[May 21, 2013] CISCO SYSTEMS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q, including this Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as "expects," "anticipates," "targets," "goals," "projects," "intends," "plans," "believes," "seeks," "estimates," "continues," "endeavors," "strives," "may," variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, under "Part II, Item 1A. Risk Factors," and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason. OVERVIEW We design, manufacture, and sell Internet Protocol ("IP") based networking and other products related to the communications and information technology ("IT") industry and provide services associated with these products and their use. We provide a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world. Our products are designed to transform how people connect, communicate, and collaborate. Our products are utilized at enterprise businesses, public institutions, telecommunications companies and other service providers, commercial businesses, and personal residences. A summary of our results is as follows (in millions, except percentages and per-share amounts): Three Months Ended Nine Months Ended April 27, April 28, April 27, April 28, 2013 2012 Variance 2013 2012 Variance Net sales $ 12,216 $ 11,588 5.4 % $ 36,190 $ 34,371 5.3 % Gross margin percentage 61.5 % 61.9 % (0.4 ) pts 61.0 % 61.5 % (0.5 ) pts Research and development $ 1,542 $ 1,358 13.5 % $ 4,425 $ 4,072 8.7 % Sales and marketing $ 2,375 $ 2,383 (0.3 )% $ 7,178 $ 7,230 (0.7 )% General and administrative $ 530 $ 562 (5.7 )% $ 1,674 $ 1,611 3.9 % Total R&D, sales and marketing, general and administrative $ 4,447 $ 4,303 3.3 % $ 13,277 $ 12,913 2.8 % Total as a percentage of revenue 36.4 % 37.1 % (0.7 ) pts 36.7 % 37.6 % (0.9 ) pts Amortization of purchased intangible assets $ 89 $ 96 (7.3 )% $ 329 $ 292 12.7 % Restructuring and other charges $ 33 $ 20 65.0 % $ 105 $ 225 (53.3 )% Operating income as a percentage of revenue 24.1 % 23.7 % 0.4 pts 23.2 % 22.4 % 0.8 pts Income tax percentage 15.9 % 22.1 % (6.2 ) pts 7.7 % 21.2 % (13.5 ) pts Net income $ 2,478 $ 2,165 14.5 % $ 7,713 $ 6,124 25.9 % Net income as a percentage of revenue 20.3 % 18.7 % 1.6 pts 21.3 % 17.8 % 3.5 pts Earnings per share-diluted $ 0.46 $ 0.40 15.0 % $ 1.44 $ 1.13 27.4 % 42-------------------------------------------------------------------------------- Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 For the third quarter of fiscal 2013, we continued to execute on our plan to deliver profitable growth over the long term by maintaining our focus on operational excellence and portfolio management. Net sales increased 5%, with net product sales increasing 5% and service revenue increasing 7%. The net product sales increase was in large part due to our acquisition of NDS, which was completed at the beginning of fiscal 2013. Total gross margin decreased by 0.4 percentage points. Operating income as a percentage of revenue increased by 0.4 percentage points, primarily as a result of our continuing focus on expense management. Diluted earnings per share increased by 15% from the prior year period, a result of both a 14% increase in net income and a decline in our diluted share count by 69 million shares. Net income for the third quarter of fiscal 2013 benefited from a lower effective tax rate. For the third quarter of fiscal 2013, as compared with the prior year period, net sales increased by $0.6 billion. The Americas contributed the majority of the increase led by a sales increase in the United States. APJC was flat, while EMEA experienced a slight decline. For the third quarter of fiscal 2013, as compared with the prior year period, net product sales and service revenue increased by $0.5 billion and $0.2 billion, respectively. The product sales increase was driven by the following: an increase of $0.3 billion from Service Provider Video products driven in large part by the acquisition of NDS at the beginning of fiscal 2013; an increase of $0.2 billion from Data Center products, due to continued strong customer demand, and an increase of $0.1 billion from Wireless products, due to continued demand for these solutions. These net product sales increases, along with the service revenue contribution, reflect, in our view, the success we are experiencing with our technology architectures and our ability to deliver customer solutions, particularly in both the enterprise and service provider data center and cloud environments. These increases were partially offset by net product sales decreases in our Switching, Security, and Collaboration product categories. In addition, sales in our Other Products category decreased by $0.1 billion due in large part to the sale of our Linksys product line which was completed in the third quarter of fiscal 2013. In summary, during the third quarter of fiscal 2013, we continued to execute on our plan to deliver profitable growth over the long term. We did so even as we continued to experience the global macroeconomic challenges we have faced in recent quarters including, in particular, weakness in the European economy, global public sector spending, and a conservative approach to IT-related capital spending by customers. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Net sales increased 5%, with net product sales increasing 4% and service revenue increasing 10%. The increase in net product sales was due in large part to our acquisition of NDS. We achieved net sales increases in our Americas and APJC geographic segments, while net sales in our EMEA geographic segment declined. Total gross margin decreased by 0.5 percentage points. As a percentage of revenue, research and development, sales and marketing, and general and administrative expenses collectively declined by 0.9 percentage points primarily due to lower sales and marketing expenses. Operating income as a percentage of revenue increased by 0.8 percentage points, primarily as a result of lower restructuring charges and our continuing focus on expense management. Diluted earnings per share increased by 27% from the prior year, a result of both a 26% increase in net income and a decline by our diluted share count of 57 million shares. A significant portion of the increase in net income was attributable to total tax benefits of $1.1 billion, primarily related to a tax settlement with the IRS, the reinstatement of the U.S. federal R&D tax credit, and lapses of the time period for assessment of tax in certain foreign jurisdictions. Strategy and Focus Areas Our focus continues to be on our five foundational priorities: • Leadership in our core business (routing, switching, and associated services), which includes comprehensive security and mobility solutions • Collaboration • Data center virtualization and cloud • Video • Architectures for business transformation We believe that focusing on these priorities best positions us to continue to expand our share of our customers' information technology spending. 43 -------------------------------------------------------------------------------- We continue to undergo product transitions in our core business, including the introduction of next-generation products with higher price performance and architectural advantages compared with both our prior generation of products and the product offerings of our competitors. We believe that many of these product transitions are gaining momentum based on the strong year-over-year product revenue growth across these next-generation product families. We believe that our strategy and our ability to innovate and execute may enable us to improve our relative competitive position in many of our product areas even in uncertain or difficult business conditions and, therefore, may continue to provide us with long-term growth opportunities. However, we believe that these newly introduced products may continue to negatively impact product gross margins, which we are currently striving to address through various initiatives, including value engineering; effective supply chain management; and delivering greater customer value through offers that include hardware, software, and services. We continue to seek to capitalize on market transitions, which we believe will continue to come at an increasing pace. Market transitions relating to the network are becoming, in our view, more significant as intelligent networks have moved from being a mere cost center issue-that is, where the focus is on reducing network operating costs and increasing network-related productivity-to becoming, additionally and increasingly, a platform for improved revenue generation as well as driving business agility and strategy execution. Market transitions for which we are primarily focused include those related to the increased role of virtualization/the cloud, video, collaboration, networked mobility technologies, the transition from Internet Protocol Version 4 to Internet Protocol Version 6, and the Internet of Everything. For example, a market in which a significant market transition is underway is the enterprise data center market, where a transition to virtualization/the cloud is rapidly evolving. There is a continued growing awareness that intelligent networks are becoming the platform for productivity improvement and global competitiveness. We believe that disruption in the enterprise data center market is accelerating, due to changing technology trends such as the increasing adoption of virtualization, the rise in scalable processing, and the advent of cloud computing and cloud-based IT resource deployments and business models. These key terms are defined as follows: • Virtualization: Refers to the process of creating a virtual, or nonphysical, version of a device or resource, such as a server, storage device, network or an operating system, in such a way that human users as well as other devices and resources are able to interact with the virtual resource as if it were an actual physical resource. For example, one type of virtualization is server or data center virtualization, which consists of aggregating the current siloed data center resources into unified, shared resource pools that can be dynamically delivered to applications on demand, thus enabling the ability to move content and applications between devices and the network. • The cloud: Refers to an information technology hosting and delivery system in which resources, such as servers or software applications, are no longer tethered to a user's physical infrastructure but instead are delivered to and consumed by the user "on demand" as an Internet-based service, whether singularly or with multiple other users simultaneously. This virtualization and cloud-driven market transition in the enterprise data center market is being brought about through the convergence of networking, computing, storage, and software technologies. We are seeking to take advantage of this market transition through, among other things, our Cisco Unified Computing System platform and Cisco Nexus product families, which are designed to integrate the previously siloed technologies in the enterprise data center with a unified architecture. We are also seeking to capitalize on this market transition through the development of other cloud-based product and service offerings through which we intend to enable customers to develop and deploy their own cloud-based IT solutions, including software-as-a-service ("SaaS") and other-as-a-service ("XaaS") solutions. The competitive landscape in the enterprise data center market is changing. Very large, well-financed, and aggressive competitors are each bringing their own new class of products to address this new market. We expect this competitive market trend to continue. With respect to this market, we believe the network will be the intersection of innovation through an open ecosystem and standards. We expect to see acquisitions, further industry consolidation, and new alliances among companies as they seek to serve the enterprise data center market. As we enter this next market phase, we expect that we will strengthen certain strategic alliances, compete more with certain strategic alliances and partners, and perhaps also encounter new competitors in our attempt to deliver the best solutions for our customers. We believe that the architectural approach that we have undertaken in the enterprise data center market is adaptable to other markets. An example of a market where we aim to apply this approach is mobility, where growth of IP traffic on handheld devices is driving the need for more robust architectures, equipment and services in order to accommodate not only an increasing number of worldwide mobile device users, but also increased user demand for broadband-quality business network and consumer web applications to be delivered on such devices. A key term in this mobility-centered market transition is "BYOD," an acronym for "bring your own device," which in the context of IT usage in companies, universities, and other organizations refers to the growing trend of employees, customers, students, and others associated with such entities to bring and use their own laptop computers, smartphones, tablets or other mobile devices for their work or participation, instead of using equipment provided by the organization. 