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Cisco, Lucent and Nortel: Prime Lenders for the Network Buildout

Scott Moritz

When the capital markets say "no," Nortel (NT Quote - Cramer on NT - Stock Picks) says "yes."

That sounds good to Peter Geddis, who is building a fiber-optic network to dwarf all fiber-optic networks. After raising $100 million in initial investments this summer, the chief executive of closely held Aerie Networks found venture capitalists were increasingly skittish about providing more funding, as telecom stocks and bonds tumbled. That left Aerie surveying a $40 million shortfall on its $150 million capital goal, the executive says.

Would the nascent networker need to scale back its plans? No. Instead, in a scene that is playing out more and more frequently across the hypercompetitive telecommunications equipment sector, Nortel rode to the young network builder's rescue. Last month, the equipment maker provided Aerie with a much-needed windfall in the form of $500 million worth of equipment financing as well as an undisclosed amount of capital for Aerie's operations, says Geddis.

Aerie is just one of the 45 vendor financing deals Nortel has on its books. As such, it offers a glimpse into a battle the big telecommunications equipment makers -- notably Nortel, Lucent (LU Quote - Cramer on LU - Stock Picks) and Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) -- are rushing to join: picking up more of the financing slack for the very companies that buy their equipment.

Islands in the Stream

While Nortel is certainly knee-deep in the lending business, rival Lucent is the true champion of vendor financing. Lucent has been saying "yes" ever since it hit the ground four years ago, to the tune of $7 billion in financing commitments, more than double Nortel's $3.1 billion. (Nortel has $1.4 billion in actual loans outstanding to buyers of its equipment; Lucent, $1.6 billion.)

Cisco, in order to compete with the incumbent telecom equipment makers, says it has been increasing its vendor financing activities through its banking arm, Cisco Capital. Cisco has so far promised $2.4 billion in loans to its customers. (Cisco's loans outstanding amount to $600 million.)

Equipment makers derive several advantages from so-called vendor financing arrangements, the terms of which often remain under wraps. Namely, they gain relationships with potentially lucrative customers and revenue that will look good on the next financial statement.

But as spending on telecommunications equipment slows and traditional financing options shrivel or become prohibitively expensive, equipment makers are racing into risky territory with their funding efforts, analysts say.

The game plays out this way, observers say: Cash-hungry start-ups with big-bandwidth dreams slither up to growth-obsessed equipment sellers. In a strong telecom-stock market like the one that prevailed this spring, these deals make everyone look good, the network companies by permitting speedy buildouts and the equipment companies by adding to already record growth rates.

But when the froth leaves the stock market, funding grows scarce. Network-building start-ups begin to fail, leaving equipment builders on the hook for bad loans and drying up anticipated revenue streams from repeat equipment sales. Worse still, the abundance of early financing for network builders feeds a glut of bandwidth providers, which further depresses prospects for network companies.

Shady Glade

Even in good times, vendor financing smacks of buying your own business. It can be even more insidious in down times: For instance, analysts and industry insiders say it can influence purchasing decisions, shifting decision-making away from the equipment's merits to who's offering cash incentives. And some on Wall Street suspect the practice in some companies' sky-high growth numbers.

"It's a real shady, backwater practice," says a Wall Street debt analyst who asked not to be identified. "Over the past year, you could make the argument that a lot of equipment companies started stuffing their revenue line by getting into vendor financing."

Lucent, Nortel and Cisco officials say vendor financing is an age-old practice. Each company says it is more cautious than its competitors about who it climbs in bed with. Yet all three have accelerated the practice in recent months, just as venture capitalists have backed away from new network projects and the stock and debt markets have fled nearly all things telecom.

Aggression

For its part, Lucent told analysts during its recent earnings conference call last month that it plans to be more "like a bank" and get even more aggressive in vendor financing. Lucent upped its outstanding loans last quarter by $300 million, or 23%. Nortel has boosted its loans to customers by nearly $300 million, or 27%, since the beginning of the year.

