Live by the Sword! Fall on Your Sword!
The critical point is: Did the upside stem from stronger than expected operations or from some other source? As you can see in the table below, a substantial part of the company’s earnings per share derives from non-operating income (i.e., investment income).
As I have noted before, "pro forma" results have no definition according to Generally Accepted Accounting Principles (GAAP). Consequently, Company X’s pro forma results may be in no way comparable to Company Y’s pro forma results. What they all report to the Securities & Exchange Commission is GAAP.
So shifting to GAAP results for some comparisons, in the graph below you can see Qualcomm’s earnings per share from other income as well as its percentage of total GAAP earnings per share. What jumps out at you is that for the first half of that time-frame, Qualcomm was getting a fairly hefty percentage of its earnings from its investments rather that from its operations. The question for investors is, "Is this unusual?"
For comparison purposes, I looked at a few other prominent technology companies: Cisco Systems Inc. (Nasdaq: CSCO), Intel Corp. (Nasdaq: INTC), and Microsoft Corp. (Nasdaq: MSFT). Like Qualcomm, they have large amounts of cash and securities and generate a fair amount of cash from operations. As you can see in the table below, I have put them on equal footings (calendar year comparisons) for the last two years.
During 2007, Qualcomm generated substantially more of its GAAP earnings per share than did the other three firms. With the deterioration of the markets in late 2008, the other income contributions for Qualcomm and Intel both generated significant losses, so they ended up being a drag on earnings for 2008.
This raises the question of why the company generates so much more investment income.
The quick answer to that is: It depends on what you invest your cash in. As all investors have come to realize, everything has a risk profile. Cash in your mattress is pretty riskless if you exclude the potential for theft, fire, or some other disaster, but it earns nothing sitting there. Buying a government bond is fairly conservative, depending upon the government. Obviously there is a flip side to the risk equation of every investment, and that’s reward. Generally speaking, the higher the risk, the higher the reward, and that appears to be the answer to Qualcomm’s other income.
In the company’s recently filed 10-Q for the December quarter, Qualcomm identified its marketable securities positions. As you can see in the graphic below, the company has approximately $5.2 billion in marketable securities. Of that total, a whopping 42 percent fall into three categories: non-investment-grade debt; equities; and mutual funds and exchange traded funds. None of these is what you would call "low risk." Of equal importance is that, as of December 31, Qualcomm has unrealized losses of nearly $900 million on these investments. Those are losses that it has yet to run through its P&L, like the $294 million it had to recognize in the December quarter, as they were deemed to be "other-than-temporary." The company’s management intends to hold on to these investments with the expectation they’ll recover their value. They may, but when? You can’t sit with unrealized losses indefinitely.
To be fair, I’m not suggesting that Qualcomm’s treasury operations are doing anything wrong. There are plenty of companies that adopt a more aggressive approach toward their investments. But investors need to take a hard look at where earnings are coming from and why. If it’s too good to be true, there may well be a downside you’re not seeing in the good times.
— Bob Faulkner, Special to Unstrung
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