44 -------------------------------------------------------------------------------- With regard to this market transition, to help such organizations meet the demands of increasing BYOD usage, our product development strategy involves a comprehensive architectural approach that will allow for, among other things, a unified security policy across the whole organization; a simplified operations and network management structure that understands application performance from a user's perspective, enhances troubleshooting capability and lowers network operating costs; and an uncompromised user experience over the organization's entire wireless and wired network that embraces use of any kind of device. Our mobility-related products and solutions reflect this architectural-based approach. Other market transitions on which we are focusing particular attention include those related to the convergence of video, collaboration, and networked mobility technologies, which we believe will drive productivity and growth in network loads and which convergence appears to be evolving even more quickly and more significantly than we had previously anticipated. Cisco TelePresence systems are one example of product offerings that have incorporated video, collaboration, and networked mobility technologies, as customers evolve their communications and business models. More generally, we are focused on simplifying and expanding the creation, distribution, and use of end-to-end video solutions for businesses and consumers. A market transition on which we are focusing is the move toward more programmable, flexible, and virtual networks, sometimes called Software Defined Networking, or SDN. This move to network programmability encompasses technologies such as SDN and is focused on moving from a hardware-centric approach for networking to a virtualized network environment that is designed to enable flexible, application-driven customization of network infrastructures. We believe the successful products and solutions in this market will combine application-specific-integrated-circuits ("ASICs") with hardware and software elements together to meet customers' total cost of ownership, quality, security, scalability and experience requirements. In our view, there is no single architecture that supports all customer requirements in this area. Our strategy is targeted to address a broad range of specific customer use cases, and we believe we have an effective strategy that also enables us to look to next steps that will follow the initial implementations that are underway. We have announced our strategy to address this opportunity with the Cisco Open Network Environment, or Cisco ONE, including overlay network technology, application programming interfaces ("APIs"), and network-operation tools called agents and controllers and we have several customers in a trial phase for these solutions. In our view, this evolution is in its very early stages, but we believe we have a differentiated strategy. We intend to continue to drive internal innovation, partner for co-development, and make strategic investments to lead this evolution. Other Key Financial Measures The following is a summary of our other key financial measures for the third quarter and first nine months of fiscal 2013 (in millions, except days sales outstanding in accounts receivable ("DSO") and annualized inventory turns): April 27, July 28, 2013 2012 Cash and cash equivalents and investments $47,388 $48,716 Deferred revenue $12,685 $12,880 DSO 37 days 34 days Inventories $1,469 $1,663 Annualized inventory turns 12.4 11.7 Nine Months Ended April 27, April 28, 2013 2012 Cash provided by operating activities $8,908 $8,403 Repurchases of common stock - stock repurchase program $1,613 $2,560 Dividends $2,392 $1,076 45-------------------------------------------------------------------------------- CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions, and estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Note 2 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended July 28, 2012, as updated as applicable in Note 2 to the Consolidated Financial Statements herein, describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. The accounting policies described below are significantly affected by critical accounting estimates. Such accounting policies require significant judgments, assumptions, and estimates used in the preparation of the Consolidated Financial Statements, and actual results could differ materially from the amounts reported based on these policies. Revenue Recognition Revenue is recognized when all of the following criteria have been met: • Persuasive evidence of an arrangement exists. Contracts, Internet commerce agreements, and customer purchase orders are generally used to determine the existence of an arrangement. • Delivery has occurred. Shipping documents and customer acceptance, when applicable, are used to verify delivery. • The fee is fixed or determinable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. • Collectibility is reasonably assured. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer's payment history. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. When a sale involves multiple deliverables, such as sales of products that include services, the multiple deliverables are evaluated to determine the unit of accounting, and the entire fee from the arrangement is allocated to each unit of accounting based on the relative selling price. Revenue is recognized when the revenue recognition criteria for each unit of accounting are met. The amount of product and service revenue recognized in a given period is affected by our judgment as to whether an arrangement includes multiple deliverables and, if so, our valuation of the units of accounting for multiple deliverables. According to the accounting guidance prescribed in Accounting Standards Codification ("ASC") 605, Revenue Recognition, we use vendor-specific objective evidence of selling price ("VSOE") for each of those units, when available. We determine VSOE based on our normal pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the historical standalone transactions have the selling prices for a product or service fall within a reasonably narrow pricing range, generally evidenced by approximately 80% of such historical standalone transactions falling within plus or minus 15% of the median rates. When VSOE does not exist, we apply the selling price hierarchy to applicable multiple-deliverable arrangements. Under the selling price hierarchy, third-party evidence of selling price ("TPE") will be considered if VSOE does not exist, and estimated selling price ("ESP") will be used if neither VSOE nor TPE is available. Generally, we are not able to determine TPE because our go-to-market strategy differs from that of others in our markets, and the extent of our proprietary technology varies among comparable products or services from those of our peers. In determining ESP, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. We typically arrive at an ESP for a product or service that is not sold separately by considering company-specific factors such as geographies, competitive landscape, internal costs, profitability objectives, pricing practices used to establish bundled pricing, and existing portfolio pricing and discounting. Some of our sales arrangements have multiple deliverables containing software and related software support components. Such sales arrangements are subject to the accounting guidance in ASC 985-605, Software-Revenue Recognition. As our business and offerings evolve over time, our pricing practices may be required to be modified accordingly, which could result in changes in selling prices, including both VSOE and ESP, in subsequent periods. There were no material impacts during the quarter nor do we currently expect a material impact in the next twelve months on our revenue recognition due to any changes in our VSOE, TPE, or ESP. Revenue deferrals relate to the timing of revenue recognition for specific transactions based on financing arrangements, service, support, and other factors. Financing arrangements may include sales-type, direct-financing, and operating leases, loans, and guarantees of third-party financing. Our deferred revenue for products was $4.0 billion and $3.7 billion as of April 27, 2013 and July 28, 2012, respectively. Technical support services revenue is deferred and recognized ratably over the period during which the services are to be performed, which typically is from one to three years. Advanced services revenue is recognized upon delivery or completion of performance. Our deferred revenue for services was $8.7 billion and $9.2 billion as of April 27, 2013 and July 28, 2012, respectively. 46 -------------------------------------------------------------------------------- We make sales to distributors and retail partners, which we refer to as two-tier systems of sales to the end customer. Revenue from distributors and retail partners is recognized based on a sell-through method using information provided by them. Our distributors and retail partners participate in various cooperative marketing and other programs, and we maintain estimated accruals and allowances for these programs. If actual credits received by our distributors and retail partners under these programs were to deviate significantly from our estimates, which are based on historical experience, our revenue could be adversely affected. Allowances for Receivables and Sales Returns The allowances for receivables were as follows (in millions, except percentages): April 27, July 28, 2013 2012 Allowance for doubtful accounts $ 225 $ 207 Percentage of gross accounts receivable 4.4 % 4.5 % Allowance for credit loss - lease receivables $ 245 $ 247 Percentage of gross lease receivables 6.5 % 7.2 % Allowance for credit loss - loan receivables $ 93 $ 122 Percentage of gross loan receivables 5.6 % 6.8 % The allowance for doubtful accounts is based on our assessment of the collectibility of customer accounts. We regularly review the adequacy of these allowances by considering internal factors such as historical experience, credit quality and age of the receivable balances, as well as external factors such as economic conditions that may affect a customer's ability to pay and expected default frequency rates, which are published by major third-party credit-rating agencies and are generally updated on a quarterly basis. We also consider the concentration of receivables outstanding with a particular customer in assessing the