The vendors say that, in many cases, they can quickly sell the loans to banks or third parties, so they aren't exposed to the risk. But selling the loans, especially on the high-yield market, has proven difficult lately. Both markets have been rocked by bankruptcies, such as the one at GST Telecom (GSTXQ Quote - Cramer on GSTXQ - Stock Picks), and by looming troubles with telcos such as ICG (ICGX Quote - Cramer on ICGX - Stock Picks), RSL Communications (RSLC Quote - Cramer on RSLC - Stock Picks), Globalstar (GSTRF Quote - Cramer on GSTRF - Stock Picks) and PSINet (PSIX Quote - Cramer on PSIX - Stock Picks). Some debt analysts predict there will be between 50 and 75 defaults in the telecom sector by the end of the year. That is more than double the defaults in telecom last year.

Aside from the risk of running up bad debt, vendor financing also helps prop up businesses that the market wouldn't necessarily bear in normal times.

In a perfect Telecosm, networks like Aerie's would always find funding. Yet the plunging share prices at many big network companies, and the funding difficulties for network builders such as Williams Communications (WCG Quote - Cramer on WCG - Stock Picks), whose network is still being built, suggest there may be an overabundance of network builders.

At least on some level, these observations might cause you to wonder if the there's a need for Aerie's nearly 200-city, 20,000-mile North American network, which is capable of carrying 25 million simultaneous phone calls on just one strand of its 432-strand cable. That amount of traffic happens to be equivalent to the nation's busiest calling hours.

The Big Tent

These ideas cause no apparent concern on the part of Aerie chief Geddis, or at Nortel, for that matter. Geddis, who came to Aerie after founding Qwest (Q Quote - Cramer on Q - Stock Picks), would seem to have a handle on the market's thirst for bandwidth. To date, Qwest has had to use only 4% of its total fiber-optic network.

But the abundance of network builders has other observers wondering. "Do we need a 28th [digital subscriber line] network provider in Brooklyn?" asks Lehman Brothers equipment analyst Steven Levy, referring to the abundance of me-too business plans in the market. "Do we need the sixth [third-generation wireless] network in Germany?" (Levy rates Lucent a neutral; he has no rating on Nortel or Cisco. Lehman hasn't underwritten for Lucent or Nortel, though it underwrote a recent Cisco stock offering.)

"In their drive to grow faster and faster, [Lucent and Nortel] may be artificially stimulating the growth of the market," says Levy. "And maybe some of these networks don't need to be built."

Aerie hopes to beat Williams, Qwest and Level 3 (LVLT Quote - Cramer on LVLT - Stock Picks) at their own game by using national fuel pipeline rights of way from energy industry partners to string its big fiber cable and sell capacity at ridiculously low cost.

Geddis said that in order to separate the product choice from the financing question, he went to all his potential vendors with identical financial terms, and Nortel responded most quickly. He says the deal is mutually beneficial: Aerie gets financing and the Nortel stamp of approval, while Nortel helps to build a good and presumably repeat customer.

Lucent knows about repeat customers: Two years ago, the company extended $2 billion in financing to broadband access provider Winstar(WCII Quote - Cramer on WCII - Stock Picks). The perpetually cash-hungry outfit has taken $1 billion of that dough already as it builds out its network. An equal-opportunity borrower, Winstar Wednesday said it tapped Cisco for up to $500 million in financing.

Bank Shot

Lucent, Nortel and Cisco see themselves in a vital role as bankers of the future network buildout. As Cisco's CFO Larry Carter indicated to analysts on a postearnings conference call Monday (as if noting added revenue synergies to financing purchases), the lenders pay "market-rate interest" on the loans.

It's a point not lost on some analysts: The added lending risk, offset by the benefits of collecting market-rate interest, isn't exactly what Wall Street is looking for in a supposedly high-growth networking investment.

With the ho-hum growth dynamic typical of banks, investors tend to price them at 12 times their 2001 earnings, while telecom equipment vendors such as Cisco and Nortel are lavished with a generous multiple of 50 times next year's expected earnings.

"If they want to be banks," says Lehman's Levy, "we'll value them as banks."