN switching products are stable to increasing, even as price per port declines. This has been the trend in the market for quite sometime, and it is factored into the industry-wide projections of 30% to 50% annual revenue growth.

GUIDANCE

ENDORSES 30%-50% INDUSTRY GROWTH. Cisco continues to endorse projections of overall industry growth of 30% to 50% per year, with fluctuations from time to time above or below that rate. The company's goal over the next 12 to 24 months is to grow revenue at or above the overall industry rate, although given Cisco's size and market-share leadership, growth in excess of the industry average is very challenging.

OPPORTUNITIES AND CHALLENGES. Cisco sees new opportunities in many of its markets. Consolidation in the industry continues to accelerate, and many experts project that a few, larger players will lead the industry -- which plays to Cisco's advantage. However, this consolidation, and technical architectural discussions, can stretch out the sell-cycles. Also, network spending continues to be slow in countries where economic conditions are slow, such as Japan, Germany and France -- although there is some suggestion that markets are finally "bottoming out" in Japan and Germany.

EXPENSE PROJECTIONS. Cisco's goal has been to keep operating expenses in the 30% to 33% range, as a percent of revenue. Past guidance has been that R&D expenditures would be in the 10% to 11% range, and right now Cisco is at the high end of that range. Sales and marketing expenses would tend to be 17% to 19%, and in Q3 it was around 18%. The goal is to keep general and administrative (G&A) expenses as close to 3% as possible. Adding all that up yields a range of 30% to 33%. Sequential expense growth should be pretty much in line with sales growth. For the short term, the mode will be one of "business as usual," with Cisco still anticipating to hire 400-500 people in the quarter, although that could be accelerated down the road, particularly in the sales area.

SALES AND MARGINS. Orders in April were strong and linear throughout the month, and the current quarter (Q4) tends to be a strong one historically. All of this -- together with good control over internal business costs -- bodes well for the fourth quarter; but with lead times as short as one to three weeks, it is difficult to forecast final results with accuracy. Some quarters can close above expectations and some below. This will be a natural part of Cisco's business going forward. Gross margin percentage held steady from Q2 to Q3, but that can fluctuate from quarter to quarter, and Cisco continues to expect that margins will decline over time.

SEQUENTIAL REVENUE GROWTH. In response to a question, Chambers advised that expectations of a return to double-digit sequential growth in revenues for Q4 would be "a little bit too optimistic." He continued, "We tend to be very conservative on the financial positioning, and we would look for single-digit this quarter in terms of the growth projections."

NEXT REPORT. The next conference call will be Tuesday, August 5, 1997 at 4:45pm EDT.

* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.