adequacy of our allowances for doubtful accounts. If a major customer's creditworthiness deteriorates, if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our operating results. The allowance for credit loss on financing receivables is also based on the assessment of collectibility of customer accounts. We regularly review the adequacy of the credit allowances determined either on an individual or a collective basis. When evaluating the financing receivables on an individual basis, we consider historical experience, credit quality and age of receivable balances, and economic conditions that may affect a customer's ability to pay. When evaluating the financing receivables on a collective basis, we use expected default frequency rates published by a major third-party credit-rating agency as well as our own historical loss rate in the event of default, while also systematically giving effect to economic conditions, concentration of risk and correlation. Determining expected default frequency rates and loss factors associated with internal credit risk ratings, as well as assessing factors such as economic conditions, concentration of risk, and correlation, are complex and subjective. Our ongoing consideration of all these factors could result in an increase in our allowance for credit loss in the future, which could adversely affect our operating results. Both accounts receivable and financing receivables are charged off at the point when they are considered uncollectible. A reserve for future sales returns is established based on historical trends in product return rates. The reserve for future sales returns as of April 27, 2013 and July 28, 2012 was $133 million and $129 million, respectively, and was recorded as a reduction of our accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenue could be adversely affected. Inventory Valuation and Liability for Purchase Commitments with Contract Manufacturers and Suppliers Our inventory balance was $1.5 billion and $1.7 billion as of April 27, 2013 and July 28, 2012, respectively. Inventory is written down based on excess and obsolete inventories determined primarily by future demand forecasts. Inventory write-downs are measured as the difference between the cost of the inventory and market, based upon assumptions about future demand, and are charged to the provision for inventory, which is a component of our cost of sales. At the point of the loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. We record a liability for firm, noncancelable, and unconditional purchase commitments with contract manufacturers and suppliers for quantities in excess of our future demand forecasts consistent with the valuation of our excess and obsolete inventory. As of April 27, 2013, the liability for these purchase commitments was $178 million, compared with $193 million as of July 28, 2012, and was included in other current liabilities. Our provision for inventory was $92 million and $91 million for the first nine months of fiscal 2013 and 2012, respectively. The provision for the liability related to purchase commitments with contract manufacturers and suppliers was $76 million and $103 million for the first nine months of fiscal 2013 and 2012, respectively. 47 -------------------------------------------------------------------------------- If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory write-downs, and our liability for purchase commitments with contract manufacturers and suppliers, and accordingly our profitability could be adversely affected. We regularly evaluate our exposure for inventory write-downs and the adequacy of our liability for purchase commitments. Inventory and supply chain management remain areas of focus as we balance the need to maintain supply chain flexibility to help ensure competitive lead times with the risk of inventory obsolescence, particularly in light of current macroeconomic uncertainties and conditions and the resulting potential for changes in future demand forecast. Warranty Costs The liability for product warranties, included in other current liabilities, was $431 million as of April 27, 2013, compared with $415 million as of July 28, 2012. See Note 12 to the Consolidated Financial Statements. Our products are generally covered by a warranty for periods ranging from 90 days to five years, and for some products we provide a limited lifetime warranty. We accrue for warranty costs as part of our cost of sales based on associated material costs, technical support labor costs, and associated overhead. Material cost is estimated based primarily upon historical trends in the volume of product returns within the warranty period and the cost to repair or replace the equipment. Technical support labor cost is estimated based primarily upon historical trends in the rate of customer cases and the cost to support the customer cases within the warranty period. Overhead cost is applied based on estimated time to support warranty activities. The provision for product warranties issued during the first nine months of fiscal 2013 and 2012 was $494 million and $474 million, respectively. The increase in the provision for warranties was primarily due to increased shipment volume of products. If we experience an increase in warranty claims compared with our historical experience, or if the cost of servicing warranty claims is greater than expected, our profitability could be adversely affected. Share-Based Compensation Expense Share-based compensation expense is presented as follows (in millions): Nine Months Ended April 27, April 28, 2013 2012 Variance Share-based compensation expense $ 880 $ 1,032 $ (152 ) Restricted stock units are valued using the market value of our common stock on the date of grant, discounted for the present value of expected dividends. Restricted stock unit awards with market-based conditions are valued using a Monte Carlo simulation. See Note 14 to the Consolidated Financial Statements. The determination of the fair value of employee stock options and employee stock purchase rights on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. For employee stock options and employee stock purchase rights, these variables include, but are not limited to, the expected stock price volatility over the term of the awards, the risk-free interest rate, and expected dividends as of the grant date. For employee stock options, we historically have used the implied volatility for two-year traded options on our stock as the expected volatility assumption required in the lattice-binomial model. For employee stock purchase rights, we used the implied volatility for traded options (with lives corresponding to the expected life of the employee stock purchase rights) on our stock. The selection of the implied volatility approach was based upon the availability of actively traded options on our stock and our assessment that implied volatility is more representative of future stock price trends than historical volatility. The valuation of employee stock options is also impacted by kurtosis and skewness, which are technical measures of the distribution of stock price returns and the actual and projected employee stock option exercise behaviors. Because share-based compensation expense is based on awards ultimately expected to vest, it has been reduced for forfeitures. If factors change and we employ different assumptions in the application of our option-pricing model in future periods or if we experience different forfeiture rates, the compensation expense that is derived may differ significantly from what we have recorded in the current period. Fair Value Measurements Our fixed income and publicly traded equity securities, collectively, are reflected in the Consolidated Balance Sheets at a fair value of $42.3 billion as of April 27, 2013, compared with $38.9 billion as of July 28, 2012. Our fixed income investment portfolio, as of April 27, 2013, consisted primarily of high-quality investment-grade securities. See Note 8 to the Consolidated Financial Statements. 48 -------------------------------------------------------------------------------- As described more fully in Note 9 to the Consolidated Financial Statements, a valuation hierarchy is based on the level of independent, objective evidence available regarding the value of the investments. It encompasses three classes of investments: Level 1 consists of securities for which there are quoted prices in active markets for identical securities; Level 2 consists of securities for which observable inputs other than Level 1 inputs are used, such as quoted prices for similar securities in active markets or quoted prices for identical securities in less active markets and model-derived valuations for which the variables are derived from, or corroborated by, observable market data; and Level 3 consists of securities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value. Our Level 2 securities are valued using quoted market prices for similar instruments or nonbinding market prices that are corroborated by observable market data. We use inputs such as actual trade data, benchmark yields, broker/dealer quotes, and other similar data, which are obtained from independent pricing vendors, quoted market prices, or other sources to determine the ultimate fair value of our assets and liabilities. We use such pricing data as the primary input, to which we have not made any material adjustments during fiscal 2013 and fiscal 2012, to make our assessments and determinations as to the ultimate valuation of our investment portfolio. We are ultimately responsible for the financial statements and underlying estimates. The inputs and fair value are reviewed for reasonableness, may be further validated by comparison to publicly available information, and could be adjusted based on market indices or other information that management deems material to its estimate of fair value. The assessment of fair value can be difficult and subjective. However, given the relative reliability of the inputs we use to value our investment portfolio, and because substantially all of our valuation inputs are obtained using quoted market prices for similar or identical assets, we do not believe that the nature of estimates and assumptions affected by levels of subjectivity and judgment was material to the valuation of the investment portfolio as of April 27, 2013. We had no Level 3 investments in our total portfolio as of April 27, 2013. Other-than-Temporary Impairments We recognize an impairment charge when the declines in the fair values of our fixed income or publicly traded equity securities below their cost basis are judged to be other than temporary. The ultimate value realized on these securities, to the extent unhedged, is subject to market price volatility until they are sold. If the fair value of a debt security is less than its amortized cost, we assess whether the impairment is other than temporary. An impairment is considered other than temporary if (i) we have the intent to sell the security, (ii) it is more likely than not that we will be required to sell the security before recovery of its entire amortized cost basis, or (iii) we do not expect to recover the entire amortized cost of the security. If an impairment is considered other than temporary based on (i) or (ii) described in the prior sentence, the entire difference between the amortized cost and the fair value of the security is recognized in earnings. If an impairment is considered other than temporary based on condition (iii), the amount representing credit loss, defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis of the debt security, will be recognized in earnings, and the amount relating to all other factors will be recognized in other comprehensive income ("OCI"). In estimating the amount and timing of cash flows expected to be collected, we consider all available information, including past events, current conditions, the remaining payment terms of the security, the financial condition of the issuer, expected defaults, and the value of underlying collateral. For publicly traded equity securities, we consider various factors in determining whether we should recognize an impairment charge, including the length of time and extent to which the fair value has been less than our cost basis, the financial condition and near-term prospects of the issuer, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. There were no impairment charges on our investments in publicly traded equity securities and fixed income securities in the first nine months of fiscal 2013 and fiscal 2012. Our ongoing consideration of all the factors described previously could result in additional impairment charges in the future, which could adversely affect our net income. We also have investments in privately held companies, some of which are in the startup or development stages. As of April 27, 2013, our investments in privately held companies were $835 million, compared with $858 million as of July 28, 2012, and were included in other assets. See Note 6 to the Consolidated Financial Statements. We monitor these investments for events or circumstances indicative of potential impairment, and we will make appropriate reductions in carrying values if we determine that an impairment charge is required, based primarily on the financial condition and near-term prospects of these companies. