For Networkers, a Squeeze From Two Sides

Williams Communications' (WCG Quote) cash crunch could signal more than a kink in the closely watched network-equipment spending cycle. It could also put several start-up optical-equipment companies in a sort of stock-market double jeopardy.

Blinded?

Cash Crunch Threatens to Slow Optical Network Buildout

Williams isn't just a good customer of these optical networking companies, such as Nasdaq highfliers Sycamore (SCMR Quote), ONI (ONIS Quote) and Corvis (CORV Quote), and closely held Tenor, Amber and Zaffire. It also happens to be an owner of these firms, through deals in which Williams received pre-IPO stock in exchange for agreeing to test or buy equipment from these companies.

When companies like Sycamore held their hugely successful IPOs, Williams' shareholdings fed into a positive cycle for the networkers: The start-up companies used the cash and the customer relationship to build their fledgling businesses; investors saw Williams' stake as a stamp of approval; shares jumped after the IPO amid the clamor to get in early on the great network buildout.

Weakening Williams' share price forcing its hand

Source: BigCharts

But now that Williams has raised the prospect of a slowdown, the cycle could turn vicious. When cash-hungry operators need money to maintain their costly network buildouts, the shares of fledgling networkers become fair game. And when investors see these shares losing their momentum and the names of big customers on the selling-shareholder lists, they could decide to lighten up, too. That could lead to a bloodletting in a closely watched and precariously priced sector, observers say.

Rite of Passage

The better-than-cash enticement has become almost a rite of passage among networking start-ups, as TheStreet.com wrote earlier this year. Many of these agreements involve purchase guarantees, and individual executives have reaped fortunes, raising questions about whether network operators' product decisions have been skewed by their stakes in these companies. Williams has since banned individuals from profiting on these deals.

Surging Sycamore unaffected by Williams selling

Source: BigCharts

But Williams is only one of a growing number of new-era communications services companies including BroadWing (BRW Quote), Enron (ENE Quote) and Qwest (Q Quote) that swap business for shares in many young networking firms. Obviously, as that trend spreads, so does the vulnerability of these networking start-ups to the downdrafts in network operators' shares that force them to look at every option when raising cash to build new infrastructure.

In a favorable market, as the networking sector has enjoyed over the past year, investors have had the luxury of essentially being able to ignore most insider selling. One observer calls it the "hear no evil, see no evil, speak no evil" attitude among the sell-side analysts.

'So Thin'

But as some investors are quick to point out, high-orbit valuations coupled with scarce customers and scant revenue make for a fragile equation.

"The floats are all so thin, and the market has been pretty jittery. So look at the implications if it happened at an inopportune time," says a money manager with a large Wall Street firm who asked not to be identified. "You can imagine the headlines, a big partner and customer is dumping a big block of stock. It would be all over the chat rooms."

"Herd psychology is not my specialty, but clearly the downside is breathtaking," says Rob McCormick, a principal at Integral Capital Partners, whose firm is one of Sycamore's largest shareholders and also holds ONI and Corvis. "If you have many things pointing in the same direction and you added the sale of a big block of stock to that, it could be the straw that broke the camel's back."

Cashing Out

As of last month, for example, Williams had completely cashed out its 200,000 shares of Sycamore. And Williams isn't exactly a disinterested party: As of its fiscal third quarter ended April 30, Williams represented 85% of Sycamore's sales.

Williams says its liquidation of the Sycamore stake is consistent with its plan of being a short-term shareholder. "We are sensitive to working our position off over time to avoid affecting the market," Williams CEO Howard Janzen wrote in an email. The Sycamore sale involved 20 transactions over a seven-month period.

So when the money flow clamps down, those cozy ties between buyers and suppliers that made for a wonderful ride up can provide a rather quick and vicious cycle down.