There's no question that the slowdown in capital spending among telecom service providers over the last six months has affected Cisco Systems (Nasdaq: CSCO) and its competitors. What Cisco investors need to know, however, is how the company records finance revenues and how exposed it is to the service carriers buying its equipment.

First, a little background. To some extent, these service providers (companies that offer customers telephone and Internet services) built networks expecting that revenues would follow. Sure, the need for bandwidth and the rapid growth of Internet traffic has signaled strong customer demand. But companies have to find a way to make a buck from the network buildout, and it's pretty clear this will never happen for companies such as ICG Communications (Nasdaq: ICGXQ), which filed for bankruptcy in October .

Many of these companies expected to tap the capital markets for funding that dried up, so they are turning to equipment makers like Cisco Systems, Lucent Technologies (NYSE: LU), and Nortel Networks (NYSE: NT). Lucent, for example, has had problems with bad customer debts and increased its allowance for uncollectible accounts receivable. Two of Cisco's customers have gone belly-up as well. If the equipment makers are ultimately unable to collect their sales proceeds, then the growth rates that we have seen for these companies will have been overstated.

Sales proceeds are not all that would be lost. There are also the expenses incurred to generate the sales in the first place: manpower, manufacturing costs, and services. Based on the information that Cisco provided on its Cisco Capital financing unit, its revenue recognition policy for vendor financing activity is conservative. This is important because it means Cisco is less likely to write off these amounts as bad debts in the future. Cisco is also recording deferred revenues on its balance sheet. This number, which Cisco used to report annually, was reported separately this quarter. Cisco includes the amounts owed under its leasing agreements in its deferred revenue balance.

As a general rule, deferred revenue is a good liability because it represents cash the company has collected in advance of satisfying all the obligations (normally in the form of warranties, services, etc.) related to those revenues. As those obligations are met, the deferred revenue becomes actual revenue in the income statement. However, in this case Cisco has provided products to customers for which it has not yet been paid in full. It then recognizes revenue from its riskiest leases as the cash is received. It will be important to keep an eye on Cisco's deferred revenue account by reviewing the financial statement footnotes, the balance sheet, and the cash flow statement. If Cisco does not ultimately collect these revenues, its financial performance will suffer as a result.

Has this affected Cisco so far? Yes. The company could be out as much as $180 million in loans due to ICG's bankruptcy. In addition, Pacific Gateway Exchange defaulted on $2.7 million in loans earlier this year. The amount of the loan default is not the only cost to Cisco. It likely also invested operating capital or hours of technical support into these companies. Cisco might get some money back through the bankruptcy proceedings.

Last week I wrote a column about revenue recognition and the changes the SEC has adopted effective in 2001. Let's take a look at how Cisco recognizes the revenues from its financing activities.

Founded in 1996, Cisco Capital (CC) helps Cisco customers finance the cost of building new networks. It's becoming an increasingly important part of Cisco's offerings to service providers. Cisco offers three types of financing to its customers:

  • Financing Lease (FL)
  • Operating Lease (OL)
  • Structured Loan (SL)

In financial terms, FLs are equivalent to the sale of a product. Revenue is generally recognized at the time the equipment is shipped. Customers typically remit lease payments over a three-year period.

When Cisco enters into OLs, the transaction is similar to having Cisco rent the property to the customer. Cisco recognizes revenue over the term of the lease, which is typically two to three years.

SLs are the riskiest type of financing transaction for Cisco. In these transactions, Cisco provides a financing option under which the customer purchases equipment, but pays for it by establishing a related debt with Cisco. In addition to Cisco equipment, the transaction can also include financing for costs associated with the buildout of the customer's network. Conservative reserves are taken for funds Cisco provides to assist with the purchase of non-Cisco equipment. Revenue for Cisco products financed by SLs is generally deferred at the time of shipment and is only recognized over the term of the loan as cash payments are received. 

CC has more than doubled in size over the past year and, given the market opportunity and customer demand, it's expected that this growth rate will continue. Funded financing activity by CC for the first quarter was approximately $625 million, which represents nearly 10% of Cisco's revenue. Two-thirds of this activity related to OLs and FLs that were primarily made to quality enterprise customers and top service provider accounts. The remaining third related to SLs to service provider accounts with a higher degree of business and credit risk.

Cisco's SL commitments are established over a two- to three-year period, and require that the customer achieve specific business milestones and/or financial covenants. Since the inception of this program, SL commitments total approximately $2.4 billion. Cisco has funded $600 million to date. Provided that the borrowers meet Cisco's requirements, it is anticipated that the remaining $1.8 billion will be funded over the next two to three years. Approximately 65% of the $600 million has been either classified as deferred revenue or reserved on Cisco's balance sheet. Cisco maintains that it is paid a market rate of return on this financing.

To see how this is impacting Cisco's balance sheet, we can check to see how quickly it's collecting its outstanding debts by measuring days sales outstanding (DSO): accounts receivable / (sales / 90). You'll find that Cisco's DSO of 40 days is one of the lowest around (though it is up from 36 days last quarter). As a result, there is less concern about Cisco overstating its revenues compared to a competitor with a higher DSO. However, increased activity by CC does cause Cisco to have more of its working capital tied up in assets less liquid than cash.

Overall, I think Cisco's doing the right thing: Help finance customers with a legitimate shot at building a business, account for the revenues conservatively, provide adequate reserves for bad debts, and collect accounts diligently. That's what business is all about, and companies such as General Electric (NYSE: GE), Ford Motor Company (NYSE: F), and Deere & Co (NYSE: DE) have built decent add-on businesses providing financing services for customers.

It's also time to make our nominations for this month's $500 investment. I'm with Matt on this one. I think we should add more Yahoo! (Nasdaq: YHOO).

Finally, if you know what it means to have a dog that's part of your family and not just a pet, please think some good thoughts for our 14-year-old Shih Tzu, Amelia, who has taken ill.

Have a great night.

Phil Weiss, TMF Grape on the Discussion Boards