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. Our impairment charges on investments in privately held companies were $23 million and $17 million for the first nine months of fiscal 2013 and 2012, respectively. 49 -------------------------------------------------------------------------------- Goodwill and Purchased Intangible Asset Impairments Our methodology for allocating the purchase price relating to purchase acquisitions is determined through established valuation techniques. Goodwill represents a residual value as of the acquisition date, which in most cases results in measuring goodwill as an excess of the purchase consideration transferred plus the fair value of any noncontrolling interest in the acquired company over the fair value of net assets acquired, including contingent consideration. We perform goodwill impairment tests on an annual basis in the fourth fiscal quarter and between annual tests in certain circumstances for each reporting unit. The assessment of fair value for goodwill and purchased intangible assets is based on factors that market participants would use in an orderly transaction in accordance with the new accounting guidance for the fair value measurement of nonfinancial assets. The goodwill recorded in the Consolidated Balance Sheets as of April 27, 2013 and July 28, 2012 was $21.6 billion and $17.0 billion, respectively. The increase in goodwill for the first nine months of fiscal 2013 was due in large part to our acquisitions of NDS and Meraki. In response to changes in industry and market conditions, we could be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. There was no impairment of goodwill in the first nine months of fiscal 2013 and 2012. We make judgments about the recoverability of purchased intangible assets with finite lives whenever events or changes in circumstances indicate that an impairment may exist. Recoverability of purchased intangible assets with finite lives is measured by comparing the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. We review indefinite-lived intangible assets for impairment annually or whenever events or changes in circumstances indicate the carrying value may not be recoverable. Recoverability of indefinite-lived intangible assets is measured by comparing the carrying amount of the asset to the future discounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. Assumptions and estimates about future values and remaining useful lives of our purchased intangible assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends and internal factors such as changes in our business strategy and our internal forecasts. There were no impairment charges related to purchased intangible assets for the first nine months of fiscal 2013 and 2012. Our ongoing consideration of all the factors described previously could result in additional impairment charges in the future, which could adversely affect our net income. Income Taxes We are subject to income taxes in the United States and numerous foreign jurisdictions. Our effective tax rates differ from the statutory rate, primarily due to the tax impact of state taxes, foreign operations, research and development ("R&D") tax credits, tax audit settlements, nondeductible compensation, international realignments, and transfer pricing adjustments. Our effective tax rate was 15.9% and 22.1% in the third quarter of fiscal 2013 and 2012, respectively. Our effective tax rate was 7.7% and 21.2% for the first nine months of fiscal 2013 and 2012, respectively. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe our reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in our historical income tax provisions and accruals. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence, including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made. Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in countries that have lower tax rates and higher than anticipated in countries that have higher tax rates; by changes in the valuation of our deferred tax assets and liabilities; by expiration of or lapses in the R&D tax credit laws; by expiration of or lapses in tax incentives; by transfer pricing adjustments, including the effect of acquisitions on our intercompany R&D cost-sharing arrangement and legal structure; by tax effects of nondeductible compensation; by tax costs related to intercompany realignments; by changes in accounting principles; or by changes in tax laws and regulations, including possible U.S. changes to the taxation of earnings of our foreign subsidiaries, the deductibility of expenses attributable to foreign income, or the foreign tax credit rules. Significant judgment is required to determine the recognition and measurement attributes prescribed in the accounting guidance for uncertainty in income taxes. The accounting guidance for uncertainty in income taxes applies to all income tax positions, including the potential recovery of previously paid taxes, which if settled unfavorably could adversely impact our provision for income taxes or additional paid-in capital. 50 -------------------------------------------------------------------------------- Further, as a result of certain of our ongoing employment and capital investment actions and commitments, our income in certain countries is subject to reduced tax rates and in some cases is wholly exempt from tax. Our failure to meet these commitments could adversely impact our provision for income taxes. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse impact on our operating results and financial condition. Loss Contingencies We are subject to the possibility of various losses arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. Third parties, including customers, have in the past and may in the future assert claims or initiate litigation related to exclusive patent, copyright, trademark, and other intellectual property rights to technologies and related standards that are relevant to us. These assertions have increased over time as a result of our growth and the general increase in the pace of patent claims assertions, particularly in the United States. If any infringement or other intellectual property claim made against us by any third party is successful, or if we fail to develop non-infringing technology or license the proprietary rights on commercially reasonable terms and conditions, our business, operating results, and financial condition could be materially and adversely affected. RESULTS OF OPERATIONS Net Sales The following table presents the breakdown of net sales between product and service revenue (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars Percent Net sales: Product $ 9,559 $ 9,106 $ 453 5.0% $ 28,293 $ 27,176 $ 1,117 4.1 % Percentage of net sales 78.2 % 78.6 % 78.2 % 79.1 % Service 2,657 2,482 175 7.1 % 7,897 7,195 702 9.8 % Percentage of net sales 21.8 % 21.4 % 21.8 % 20.9 % Total $ 12,216 $ 11,588 $ 628 5.4 % $ 36,190 $ 34,371 $ 1,819 5.3 % We manage our business primarily on a geographic basis, organized into three geographic segments. Our net sales, which include product and service revenue for each segment, are summarized in the following table (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars Percent Net sales: Americas $ 7,127 $ 6,466 $ 661 10.2 % $ 21,286 $ 19,606 $ 1,680 8.6 % Percentage of net sales 58.4 % 55.8 % 58.9 % 57.0 % EMEA 3,131 3,160 (29 ) (0.9 )% 9,065 9,255 (190 ) (2.1 )% Percentage of net sales 25.6 % 27.3 % 25.0 % 27.0 % APJC 1,958 1,962 (4 ) (0.2 )% 5,839 5,510 329 6.0 % Percentage of net sales 16.0 % 16.9 % 16.1 % 16.0 % Total $ 12,216 $ 11,588 $ 628 5.4 % $ 36,190 $ 34,371 $ 1,819 5.3 % 51-------------------------------------------------------------------------------- Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 For the third quarter of fiscal 2013, as compared with the third quarter of fiscal 2012, net sales increased by 5%. Net product sales increased by 5%, while service revenue increased by 7%. Net product sales reflected growth in our Americas and APJC geographic segments, while net product sales declined in the EMEA segment. Service revenues increased in our Americas and EMEA geographic segments, while service revenue decreased in our APJC segment. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 For the first nine months of fiscal 2013, as compared with the first nine months of fiscal 2012, net sales increased by 5%. Net product sales increased by 4%, while service revenue increased by 10%. The increase in net product sales reflected growth in our Americas and APJC geographic segments, while net product sales declined in the EMEA segment. Service revenues increased across all of our geographic segments. We conduct business globally in numerous currencies. The direct effect of foreign currency fluctuations on sales has not been material because our sales are primarily denominated in U.S. dollars. However, if the U.S. dollar strengthens relative to other currencies, such strengthening could have an indirect effect on our sales to the extent it raises the cost of our products to non-U.S. customers and thereby reduces demand. A weaker U.S. dollar could have the opposite effect. However, the precise indirect effect of currency fluctuations is difficult to measure or predict because our sales are influenced by many factors in addition to the impact of such currency fluctuations. In addition to the impact of macroeconomic factors, including a cautious IT spending environment and budget-driven reductions in spending by government entities, net sales by segment in a particular period may be significantly impacted by several factors related to revenue recognition, including the complexity of transactions such as multiple-element arrangements; the mix of financing arrangements provided to our channel partners and customers; and final acceptance of the product, system, or solution, among other factors. In addition, certain customers tend to make large and sporadic purchases, and the net sales related to these transactions may also be affected by the timing of revenue recognition, which in turn would impact the net sales of the relevant segment. As has been the case in certain of our emerging countries from time to time, customers require greater levels of financing arrangements, service, and support, and this may occur in future periods, which may also impact the timing of the recognition of revenue. Net Product Sales by Segment The following table presents the breakdown of net product sales by segment (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars Percent Net product sales: Americas $ 5,364 $ 4,889 $ 475 9.7 % $ 16,067 $ 14,919 $ 1,148 7.7 % Percentage of net product sales 56.1 % 53.7 % 56.8 % 54.9 % EMEA 2,590 2,639 (49 ) (1.9 )% 7,469 7,758 (289 ) (3.7 )% Percentage of net product sales 27.1 % 29.0 % 26.4 % 28.5 % APJC 1,605 1,578 27 1.7 % 4,757 4,499 258 5.7 % Percentage of net product sales 16.8 % 17.3 % 16.8 % 16.6 % Total $ 9,559 $ 9,106 $ 453 5.0 % $ 28,293 $ 27,176 $ 1,117 4.1 % Americas Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Our Americas segment grew by 10% led by net product sales increases in the service provider, commercial, and enterprise markets. The growth in net product sales to the service provider market was due in part to our acquisition of NDS at the beginning of fiscal 2013. We continued to experience a decline in net product sales in the public sector market for the third quarter of fiscal 2013. From a country perspective, net product sales increased by 12% in the United States and 20% in Brazil. Net product sales in Canada and Mexico declined by 10% and 5%, respectively, compared with the corresponding period of fiscal 2012. 