Conference Call, 02/04/98

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

Cisco Systems Inc.
<% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>
170 W. Tasman Dr.
San Jose, CA 95134
(408) 526-4000
http://www.cisco.com

Revenues: 
 Q2 '98 $2016 million (+27%) 
 Q2 '97 $1592 million 
  
 Earnings per share: 
 Q2 '98 $0.43 (+26%) 
 Q2 '97 $0.34

ANN ARBOR, Mich. (Feb.3, 1998) /FOOLWIRE/ -- Cisco Systems today reported fiscal second quarter earnings of $0.43 per share (diluted), a 26% increase over the last year's $0.34. Quarterly revenues totaled $2.02 billion, up 27% from last year's $1.59 billion. Revenues grew 8% sequentially.

EARNINGS STATEMENT HIGHLIGHTS. Gross margin increased to 65.4% from the preceding quarter's 65.1%. Continued good execution from value engineering activities helped to offset negative product mix variances and aggressive pricing from some competitors; in addition, Cisco has benefited from some reductions in memory pricing. Operating expenses declined sequentially from 32.9% of sales to 32.7%. Research and development expense was 11.8% of revenues, down slightly from the 12.0% in the first fiscal quarter. Sales and marketing expense was 18.0%, versus 17.8% in Q1; and general and administrative expense was 2.9%, down slightly from last quarter.

BALANCE SHEET. Cash increased by $448 million in the quarter to $4.0 billion. Inventory increased by $27 million to $268 million, while inventory turns increased sequentially from 10.5-times to 10.9-times. Inventory levels should be expected to increase somewhat as customer lead times decrease and Cisco moves to a two-tiered distribution strategy. Days sales outstanding was essentially flat at 57 days versus 56 days last in the preceding quarter.

HEADCOUNT. Headcount increased by 796 to 12,075. Most of the new hires were in sales and engineering.

LIGHTSPEED. The acquisition of Lightspeed was previously expected to close in the quarter, but it is more likely now that it will close in mid-February. This will result in a one-time charge of $0.11 to $0.15 in fiscal Q3.

ORDERS. Orders were linear throughout the quarter, with the exception of the holiday pause. Order growth was better than 30% on an annualized basis in the quarter, and book-to-bill was in excess of 1.0.

GEOGRAPHIC MARKETS. Geographically, the Americas continued strong, with the U.S. providing 55% of orders. The rest of the Americas brought in 7% of orders. Europe is strengthening, and provided 28% of orders (including Australia, New Zealand, and the Middle East). Asia accounted for 10% of orders, down from 12% last quarter and the typical rate of 16%. The Asian numbers were characterized as "bad news-good news": the bad news is that orders are declining; the "good" news is that they are such a small percent of the mix that there's not much lower they can go -- although Cisco cautioned that single-digit order flow could be seen over the next year. Japan constitutes the majority of Asian orders, and the situation is not likely to improve very much there in the near term. China is most of the balance, and growth there is very strong -- over 100% year-over-year. Southeast Asia is a very small percentage of Cisco's business.

MARKET OVERVIEW. Cisco management said they are seeing "good activity" across all of Cisco's lines of business and that the company "continues to gain market share against almost all key competitors" and continues to maintain its "#1 or #2 position in almost all product areas." Service provider orders and activity continues to improve, although continued consolidation, lumpy order rates and other factors continue to create a certain amount of uncertainty in the near term. Additionally, sales to service providers have displayed some seasonality, with sales stronger in the second half of the calendar year. Cisco continues to see an increased acceptance of strategic end-to-end vendor decisions by customers across all markets. Cisco continues to gain market share in LAN switching, dial access, and WAN. In LAN switching, quarter-over-quarter order growth continues to be in the comfortable double-digits. In Q2, Cisco's dial access product revenues grew comfortably above 20% quarter-over-quarter and exceeded $135 million, apparently putting Cisco ahead of Ascend <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %> for the first time in this market. Cisco is also pleased with the high-end segment of its WAN business unit, where orders exceeded $165 million in the quarter. In token ring, Cisco sees good growth with orders growing over 30% quarter-over-quarter. Cisco continues to make progress in its small and medium-business line. The recently announced Cisco office stack is being well accepted in this market. The Cisco 2900 XL fast ethernet switch is also meeting with good acceptance.

PARTNERSHIP STRATEGY. The partnership strategy is also going well. Cisco announced a strategic alliance with US West <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: USW)") else Response.Write("(NYSE: USW)") end if %>, expanded its alliance with Fujitsu, and continued to expand its relationships with Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>, Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %>, and EDS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EDS)") else Response.Write("(NYSE: EDS)") end if %>. US West also designated Cisco as its preferred networking vendor for the buildout of its broadband data network.

CISCO CONNECTION. Cisco continues to use its own network technology and applications to gain competitive advantages. Cisco is currently booking more than 41% of its orders on line through Cisco Connection, with a network-commerce annual run rate of more than $3.6 billion, the largest of any company in the world.

