CISCO'S OTHER ASSETS
This editorial ran in March on Grantsinvestor.com, but IMO still a good read today
by Eric J. Fry 07:05 AM 03|21|2001
In which we ponder a question generated by the tech wonder's latest 10-Q: Are Cisco's 'other assets' a cause for concern?
This just in from the peripatetic crew in our Dead Horse (Beating) department: Cisco's 10-Q offers newly troubling tidbits concerning the company's financials, specifically its mushrooming "other assets." This latest discovery, made by Grant's Investor analyst Robert Tracy, prompts two questions: (1) What is an "other asset?"; and (2) Why should we care?
As its mysterious name implies, an "other asset" can be just about anything. Traditionally, this line on the balance sheet has included innocuous little items like prepaid expenses or minor intangible assets like mailing lists. However, in the Internet domain from which Cisco hails, this "other assets" line has become more variable, and a lot larger. Assets like customer financing arrangements and venture capital investments now find their way into this line. (Imagine a two-car garage, originally designed to house two vehicles, that turns into a receptacle for everything from old bicycles to rusted garden tools to boxes of college textbooks.) Helpfully, Cisco's 10-Q now breaks out the "other assets" line into sub-components, of which the largest two are "minority investments" and "inventory financing." As these two categories are large and growing, Tracy suspects that investors may have new reason for concern.
"Nobody seems to be paying attention to the 'other assets' line," Tracy cautions. "But it has been growing much faster than lease receivables and total assets." Lease receivables are, of course, the latest focus of the presumably gimlet-eyed sell-side analysts. Now that the vendor-financing horse frolics miles from the barn, the sell side wants to keep close tabs on it. Thus, Cisco has received analytical high fives for reducing its lease receivables 6% year-over-year. But, at the same time, Tracy notes, "the 'other assets' line has expanded 10-fold since the end of fiscal 1999, to $2,377 billion." The so-called minority investments are contributing greatly to the increase.
At a balance of $765 million in the second quarter ended January 27, minority investments surpassed Cisco's $516 million of lease receivables. Furthermore, the lease receivables line increased $584 million just in the last 12 months. So what are these things? Says Tracy: "When I asked the Cisco investor relations department back in September about the minority investments, I was told that they are mostly investments in non-publicly traded entities. At that time, Cisco had over 120 such minority investments. Per the IR: 'Minority investments give us an opportunity to watch what is going on in the market. We do not always have to acquire, but certainly in some cases we take a passive board seat or an observer board seat. Just to watch what is going on in the market space.'"
For perspective, the $584 million Cisco has spent over the last year "to watch what is going on in the market" equals 150% of the amount spent for general and administrative expenses for the six months through Jan. 27, 2001, as well as 30% of the past six months' operating income. Furthermore, the $765 million balance-sheet value of the minority investments might bear little resemblance to their real-world values in the wake of the dot.com implosion.
The second rapidly growing, and therefore troubling, component of Cisco's other assets is "inventory financing."
At $645 million, inventory financing is bigger than the lease receivables. Cisco's second-quarter Q explains the phenomenon thusly: "Certain portions of our vendor base are or have been capacity-constrained and this has resulted in increased cost pressure on certain components and increased levels of inventories due to longer term purchase commitments, which we have entered into to maintain or reduce lead times. We also provide inventory financing to certain of our suppliers."
This explanation raises more questions than it answers. Why has it become so much more important in the past six months for Cisco to supply financing to its vendors? What are the terms of the financing -- i.e., interest rates, collateral, payment schedule, etc.? Why is Cisco providing the financing as opposed to a bank?
Let's speculate. Were Cisco's eyes bigger than its stomach, inventory-wise? As it is, Cisco's inventory is rising, especially that part of inventory comprised of work in process and raw materials. Is the growth in inventory financing yet one more manifestation of ballooning inventories? For example, are the contract manufacturers holding Cisco inventory on their balance sheets? Was the company perhaps a bit too bullish on its prospects for the future, causing it to commit itself to larger inventory purchases than what it can now digest? Only Cisco knows for sure. But the growth is worrisome, nonetheless.
Perhaps the combined $1.2 billion jump in Cisco's minority investments and inventory financings is of little concern. Or more likely, perhaps this trend is emblematic of a new Cisco that must battle a profitability war on multiple fronts. To dispel any inclination toward complacency, Tracy offered a final observation, "Cisco's comprehensive income has fallen into the red."
Comprehensive income is a GAAP disclosure that includes those items which impact shareholders' equity as net income, but are not reflected in the income statement. Two of the more prominent adjustments for most companies are for foreign-currency translation and changes in unrealized gains or losses for marketable securities available for sale. In Cisco's case, unrealized losses in its investment portfolio swung its comprehensive income decisively into the red. Unrealized investment losses totaled $2.2 billion for the fiscal first half, compared to a gain of $1.5 billion for last year's first half.
You take $1.2 billion here, $2.2 billion there, and pretty soon. . . .
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