52 -------------------------------------------------------------------------------- Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The increase in net product sales in the Americas segment was led by growth in the service provider, commercial and enterprise markets. The growth in net product sales to the service provider market was due in part to our acquisition of NDS at the beginning of fiscal 2013. We experienced a decline in net product sales to the public sector market for the first nine months of fiscal 2013 due in large part to lower net product sales to the U.S. public sector. From a country perspective, net product sales increased by 10% in both the United States and Brazil, and 4% in Mexico. These increases were partially offset by a net product sales decline of 10% in Canada. EMEA Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Net product sales in the EMEA segment decreased slightly as the decline in the enterprise market was partially offset by net product sales increases in the commercial and service provider markets, which included sales of NDS products. Net product sales were flat in the public sector market. From a country perspective, net product sales decreased by 12% in the Netherlands, 9% in Russia, 6% in Germany, and 3% in France. Partially offsetting these declines were net product sales increases of 21% in Italy and 4% in the United Kingdom. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The decrease in EMEA net product sales was attributable to declines in the enterprise, public sector and service provider markets. Sales to the commercial market were relatively flat. From a country perspective, net product sales decreased by 17% in the Netherlands, 3% in the United Kingdom, 7% in Germany, 6% France, and 12% in Italy. Partially offsetting these product sales declines was an 8% increase in net product sales in Russia. APJC Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 The increase in net product sales in the APJC segment was led by net product sales growth in the commercial market and, to a lesser degree, in the service provider and public sector markets. The growth in the service provider market was due in large part to our acquisition of NDS. These product sales increases were partially offset by a decrease in net product sales in the enterprise market. From a country perspective, net product sales increased by 27% in India and 1% in Australia, partially offset by net product sales declines of 14% in Japan and 5% in China. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The increase in net product sales was across most of our customer markets in the APJC segment, with growth in the public sector, service provider and commercial markets. The growth in the service provider market was due in large part to our acquisition of NDS. We experienced a net product sales decline in the enterprise market in the APJC segment. From a country perspective, net product sales increased by 35% in India and 12% in Australia, partially offset by net product sales declines of 7% in Japan and 1% in China. 53 -------------------------------------------------------------------------------- Net Product Sales by Groups of Similar Products In addition to the primary view on a geographic basis, we also prepare financial information related to groups of similar products and customer markets for various purposes. Our product categories consist of the following categories (with subcategories in parentheses): Switching (fixed switching, modular switching, and storage); NGN Routing (high-end routers, mid-range and low-end routers, and other NGN Routing products); Service Provider Video (connected devices, video software and solutions, cable access and NDS); Collaboration (unified communications and Cisco TelePresence); Data Center; Wireless; Security; and Other Products. The Other Products category consists primarily of emerging technology products and other networking products. The following table presents net sales for groups of similar products (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars Percent Net product sales: Switching $ 3,598 $ 3,661 $ (63 ) (1.7 )% $ 10,938 $ 10,969 $ (31 ) (0.3 )% Percentage of net product sales 37.6 % 40.2 % 38.7 % 40.4 % NGN Routing 2,140 2,134 6 0.3 % 6,138 6,296 (158 ) (2.5 )% Percentage of net product sales 22.4 % 23.4 % 21.7 % 23.2 % Service Provider Video 1,299 999 300 30.0 % 3,667 2,896 771 26.6 % Percentage of net product sales 13.6 % 11.0 % 13.0 % 10.7 % Collaboration 1,013 1,022 (9 ) (0.9 )% 2,978 3,190 (212 ) (6.6 )% Percentage of net product sales 10.6 % 11.2 % 10.5 % 11.7 % Data Center 515 291 224 77.0 % 1,480 883 597 67.6 % Percentage of net product sales 5.4 % 3.2 % 5.2 % 3.2 % Wireless 523 413 110 26.6 % 1,529 1,175 354 30.1 % Percentage of net product sales 5.5 % 4.5 % 5.4 % 4.3 % Security 327 342 (15 ) (4.4 )% 1,001 994 7 0.7 % Percentage of net product sales 3.4 % 3.8 % 3.5 % 3.7 % Other 144 244 (100 ) (41.0 )% 562 773 (211 ) (27.3 )% Percentage of net product sales 1.5 % 2.7 % 2.0 % 2.8 % Total $ 9,559 $ 9,106 $ 453 5.0 % $ 28,293 $ 27,176 $ 1,117 4.1 % Certain reclassifications have been made to the prior period amounts to conform to the current period's presentation. Switching Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Net product sales in our Switching product category decreased slightly primarily due to the impact of macroeconomic and public sector spending challenges. Sales of modular switches declined by 9%, or $134 million, driven by lower sales of Cisco Catalyst 6500 Series Switches, partially offset by higher sales of Cisco Nexus 7000 Series Switches. The decrease in sales of modular switches was partially offset by a 4%, or $82 million, increase in sales of LAN fixed-configuration switches resulting from higher sales of our various Cisco Nexus Series Switches in this category. Net product sales in the Switching product category were also negatively impacted by an 8% decrease in sales of storage products. 54 -------------------------------------------------------------------------------- Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Within the Switching product category, sales of LAN fixed-configuration switches increased by 3%, or $163 million, sales of modular switches decreased by 3% or $119 million, and sales of storage products decreased by 18%, or $75 million. The increase in sales of LAN fixed-configuration switches was primarily due to higher sales of Cisco Nexus Series Switches and fixed switching optics modules, partially offset by sales declines in certain of our Cisco Catalyst product families. Sales of modular switches decreased due to lower sales of Cisco Catalyst 6500 Series Switches partially offset by higher sales in Cisco Nexus 7000 Series Switches and optics modules. NGN Routing Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Overall, sales in our NGN Routing product category were flat, with increases in sales in our midrange and low-end router products being offset by decreases in sales of our high-end router products and other NGN Routing products. Higher sales in our midrange and low-end router products were driven by the continued adoption of our Integrated Service Routers ("ISR") platform. Sales in high-end router products decreased by 2%, or $21 million, due to lower sales of Cisco CRS-3 Carrier Routing System products and our legacy high-end router products, partially offset by strong adoption of our Cisco Aggregation Service Routers ("ASR") products. The decline in sales of other NGN Routing products was due to decreased sales of other routing products. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The decrease in sales of our NGN Routing product category was driven by a 3%, or $111 million, decrease in sales of high-end router products and a 12%, or $64 million, decrease in sales of other NGN Routing products. Within the high-end router products category, we experienced lower sales of our Cisco CRS-3 Carrier Routing System products and our legacy high-end router products. These decreases were partially offset by sales growth in several Cisco ASR products. The decline in sales of other NGN Routing products was due to decreased sales of other routing and optical networking products. Service Provider Video Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Our Service Provider Video product category grew 30%, or $300 million, primarily due to the acquisition of NDS at the beginning of fiscal 2013, which contributed a substantial majority of the total sales increase. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The increase in sales of Service Provider Video products was in large part due to the acquisition of NDS at the beginning of fiscal 2013, followed by increased sales in connected devices of 11%, or $219 million, and to a lesser degree increased sales in video software and solutions of 11%, or $21 million. The increase in sales of connected devices products was primarily due to increased sales of cable set-top boxes. Collaboration Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Our Collaboration category continues to shift its focus to recurring revenue streams driven by SaaS offerings. Overall, sales of Collaboration products slightly decreased primarily due to lower sales of Cisco TelePresence products. Partially offsetting this decrease was a slight increase in sales of unified communications products due mainly to higher sales of collaborative web-based offerings. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The sales decrease in our Collaboration product category was primarily due to a decline in sales of Cisco TelePresence Systems and to a lesser degree, a decline in sales of unified communications products. Lower public sector spending in the United States, as well as demand weakness in Europe during the first half of the fiscal year, were significant drivers of the decline in sales of Cisco TelePresence Systems. We also experienced a decline in sales of unified communications products which was due primarily to lower sales of unified communications infrastructure products. Data Center Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 We continue to experience strong growth in our Data Center product category which grew 77% with strong sales growth of our Cisco Unified Computing System products across all geographic segments and customer markets. The increase was due in large part to the momentum we are experiencing with our products across all customer market segments for both data center and cloud environments as current customers increase their data center build-outs, and as new customers purchase products. The growth in our Data Center category was also positively impacted by lower than anticipated sales in the third quarter of fiscal 2012 as certain customers at that time were still evaluating our new server chip technology platform. 