DATA/VOICE/VIDEO INTEGRATION. It now appears that data, voice, and video will come together over a single network fabric. It also appears that this will be a data-packet, cell-based architecture rather than voice, circuit-based architecture. This has obvious advantages for Cisco -- but only if the company leverages it advantages in several areas. These include additional products, enterprise and service provider sales and support coverage, and key partnerships and acquisitions. These efforts help Cisco effectively compete against a flood of new start-ups as well as traditional voice-network players who are strongly entrenched with many large service providers and have very deep pockets. Cisco sees many more opportunities in both its traditional data network market and its expanding data/voice/video market than it is able to take advantage of. These opportunities offer large revenue potential as well as strategic positioning for future growth in new markets. If Cisco does not move quickly, it will allow competitors to gain the leadership in the new areas. Moving quickly is key to establishing leadership and future revenue potential. With that in mind, the company is going to slightly increase R&D spending and distribution spending as a percentage of total revenue for the next three to five quarters. These resources will be focused primarily in the following areas: data/voice/video integration; expansion of Cisco's end-to-end strategy; service provider coverage; and expansion of Cisco's "high touch" sales and support model, especially outside of North America. Cisco is pleased with its two-tier booking results, which are now at approximately a $1 billion run rate per year.

D/V/V INTEGRATION STRATEGY. Internationally, where communication costs are high and communication providers are more highly regulated, enterprise customers are motivated by a payback in investment that provides for toll bypass or toll reduction. In the U.S., where deregulation is common and voice tariffs are becoming increasingly commoditized, the business drivers are somewhat different. The opportunity is to provide increased productivity and superior customer service through integrated applications, such as unified messaging, Web call centers, and desktop video. Cisco has a strategy in place designed to help customers migrate to new d/v/v applications, leveraging much of their current communications infrastructure. For the enterprise segment (approximately a $10 billion market), Cisco's five-phase strategy focuses first on WAN backbone integration and aggregation; second, WAN access integration; third, public-switched telephone networking (PSTN) gateways -- the ability to gateway between the networks and the PSTN; fourth, campus LAN-PBX applications and integration; and fifth, unified application capabilities. During 1997, Cisco delivered several new products to support this strategy, and in January of 1998 Cisco announced the second phase of its d/v/v integration plan and introduced several new product offerings. In the balance of 1998, Cisco will enhance these existence offerings and launch new offerings as part of phases three through five. The strategy will embrace open standards, and in typical Cisco fashion, the company's strategy will be technology agnostic, supporting voice over frame relay, voice over ATM, and voice over IP.

PARTNERSHIP IN D/V/V. Cisco partners with Alcatel in Europe and with NEC in Japan. Cisco would like to partner with either Lucent <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %> or Northern Telecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %> and continues to pursue that aggressively. Both sides will have to get their commitments established within the next 9 to 12 months, after which time product lines could overlap too much to be effective partners. Cisco is "cautiously optimistic" in this regard.

GIGABIT ETHERNET. Cisco is positioned well. The company's strategy won't be of the stand-alone product type but will instead involve integrating gigabit technology into multiple products using a modular approach. The company will integrate gigabit technology into multiple products using a modular approach. Growth rates for this segment will probably be well above the overall industry growth rate. Cisco believes they can double their sales quarter over quarter for the first few quarters. Cisco doesn't enter a market in which they don't believe they can eventually capture at least a 25% share and capture a 40% to 70% share if they execute very well.

LAYER 3 SWITCHES. Cisco is completely agnostic with regard to technology. Cisco's routing and switching technologies are increasingly integrated, both logically and even physically. It becomes increasingly difficult to distinguish between router sales and switch sales. Gross margins are not all that different from those for traditional routers.

LOW-END BUSINESS SEGMENT. Cisco believes that the small- and medium-business area will be an area of significant growth. Cisco will begin to focus on the consumer market in this calendar year. For example, Cisco software and products will be integrated in Internet appliances, such as working with Intel to integrate Cisco technology into their chip for set-top boxes. Cisco will also be active in cable modems, integrating its technology into PC operating systems, and similar ventures, primarily with partners.

AREAS OF CONCERN. These continue to be: economic conditions in specific countries, service provider spending by country, and competition by startups and established players, as well as historical seasonality challenges in the third quarter. With regard to Asia, our guidance is to be conservative, and it is already factored into our business planning. Everyone is worried about a worst-case scenario, however unlikely it is to occur.

GUIDANCE. To seize the major opportunities with regard to data/voice/video integration, Cisco intends to ramp up hiring and R&D, aiming to add 1000 to 1500 new hires in the next three or four months. Operating expense is therefore expected to move toward 34% of sales. The tax rate for Q2 was 35% and that rate should continue through the balance of FY98. In FY99 the tax provision is expected to decline slightly to 34%. Q3 share count will be approximately 1,078 million, including approximately 3 million shares for the Lightspeed acquisition. Cisco sees no change in the basic drivers of the industry. Industry experts continue to project 30% to 50% annual revenue growth industry-wide, and Cisco's goal is to grow at or above the industry rate, although that becomes increasingly challenging given Cisco's market share. With shorter lead times, it is difficult to know until late in any quarter whether the company will close at, above, or below expectations.

NEXT REPORT. The Q3 report and conference call will be on Tues., May 5, 1998, at 4:45pm Eastern time.

* 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.