Vendor Financing Backfires
When finance professor Cecelia Ricci looked at start-up Winstar Communications balance sheet last year, it took her about three hours to decide.
"This company has absolutely no chance of survival," she remembered thinking.
Financed by a rogues gallery of junk bonds and seven rounds of preferred stock, the fixed broadband wireless companys numbers flashed more distress signals than the U.S. spy plane as it approached Hainan Island.
Yet, Lucent Technologies and Cisco Systems, hell-bent on winning customers and milking the explosive late-90s expansion of new networks, agreed to sell Winstar equipment and lend the company the money to pay for it. Lucent extended $2 billion; Cisco $500 million.
"Why didnt these vendors get this?" asked Ricci, who teaches at Montclair State University in New Jersey and has extensively researched vendor financing. "All they had to do was look at Winstars financials and they wouldnt go near them. They just werent paying attention."
Winstars bankruptcy announcement last week tore open the shutters that had been hiding the telecom vendors dark secret: They had made a common practice of recklessly financing deals with the shakiest of start-up carriers. That practice likely will cost investors billions of dollars by the time all the bankruptcies and defaults are counted.
Business customers also stand to lose. As providers of interactive services go under, customers are left stranded and without competitive options for a range of services, and as the giant vendors are forced to retrench, less money is likely to be available for development of solutions for corporate customers.
Last week, Winstar, once the golden child of the fixed broadband wireless upstarts, filed a $10 billion lawsuit against Lucent, claiming the equipment maker broke part of its $2 billion vendor financing deal and forced it into Chapter 11 bankruptcy protection. Winstar had been widely respected for its strong management and prominent backers.
Lucent denied any wrongdoing in its deal with Winstar.
The dispute between Lucent and Winstar was likely born of the vague language often found in vendor financing deals. Usually the operator is required to reach a benchmark to continue to qualify for loans. "The problem with any of these contracts is how quantifiable are the milestones," said Bill Lesieur, an industry analyst at Technology Business Research. "Its full of legal jargon about meeting certain build-outs or best efforts."
More broadly, the fight points to the dangers of vendors doling out too loose and too liberal doses of financing to start-ups.
"Nobody will talk about it. No one wants to discuss it ever which is odd in itself," said Nancee Ruzicka, program manager at market researcher The Yankee Group. "And it doesnt show up as recognizable as you would expect on the books. Its a little shady."
Several experts who have examined the practice have sympathy for the vendors. In retrospect, start-up carriers were overly aggressive in building out their networks to compete with entrenched giants. While some vendors may have recognized irrational business plans, they may not have felt they could pass on contracts. But getting those deals required financing the equipment they were selling.
"It became kind of a table stakes of doing business," said Andy Belt, executive vice president at consultancy Adventis.
But now, the bets are turning into nightmares:
Cisco extended $180 million to ICG Communications, which later declared bankruptcy. Cisco loaned $75 million to Rhythms NetConnections, which is tottering on the brink.
Lucent extended a $1.35 billion line of credit to Leap Wireless International, and now the young company owes $111 million. Lucent also recently restructured a $425 million deal with TeleCorp PCS, which gives the supplier more time.
Nortel extended $150 million in credit to NETtel Communications last year. NETtel filed for bankruptcy in October; in December, the highest bid for its assets was $21.4 million.
In all, Lucent last year committed to $5.7 billion in credit to customers. Nortel CEO John Roth said credit commitments to customers decreased from $4.1 billion at the end of 2000 to $2.8 billion at the end of March. Cisco this year has offered $1.1 billion of $2 billion available in vendor financing, the majority of which is operating and equipment leases.
The companies report vendor financing in myriad ways: Sometimes the deals are tucked into the vendors capital arm, sometimes they show up as current revenue and sometimes they are recorded as future revenue.
Ricci, who has researched financing strategies at a half dozen of the worlds largest telecom equipment firms, believes the Securities and Exchange Commission should require more public revelations of financing by telecom vendors to save investors from being blindsided.
"Lucent investors had no idea of the risk they were facing," she said. "Cisco investors didnt know that 30 percent of revenues were coming that way. There definitely needs to be someplace to report loans to customers and loan guarantees."
Alcatel, Nokia, Ericsson and Seimens list vendor financing in their financial statements, but "not in any clear fashion," she said.
Belatedly, the vendors are getting the message.
"They certainly need to be more careful, and now they are," Ruzicka said. "I can tell by the sheer volume of calls I am getting [from the capital lending arms of the largest vendors.] Theyre asking about markets, what products are selling, what will be hot in six months. Theyre being more diligent in evaluating who they sign on with."
Said Cisco spokeswoman Caroline Brown, "Were obviously going to be more conservative."
But financing gear has been a requirement for closing many deals.
A recent Lucent report noted: "Lucents customers worldwide are requiring their suppliers to arrange or provide long-term financing for them as a condition of obtaining or bidding on infrastructure projects."
Analysts agreed. "Were these things being slapped on in the end to close a sale? Yes. Were they run through a process of due diligence?" Lesieur said. "Of course not. It was more important to land the contract to show growth."
So the vendors kept making deals, knowing that if they didnt, their competitors would.
"Network-building was being funded by venture capital with reckless abandon," said Chris Thiessen at research firm MetaMarkets.com.
If a start-up carrier has a solid business plan, it should be able to get funding for its equipment from other sources, said Nikos Theodosopoulos, senior telecom equipment analyst at UBS Warburg.
While Winstar felt it was left in the lurch, some of its peers may be luckier for not having scored huge vendor financing deals originally. Teligent, another fixed wireless company, has no vendor financing agreements.
"To the degree that vendors are coming down hard on folks, we avoid that entire situation," said Mike Kraft, senior vice president of marketing and communications at Teligent. Threats of bankruptcy surrounded Teligent at the end of last year, but the company is now funded at least into mid-2001.
XO Communications, a broadband provider that uses fixed wireless technology, also said it doesnt have any vendor financing deals and is funded into the second half of 2002.
Analyst Lesieur believes competitive providers have embarked on what will ultimately be a 20-year build-out process, with this as year four. "Were going through a realignment of markets and technology and capital, but its still going to happen," he said.