55 -------------------------------------------------------------------------------- To the extent our Data Center business grows and achieves further market penetration, we expect that, in comparison to what we have experienced during the initial rapid growth of this portion of our business, the growth rates for our Data Center product sales will experience more normal seasonality consistent with the overall server market. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Sales of Data Center products increased significantly due to increased sales of Cisco Unified Computing System products. The increase was due in large part to similar factors as those affecting the three month period discussed immediately above. Wireless, Security, and Other Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Sales of Wireless products increased 27%, or $110 million, primarily reflecting the continued customer adoption of and migration to the Cisco Unified Access Network architecture, and also reflecting increased sales of new products in this category as well as sales from our acquisition of Meraki. Sales of our Security products were down 4%, or $15 million, led by a decline in sales of our content security products, partially offset by higher sales in high-end firewall products within our network security product portfolio. We experienced a decrease in sales of Other Products due in large part to the sale of our Linksys product line in the third quarter of fiscal 2013. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Sales of Wireless products increased 30%, or $354 million, due to similar factors as those affecting the three month period discussed above. Sales of security products increased slightly and were driven in part by the relatively recent update of our firewall security product portfolio. We experienced a decrease in sales of Other Products due in large part to lower sales of our former Linksys products. 56 -------------------------------------------------------------------------------- Net Service Sales by Segment The following table presents the breakdown of service revenue by segment (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars PercentNet service sales: Americas $ 1,763 $ 1,577 $ 186 11.8 % $ 5,219 $ 4,687 $ 532 11.4 % Percentage of net service sales 66.3 % 63.5 % 66.1 % 65.1 % EMEA 541 521 20 3.8 % 1,596 1,497 99 6.6 % Percentage of net service sales 20.4 % 21.0 % 20.2 % 20.8 % APJC 353 384 (31 ) (8.1 )% 1,082 1,011 71 7.0 % Percentage of net service sales 13.3 % 15.5 % 13.7 % 14.1 % Total $ 2,657 $ 2,482 $ 175 7.1 % $ 7,897 $ 7,195 $ 702 9.8 % Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Service revenue increased by 7%, with worldwide technical support services revenue increasing by 5%, and worldwide advanced services, which relate to consulting support services for specific customer network needs, experiencing 14% revenue growth. Technical support service experienced growth in the Americas and EMEA segments. Renewals and technical support service contract initiations associated with product sales provided an installed base of equipment being serviced which, in concert with new service offerings, were the primary factors driving these sales increases. Advanced services revenue also grew in the Americas and EMEA segments driven by solid growth in both transaction and subscription revenues. The decrease in service revenue in the APJC segment was due mainly to the completion of several large, multiyear projects in this segment during the third quarter of fiscal 2012. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Service revenue experienced solid growth across all of our geographic segments for the period. Worldwide technical support services revenue increased by 7%, and worldwide advanced services experienced 19% revenue growth. Technical support services revenue grew across all of our geographic segments. We experienced revenue growth in advanced services across all geographic segments, led by growth in the Americas segment. Advanced services revenue growth was driven by strong growth in both transaction and subscription revenues. Gross Margin The following table presents the gross margin for products and services (in millions, except percentages): Three Months Ended Nine Months Ended Amount Percentage Amount Percentage April 27, April 28, April 27, April 28, April 27, April 28, April 27, April 28, 2013 2012 2013 2012 2013 2012 2013 2012 Gross margin: Product $ 5,777 $ 5,543 60.4 % 60.9 % $ 16,906 $ 16,400 59.8 % 60.3 % Service 1,734 1,626 65.3 % 65.5 % 5,187 4,724 65.7 % 65.7 % Total $ 7,511 $ 7,169 61.5 % 61.9 % $ 22,093 $ 21,124 61.0 % 61.5 % 57-------------------------------------------------------------------------------- Product Gross Margin The following table summarizes the key factors that contributed to the change in product gross margin percentage for the third quarter and first nine months of fiscal 2013 as compared with the corresponding prior year periods: Product Gross Margin Percentage Three Months Ended Nine Months Ended (1) Fiscal 2012 60.9 % 60.3 % Sales discounts, rebates, and product pricing (2.8 )% (2.9 )% Mix of products sold (1.7 )% (1.0 )% Amortization of purchased intangible assets (0.4 )% (0.5 )% Acquisition fair value adjustment to inventory and other - % (0.2 )% Productivity (2) 4.4 % 4.1 % Fiscal 2013 60.4 % 59.8 % (1) Beginning in the second quarter of fiscal 2013, we refined our methodology for presenting the items in the preceding table and accordingly certain reclassifications have been made to the nine months ended amounts to conform to the presentation made for the three months-ended amounts. (2) Productivity includes overall manufacturing-related costs, shipment volume, and other items not categorized elsewhere. Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Product gross margin decreased by 0.5 percentage points for the period. The decrease was primarily due to the impact of higher sales discounts, rebates, and unfavorable product pricing, which were driven by normal market factors and by the geographic mix of net product sales. These factors impacted most of our customer markets and each of our three geographic segments. Additionally, our product gross margin for the third quarter of fiscal 2013 was negatively impacted by the shift in the mix of products sold, primarily as a result of sales increases of our relatively lower margin Cisco Unified Computing System and Service Provider Video products. Further, our recent acquisitions, in particular NDS, resulted in higher amortization expense from purchased intangible assets. These factors were partially offset by productivity improvements. The productivity improvements were in large part due to increased benefits from cost savings particularly in certain of our Switching and NGN Routing categories in which product transitions have been taking place; driven by value engineering efforts, favorable component pricing; and continued operational efficiency in manufacturing operations. Value engineering is the process by which production costs are reduced through component redesign, board configuration, test processes, and transformation processes. Our future gross margins could be impacted by our product mix and could be adversely affected by further growth in sales of products that have lower gross margins, such as Cisco Unified Computing System and Service Provider Video products. Our gross margins may also be impacted by the geographic mix of our revenue and, as was the case in fiscal 2012 and 2011, may be adversely affected by increased sales discounts, rebates, and product pricing attributable to competitive factors. Additionally, our manufacturing-related costs may be negatively impacted by constraints in our supply chain, which in turn could negatively affect gross margin. If any of the preceding factors that in the past have negatively impacted our gross margins arise in future periods, our gross margins could continue to decline. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Product gross margin decreased by 0.5 percentage points for the period. The decrease was primarily due to the impact of higher sales discounts, rebates, and unfavorable product pricing, which were driven by normal market factors and by the geographic mix of net product sales. These factors impacted most of our customer markets and all of our geographic segments. Additionally, our product gross margin for the first nine months of fiscal 2013 was negatively impacted by the shift in the mix of products sold, primarily as a result of sales increases in our relatively lower margin Cisco Unified Computing System and Service Provider Video products. Further, as discussed above, our acquisition of NDS resulted both in higher amortization expense from purchased intangible assets and costs resulting from a fair value adjustment to inventory acquired as part of the business combination, each of which negatively impacted our product gross margin for the first nine months of fiscal 2013. These factors were partially offset by productivity improvements driven by similar factors as discussed in the three month period immediately above. 58 -------------------------------------------------------------------------------- Service Gross Margin Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 Our service gross margin percentage decreased by 0.2 percentage points for the third quarter of fiscal 2013 period. This decrease was primarily due to increased cost impacts such as headcount-related costs, particularly in advanced services and unfavorable mix. The mix impacts were due to our lower gross margin advanced services business contributing a higher proportion of service revenue for the third quarter of fiscal 2013, as compared with the prior year period. Our service gross margin was also negatively impacted by the completion of several large, multiyear projects during the third quarter of fiscal 2012. Our service gross margin normally experiences some fluctuations due to various factors such as the timing of contract initiations and renewals, our strategic investments in headcount, and the resources we deploy to support the overall service business. Other factors include the mix of service offerings, as the gross margin from our advanced services is typically lower than the gross margin from technical support services. