The Buffet is Closed

On Friday nights in Northern Wisconsin every bowling alley, tavern and restaurant serves up an all-you-can-eat fish fry. Fried fish gourmets, however, head not to mere restaurants, but to supper clubs where the feast is described as all-you-care-to-eat. Whichever phrase is used, the meaning is the same: Eat up, it's practically free.

Swap the deep-fried fish and mounds of potato salad for optical and wireless networking equipment and you've got a reasonable approximation of the atmosphere surrounding vendor financing in the telecommunications industry from late 1997 until today.

Although there are good reasons why the practice of vendor financing has taken a beating over the last six months, it's not the financial equivalent of cholesterol. In fact, even its most ardent detractors concede that, under the right circumstances, it's a legitimate financial tool.

But over the past four years it wasn't used responsibly, and its abuse contributed to the troubled financial condition of some major equipment vendors. On the other side, carriers that availed themselves of the largesse are in even worse financial condition. Now, as both sides struggle with these debts, investors suffer with them. Worst of all, the abuses have tarnished the reputation of the telecom industry as a whole.

MORE TARTAR SAUCE, PLEASE

Back when money was plentiful, even the promise of profitability garnered service providers tens and even hundreds of millions of vendor-financing dollars. Service providers built their networks with virtually no money down, while vendors racked up record sales figures.

“When we were in a go-go market, all sorts of investment money was flowing in, and stock prices were accelerating,” says Yipes CEO Jerry Parrick.

Accelerating the flow of vendor financing even further was the practice of service providers giving vendors equity in the form of stock warrants. If a service provider had a successful IPO, vendors could capitalize on their warrants. Such potential stock gains sweetened the pot for vendors already eager to make the sale.

Taken at face value, these side bets may seem relatively harmless. But when these deals go undisclosed the relationship begins to appear incestuous.

Most vendor-financing covenants expressly prohibit disclosure of whether warrants are included, the interest rate at which equipment is financed, the sales milestones that companies must reach before the next block of funding is released and a host of other particulars. Increased scrutiny is changing that situation, but only slightly.

The biggest problem created by this lack of transparency is that it allowed carriers to boast about huge cash infusions and vendors to claim sales — paid for with their own money — before equipment was even shipped.

“We've been running a great big scam in the marketplace,” says Tom Nolle, president and CEO of consulting firm CIMI Inc. “The whole vendor financing issue came about because of the desire in the technology space to sustain what would appear to Wall Street to be upward momentum in sales.”

For some companies, that upward momentum was more illusory than real.

SOMETHING FISHY

The subterfuge took another nefarious twist — at least in the eyes of one industry executive who compares vendor financing to channel stuffing: the practice of pressing resellers to take on more inventory than they can realistically move. “If the stock market is looking to you to maintain a high rate of growth, and you're starting to plateau, you respond to the lure of stuffing customers by giving them financing so they take on more purchases than they need.”

The practice continued until the stock and debt markets reassessed technology issues more closely and found some sobering statistics: By the end of 2000, Lucent had committed $7.5 billion in vendor financing, although the amount it actually advanced was only $1.8 billion. As for Nortel, the figures were $4.1 billion committed and $1.6 billion advanced.

Like justifiable homicide, you can make an argument that vendor financing is a reasonable strategy.
— TOM NOLLE / CEO OF CIMI INC.

When the next five largest equipment vendors are accounted for, the amount funded rises to more than $10 billion as of late first quarter 2001 and the amount committed is more than $25 billion. Although these numbers are just a fraction of those companies' combined revenues, they are already in the process of coming back to haunt the biggest seven vendors — not to mention the carriers that owe the money.

Adding to the vendor-financing backlash, a Salomon Smith Barney report estimates a 30 percent growth in debt defaults from 2000 to 2001. Combined with the fact that the amount committed by top vendors is as much as three times the amount advanced, it's likely that equipment vendors will be left holding a sizeable amount of worthless paper.

Whatever the value of that paper, equipment vendors never intended to hold it.

“These companies are in the business of manufacturing or arranging the manufacture of equipment,” says John Page, vice president of Moody's Investors Service. “They're not set up as banks, yet many are holding billions of dollars of paper.”

The original idea was to turn around and sell that paper to third parties as quickly as possible. In the current market, there are very few buyers interested in that paper, so vendors are beginning to write it off.

Even so, the snowball hasn't finished growing. As carriers have less access to capital — which they need to build out their networks and stay in business — they draw on their vendor-financing commitments even more. This further increases the financial pressure on vendors.

USE IS NOT ABUSE

Despite this cause and effect scenario, Nokia announced in early April that it's committing ε2.2 billion in vendor financing to Orange SA and Hutchison UK. And Nokia claims it has two good reasons for doing so.