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 Our service gross margin percentage was unchanged compared with the corresponding period in fiscal 2012. Although we experienced higher sales volume led by growth in advanced services and in technical support services, the resulting benefit to gross margin was offset by increased cost impacts such as headcount-related costs, particularly in advanced services; partner delivery costs; and unfavorable mix. The mix impacts were due to our lower gross margin advanced services business contributing a higher proportion of service revenue for the first nine months of fiscal 2013, as compared with the prior year period. Gross Margin by Segment The following table presents the total gross margin for each segment (in millions, except percentages): Three Months Ended Nine Months Ended Amount Percentage Amount Percentage April 27, April 28, April 27, April 28, April 27, April 28, April 27, April 28, 2013 2012 2013 2012 2013 2012 2013 2012 Gross margin: Americas $ 4,460 $ 4,053 62.6 % 62.7 % $ 13,341 $ 12,319 62.7 % 62.8 % EMEA 2,044 2,019 65.3 % 63.9 % 5,850 5,868 64.5 % 63.4 % APJC 1,197 1,242 61.1 % 63.3 % 3,494 3,342 59.8 % 60.7 % Segment total 7,701 7,314 63.0 % 63.1 % 22,685 21,529 62.7 % 62.6 % Unallocated corporate items (1) (190 ) (145 ) (592 ) (405 ) Total $ 7,511 $ 7,169 61.5 % 61.9 % $ 22,093 $ 21,124 61.0 % 61.5 % (1) The unallocated corporate items include the effects of amortization of acquisition-related intangible assets, share-based compensation expense, impact to cost of sales from purchase accounting adjustments to inventory, and restructuring and other charges. We do not allocate these items to the gross margin for each segment because management does not include such information in measuring the performance of the operating segments. Three Months Ended April 27, 2013 Compared with Three Months Ended April 28, 2012 We experienced a gross margin percentage decrease in our Americas and APJC segments, while our EMEA segment experienced a gross margin percentage increase. The Americas segment experienced a slight decrease in its gross margin percentage due to the impacts from higher sales discounts, rebates and unfavorable pricing; and also due to unfavorable mix impacts. The unfavorable mix impacts were due in large part to higher revenue from our lower margin Data Center products. Partially offsetting these factors were productivity improvements, driven in large part by lower overall manufacturing costs and higher volume. Our EMEA segment gross margin percentage increased as a result of productivity improvements and a more favorable mix of products sold during the current period, driven in large part by a favorable mix within the Service Provider Video category. Partially offsetting these factors were the impacts from higher sales discounts, rebates and unfavorable pricing. The gross margin percentage decreased in our APJC segment due to the impact of higher sales discounts, rebates, unfavorable pricing, and unfavorable mix impacts and also due to the decline in our service gross margin. The decline in service gross margin in our APJC segment for the current period was largely due to the completion of several large, multiyear projects during the third quarter of fiscal 2012. 59 -------------------------------------------------------------------------------- The gross margin percentage for a particular segment may fluctuate, and period-to-period changes in such percentages may or may not be indicative of a trend for that segment. Our product and service gross margins may be impacted by economic downturns or uncertain economic conditions as well as our movement into new market opportunities and gross margins could decline if any of the factors that impact our gross margins are adversely affected in future periods. Nine Months Ended April 27, 2013 Compared with Nine Months Ended April 28, 2012 The Americas segment experienced a slight gross margin percentage decrease due to higher sales discounts, rebates and unfavorable pricing, and also due to an unfavorable mix impact, all partially offset by productivity improvements. The gross margin percentage increase in our EMEA segment was primarily the result of productivity improvements from lower overall manufacturing costs, a favorable mix of products sold, and higher service gross margin. Partially offsetting these favorable impacts to gross margin were negative impacts from higher sales discounts, rebates and unfavorable pricing. The APJC segment gross margin percentage decreased as compared with the corresponding period of fiscal 2012, due to the impact of higher sales discounts, rebates and unfavorable pricing, and also due to unfavorable mix impacts. Partially offsetting these factors were productivity improvements, driven in large part by lower overall manufacturing costs and higher volume. Factors That May Impact Net Sales and Gross Margin Net product sales may continue to be affected by factors, including global economic downturns and related market uncertainty, that have resulted in cautious IT-related capital spending in our enterprise, service provider, public sector, and commercial markets; changes in the geopolitical environment and global economic conditions; competition, including price-focused competitors from Asia, especially from China; new product introductions; sales cycles and product implementation cycles; changes in the mix of our customers between service provider and enterprise markets; changes in the mix of direct sales and indirect sales; variations in sales channels; and final acceptance criteria of the product, system, or solution as specified by the customer. Sales to the service provider market have been and may be in the future characterized by large and sporadic purchases, especially relating to our router sales and sales of certain products within our collaboration and data center product categories. In addition, service provider customers typically have longer implementation cycles; require a broader range of services, including network design services; and often have acceptance provisions that can lead to a delay in revenue recognition. Certain of our customers in certain emerging countries also tend to make large and sporadic purchases, and the net sales related to these transactions may similarly be affected by the timing of revenue recognition. As we focus on new market opportunities, customers may require greater levels of financing arrangements, service, and support, especially in certain emerging countries, which in turn may result in a delay in the timing of revenue recognition. To improve customer satisfaction, we continue to focus on managing our manufacturing lead-time performance, which may result in corresponding reductions in order backlog. A decline in backlog levels could result in more variability and less predictability in our quarter-to-quarter net sales and operating results. Net product sales may also be adversely affected by fluctuations in demand for our products, especially with respect to telecommunications service providers and Internet businesses, whether or not driven by any slowdown in capital expenditures in the service provider market; price and product competition in the communications and information technology industry; introduction and market acceptance of new technologies and products; adoption of new networking standards; and financial difficulties experienced by our customers. We may, from time to time, experience manufacturing issues that create a delay in our suppliers' ability to provide specific components, resulting in delayed shipments. To the extent that manufacturing issues and any related component shortages result in delayed shipments in the future, and particularly in periods when we and our suppliers are operating at higher levels of capacity, it is possible that revenue for a quarter could be adversely affected if such matters are not remediated within the same quarter. For additional factors that may impact net product sales, see "Part II, Item 1A. Risk Factors." Our distributors and retail partners participate in various cooperative marketing and other programs. Increased sales to our distributors and retail partners generally result in greater difficulty in forecasting the mix of our products and, to a certain degree, the timing of orders from our customers. We recognize revenue for sales to our distributors and retail partners generally based on a sell-through method using information provided by them, and we maintain estimated accruals and allowances for all cooperative marketing and other programs. 60 -------------------------------------------------------------------------------- Product gross margin may be adversely affected in the future by changes in the mix of products sold, including periods of increased growth of some of our lower margin products; introduction of new products, including products with price-performance advantages; our ability to reduce production costs; entry into new markets, including markets with different pricing structures and cost structures, as a result of internal development or through acquisitions; changes in distribution channels; price competition, including competitors from Asia, especially those from China; changes in geographic mix of our product sales; the timing of revenue recognition and revenue deferrals; sales discounts; increases in material or labor costs, including share-based compensation expense; excess inventory and obsolescence charges; warranty costs; changes in shipment volume; loss of cost savings due to changes in component pricing; effects of value engineering; inventory holding charges; and the extent to which we successfully execute on our strategy and operating plans. Additionally, our manufacturing-related costs may be negatively impacted by constraints in our supply chain. Service gross margin may be impacted by various factors such as the change in mix between technical support services and advanced services; the timing of technical support service contract initiations and renewals; share-based compensation expense; and the timing of our strategic investments in headcount and resources to support this business. Research and Development ("R&D"), Sales and Marketing, and General and Administrative ("G&A") Expenses R&D, sales and marketing, and G&A expenses are summarized in the following table (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, Variance in Variance in April 27, April 28, Variance in Variance in 2013 2012 Dollars Percent 2013 2012 Dollars PercentResearch and development $ 1,542 $ 1,358 $ 184 13.5 % $ 4,425 $ 4,072 $ 353 8.7 % Percentage of net sales 12.6 % 11.7 % 12.2 % 11.8 % Sales and marketing 2,375 2,383 (8 ) (0.3 )% 7,178 7,230 (52 ) (0.7 )% Percentage of net sales 19.4 % 20.6 % 19.8 % 21.0 % General and administrative 530 562 (32 ) (5.7 )% 1,674 1,611 63 3.9 % Percentage of net sales 4.3 % 4.8 % 4.6 % 4.7 % Total $ 4,447 $ 4,303 $ 144 3.3 % $ 13,277 $ 12,913 $ 364 2.8 % Percentage of net sales 36.4 % 37.1 % 36.7 % 37.6 % R&D Expenses The increase in R&D expenses for the third quarter and first nine months of fiscal 2013, as compared with the corresponding periods in fiscal 2012, was primarily due to higher headcount-related expenses attributable in large part to our acquisition of NDS at the beginning of fiscal 2013. Partially offsetting these costs was lower share-based compensation expense. We continue to invest in R&D in order to bring a broad range of products to 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 purchase or license technology from other businesses, or we may partner with or acquire businesses as an alternative to internal R&D. Sales and Marketing Expenses The decrease in sales and marketing expenses for the third quarter and first nine months of fiscal 2013, as compared with the corresponding periods in fiscal 2012, was primarily due to lower discretionary spending and lower share-based compensation expense. These items were partially offset by higher headcount-related expense resulting largely from our acquisition of NDS at the beginning of fiscal 2013. G&A Expenses G&A expenses decreased for the third quarter of fiscal 2013, as compared with the third quarter of fiscal 2012, primarily due to lower corporate-level expenses, driven by a recovery in the market value of property held for sale. Lower share-based compensation also contributed to the decline in G&A expenses. These items were partially offset by higher headcount-related expense resulting largely from our acquisition of NDS at the beginning of fiscal 2013. G&A expenses increased in the first nine months of fiscal 2013, as compared with the corresponding period in fiscal 2012, primarily due to increased headcount-related expenses attributable in part to the acquisition of NDS at the beginning of fiscal 2013, and also due to higher corporate-level expenses. Corporate-level expenses, which tended to vary from period to period, included operational infrastructure activities such as real estate actions; IT project implementations, which included investments in our global data center infrastructure; and investments related to operational and financial systems. 61 -------------------------------------------------------------------------------- Effect of Foreign Currency In the third quarter of fiscal 2013, foreign currency fluctuations, net of hedging, decreased the combined R&D, sales and marketing, and G&A expenses by $43 million, or approximately 1.0%, compared with the third quarter of fiscal 2012. In the first nine months of fiscal 2013, foreign currency fluctuations, net of hedging, decreased the combined R&D, sales and marketing, and G&A expenses by $192 million, or approximately 1.5%, compared with the first nine months of fiscal 2012. Headcount Our headcount increased by 675 employees in the third quarter of fiscal 2013 and increased by approximately 7,500 employees in the first nine months of fiscal 2013. The increase for the third quarter of fiscal 2013 was attributable to headcount from new acquisitions, as well as strategic hiring primarily in engineering and services, partially offset by the reduction in headcount related to the sale of our Linksys product line. The increase for the first nine months of fiscal 2013 was attributable to these factors as well as the acquisition of NDS at the beginning of fiscal 2013. Share-Based Compensation Expense The following table presents share-based compensation expense (in millions): Three Months Ended Nine Months Ended April 27, April 28, April 27, April 28, 2013 2012 2013 2012 Cost of sales - product $ 10 $ 12 $ 31 $ 39 Cost of sales - service 34 39 105 116 Share-based compensation expense in cost of sales 44 51 136 155 Research and development 72 97 228 297 Sales and marketing 118 138 383 429 General and administrative 38 51 136 153 Restructuring and other charges - - (3 ) (2 ) Share-based compensation expense in operating expenses 228 286 744 877 Total share-based compensation expense $ 272 $ 337 $ 880 $ 1,032 The year-over-year decrease in share-based compensation expense for the third quarter and first nine months of fiscal 2013, as compared with the corresponding prior year periods, was due primarily to the effect of a decrease in the aggregate value of share-based awards granted in recent periods and stock option awards from prior years becoming fully amortized. See Note 14 to the Consolidated Financial Statements. Amortization of Purchased Intangible Assets The following table presents the amortization of purchased intangible assets included in operating expenses (in millions): Three Months Ended Nine Months Ended April 27, April 28, April 27, April 28, 2013 2012 2013 2012 Amortization of purchased intangible assets included in operating expenses $ 89 $ 96 $ 329 $ 292 The decrease in amortization of purchased intangible assets for the third quarter of fiscal 2013, as compared with the third quarter of fiscal 2012, was due mainly to certain purchased intangible assets having become fully amortized in the beginning of the current period, partially offset by the continuing amortization of purchased intangible assets from our acquisitions of NDS at the beginning of fiscal 2013, and from our other, more recent acquisitions. The increase in the amortization of purchased intangible assets in the first nine months of fiscal 2013, as compared with the corresponding period in fiscal 2012, was due to amortization of purchased intangible assets from our acquisitions of NDS at the beginning of fiscal 2013, and from our other, more recent acquisitions. For additional information regarding purchased intangible assets, see Note 4 to the Consolidated Financial Statements. 62 -------------------------------------------------------------------------------- The fair value of acquired technology and patents, as well as acquired technology under development, is determined at acquisition date primarily using the income approach, which discounts expected future cash flows to present value. The discount rates used in the present value calculations are typically derived from a weighted-average cost of capital analysis and then adjusted, as appropriate, to reflect risks inherent in the development lifecycle. We consider the pricing model for products related to these acquisitions to be standard within the high-technology communications industry, and the applicable discount rates represent the rates that market participants would use for valuation of such intangible assets. Restructuring and Other Charges In the third quarter and first nine months of fiscal 2013, we incurred within operating expenses net restructuring and other charges of approximately $33 million and $105 million, respectively. These charges were related primarily to employee severance charges for employees subject to our workforce reduction that we announced in late fiscal 2011. In the third quarter and first nine months of fiscal 2012, we incurred within operating expenses restructuring and other charges of $20 million and $225 million, respectively. See Note 5 to the Consolidated Financial Statements. Operating Income The following table presents our operating income and our operating income as a percentage of revenue (in millions, except percentages): Three Months Ended Nine Months Ended April 27, April 28, April 27, April 28, 2013 2012 2013 2012 Operating income $ 2,942 $ 2,750 $ 8,382 $ 7,694 Operating income as a percentage of revenue 24.1 % 23.7 % 23.2 % 22.4 % In the third quarter of fiscal 2013, as compared with the third quarter of fiscal 2012, operating income increased by 7%, and as a percentage of revenue operating income increased by 0.4 percentage points. The increase largely resulted from our continuing focus on expense management which resulted in lower sales and marketing and G&A expenses as a percentage of revenue. In the first nine months of fiscal 2013, as compared with the first nine months of fiscal 2012, operating income increased by 9%, and as a percentage of revenue operating income increased by 0.8 percentage points. The increase largely resulted from our continuing focus on expense management which resulted in lower sales and marketing and G&A expenses as a percentage of revenue, and from lower restructuring and other charges. Interest and Other Income (Loss), Net Interest Income (Expense), Net The following table summarizes interest income and interest expense (in millions): Three Months Ended Nine Months Ended April 27, April 28, Variance April 27, April 28, Variance 2013 2012 in Dollars 2013 2012 in Dollars Interest income $ 162 $ 161 $ 1 $ 483 $ 483 $ - Interest expense (145 ) (151 ) 6 (440 ) (449 ) 9Interest income (expense), net $ 17 $ 10 $ 7 $ 43 $ 34 $ 9 For the third quarter and first nine months of fiscal 2013, interest income remained fairly constant compared with the corresponding periods in fiscal 2012. Increased interest income earned on financing receivables was substantially offset by lower interest income from our portfolio of cash, cash equivalents, and fixed income investments as a result of lower average rates of interest on our portfolio of cash, cash equivalents, and fixed income investments. For the third quarter and first nine months of fiscal 2013, interest expense decreased slightly compared with the corresponding periods in fiscal 2012 due to the favorable impact of interest rate swaps as the three-month LIBOR rate decreased. 63 --------------------------------------------------------------------------------Other Income (Loss), Net The components of other income (loss), net, are summarized as follows (in millions): Three Months Ended Nine Months Ended April 27, April 28, Variance April 27, April 28, Variance 2013 2012 in Dollars 2013 2012 in Dollars Gains (losses) on investments, net: Publicly traded equity securities $ (2 ) $ 15 $ (17 ) $ 12 $ 30 $ (18 ) Fixed income securities 8 15 (7 ) 34 46 (12 ) Total available-for-sale investments 6 30 (24 ) 46 76 (30 ) Privately held companies (15 ) (3 ) (12 ) (69 ) (38 ) (31 ) Net gains (losses) on investments (9 ) 27 (36 ) (23 ) 38 (61 ) Other gains (losses), net (5 ) (8 ) 3 (46 ) 7 (53 ) Other income (loss), net $ (14 ) $ 19 $ (33 ) $ (69 ) $ 45 $ (114 ) The decrease in total net gains on available-for-sale investments in the third quarter of fiscal 2013 compared with the third quarter of fiscal 2012 was attributable to losses on publicly traded equity securities and lower gains on fixed income securities in the current period as a result of market conditions and the timing of sales of these securities. The change in net losses on investments in privately held companies was driven primarily by equity method losses in the third quarter of fiscal 2013, due mainly to higher losses from our proportional share of the VCE joint venture. The change in other gains (losses), net for the third quarter of fiscal 2013 as compared with the third quarter of fiscal 2012 was primarily due to foreign exchange impacts partially offset by an increase in donations. The decrease in total net gains on available-for-sale investments in the first nine months of fiscal 2013 compared with the first nine months of fiscal 2012 was attributable primarily to lower gains on both publicly traded equity securities and fixed income securities in the current period as a result of market conditions and the timing of sales of these securities. The change in net losses on investments in privately held companies was driven primarily by higher equity method losses in the first nine months of fiscal 2013. The change in other gains (losses), net for the first nine months of fiscal 2013 as compared with the first nine months of fiscal 2012 was primarily due to foreign exchange impacts and an increase in donations. Provision for Income Taxes Our provision for income taxes is subject to volatility and could be adversely impacted by earnings being lower than anticipated in countries that have lower tax rates, higher than anticipated in countries that have higher tax rates, and by expiration of or lapses in tax incentives. Our provision for income taxes does not include provisions for U.S. income taxes and foreign withholding taxes associated with the repatriation of undistributed earnings of certain foreign subsidiaries that we intend to reinvest indefinitely in our foreign subsidiaries. If these earnings were distributed to the United States in the form of dividends or otherwise, or if the shares of the relevant foreign subsidiaries were sold or otherwise transferred, we would be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes. Further, as a result of certain of our ongoing employment and capital investment actions and commitments, our income in certain countries is subject to reduced tax rates and in some cases is wholly exempt from tax. Our failure to meet these commitments could adversely impact our provision for income taxes. Our provision for income taxes resulted in an effective tax rate of 15.9% for the third quarter of fiscal 2013, as compared with an effective tax rate of 22.1% for the third quarter of fiscal 2012, which resulted in a net 6.2 percentage point decrease in the effective tax rate for the third quarter of fiscal 2013, as compared with the third quarter of fiscal 2012. The decrease in the effective tax rate was due to the net tax benefit of $117 million which is due in large part to lapses of the time period for assessment of tax in certain foreign jurisdictions recorded in the third quarter of fiscal 2013. Our provision for income taxes resulted in an effective tax rate of 7.7% for the first nine months of fiscal 2013 as compared with 21.2% for the first nine months of fiscal 2012, which resulted in a net 13.5 percentage point decrease for the first nine months of fiscal 2013, as compared with the first nine months of fiscal 2012. The decrease in the effective tax rate was primarily due to the recognition of a net benefit to the provision for income taxes of $794 million related to our settlement with the IRS, a tax benefit of $152 million related to the reinstatement of the U.S. federal R&D tax credit, and a tax benefit of $117 million which is due in large part to lapses of the time period for assessment of tax in certain foreign jurisdictions. 64-------------------------------------------------------------------------------- [ Back To TMCnet.com's Homepage ]