First, Nokia is using vendor financing as an opportunity to increase its market share, while its relatively cash-poor competitors beef up their bottom lines. More importantly, it views France Telecom's Orange and Hutchison as blue-chip companies that pose little risk of defaulting. In fact, analysts and industry executives point out that extending vendor financing to investment-grade companies is a wholly legitimate type of funding.

And all of the latest vendor-financing deals haven't been limited to blue chips, either. Sigma Networks, a year old metro-area networks service provider with luminaries like Marc Andreessen and Reed Hundt on its board, recently announced a $435 million venture-capital round that included $290 million of vendor financing. Sigma CEO John Peters defends it as a justifiable way to help fund a business.

“Capital-intensive businesses such as ours require a combination of equity and debt,” he says. “So you have to ask, ‘from whom do you take your debt?’ In a perfect world like we had a couple of years ago you want to take your debt from a neutral party. In today's market, the rule of thumb is to get as much vendor debt as you can. If you don't, you're probably not going to be in business.”

Even vendor financing's harshest critics concede — albeit backhandedly — that as long as it's used judiciously, it's a practice that can be defended.

“Like justifiable homicide, you can make an argument that vendor financing is a reasonable strategy,” says Nolle.

In the best of worlds, vendor-financing deals take place between vendors that can afford to lend money and a service provider that has selected equipment because it is the best available for its network. Of course, that service provider will have a good chance of generating enough revenue to service the debt. Additionally, all but the most proprietary information will be available to investors.

Just because networks and systems are not built in a perfect world doesn't mean vendor deals won't take place. So, in place of perfection, there's a return to financial restraint. Vendors are becoming more conservative with how much they lend and to which companies. They are also less liberal about when the equipment in those deals is accounted for as a sale.

Under these real-world conditions, vendors won't be able to claim that their fish is so good that every customer is eating five and a half pounds. On the other hand, they won't be the ones stuck with the bill for a multi-billion dollar fish fry, either.

E-MAIL STEVE AT SSKOBEL@INTERTEC.COM

WEB RESOURCES:

• Unpaid Pipers / www.telecomclick.com
• Economic Analysis of Vendor Financing / www.dismal.com

SUGAR DADDIES GONE SOUR

COMPANY	COMMITMENTS	ADVANCED	NOTES
Lucent	$7.50 billion	$2.54 billion	Does not include anticipated commitment of $1.6 billion to Telefonica expected this year.
Nortel	$4.10 billion	$1.60 billion
Nokia	$3.71 billion	$900 million	Includes $2.51 billion from April deals with France Telecom and Hutchison 3G UK.
Tellabs	$3.4 billion	Not Released
Motorola	$3.38 billion	$2.89 billion
Alcatel	$2.95 billion	$1.43 billion
Ericsson	$2.04 billion	$1.03 billion
Cisco	$2.00 billion	$475 million
ADC	$229 million	$71.4 million	As of 1/31/01
Sycamore	$200 million	$50 million
UNLESS OTHERWISE NOTED, ALL FIGURES ARE AS OF 12/31/00
SOURCE: CREDIT SUISSE FIRST BOSTON AND COMPANY CONTACTS

CARRIERS THAT JUST SAY NO

Equipment manufacturers are encountering a rare and wondrous species: service providers that refuse vendor financing. And given the current economic climate, it's an encounter worth cultivating.

“Yipes intentionally stays away from vendor financing because we want the freedom to take equipment from different vendors into our infrastructure at any time,” says Yipes CEO Jerry Parrick.

“Manufacturer-agnostic” is the term Parrick and other executives use when they're stressing their philosophy against drinking from the cup of vendor financing.

Parrick is proud of the $290 million Yipes raised without vendor financing. He concedes that the company received token investments from manufacturers, but adds that they have all been under $5 million and are largely symbolic.

Jerry Pederson, CFO of Touch America, has another reason for avoiding vendor financing. “We believe that not being dependent on vendor financing gives our COO greater ability to negotiate best terms from multiple vendors.”

Of course, it's easier for Pederson to make that statement than it is for leaders of many startups. Touch America was recently spun off from the Montana Power Company after a 17-year incubation period and is debt free, fully funded and expects to have a 26,000-mile coast-to-coast, border-to-border fiber-optic network in place by year's end.

GiantLoop Network's business model makes it easier for it to refuse vendor debt than it is for other service providers.

“We build private optical infrastructures for enterprise customers on a per contract basis,” says Jack Lodge, product marketing director.

That reduces the company's need to make huge capital outlays before it secures customers.

Refusing money may be a way of saying, “see how conservative we are,” but it also might be a way of spinning the fact that vendors have decided to keep their dollars to themselves — or throw them at a competitor.