Rhythms and Blues: Cisco Funds Cash-Strapped DSL Outfit as Investors Flee

Investors may think Rhythms NetConnections (RTHM Quote) is on its last legs, but Cisco (CSCO Quote) is handing the troubled telco a crutch.

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With Rhythms' shares trading around $1.50, its high-yield bonds fetching between 43 and 73 cents on the dollar and its preferred-stock dividends having been deferred Tuesday, some people might not see sunshine in the broadband service provider's future.

Enter Cisco. Having lent $75 million to Rhythms, the Englewood, Colo.-based wholesale provider of digital subscriber lines, Cisco has offered to lend the struggling DSL firm an additional $50 million, to help Rhythms continue with its buildout plans.

Cisco's benevolence underlines the willingness of the big equipment sellers such as Nortel (NT Quote) and Lucent (LU Quote) to underwrite the expansion plans of struggling phone and Internet service providers that, in many cases, can't find financing from traditional sources. Critics say lending customers money to buy gear helps pump up revenue growth, at the expense of increasing exposure to bad debt, bankruptcy and distressed property. Worries about these issues have pressured networking stocks in recent months; Cisco dropped a quarter Tuesday to close at $51.

Rash on the Forehead

Cisco bulls brush off the lending risk, repeating the company's line that all borrowers are carefully screened for their ability to pay back the loans and that in many cases the debt is repackaged and sold off to third parties. But more and more, investors are taking a skeptical look at the practice and seeing it as a way to prop up weak businesses in order to pad sales and meet the Street's growth expectations.

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"I think we will see a rash of bankruptcies in the next six months, particularly from the smaller, poorly capitalized guys like Rhythms," says one Boston-based hedge fund manager who asked not to be identified.

"If Cisco's business was as robust as they want you to think it is, they wouldn't have to be doing this for Rhythms, because they'd be busy enough already," says the unnamed hedge fund manager, who holds no positions in Rhythms, Cisco, Nortel or Lucent, though he was short those stocks earlier this year.

Toll House Morsels

Things weren't always so bleak for Rhythms. Wall Street once cheered Rhythms, Covad (COVD Quote) and Northpoint (NPNT Quote) as the brilliant and brazen upstarts willing to pry open the high-speed Net access bottleneck controlled by the plodding Baby Bells.

However, after spending vast fortunes installing DSL lines while fighting the Bells in court, the DSL players gradually came to see that the business model would go on hemorrhaging money indefinitely and that something had to give. The implied endgame was to be acquired by a larger telco. The thinking was: If you build enough local broadband access network, a larger telco will see it as a perfect fit with a new local service strategy. But investor impatience and burgeoning metropolitan fiber-optic capacity helped weaken the plan.

Rhythms' turnaround scenario isn't helped by the company it keeps. Struggling rival Covad said Monday that it was cutting 400 people, or 13% of its staff, in order to eliminate 25% of its costs. And Northpoint, though it found its white knight buyer in Verizon (VZ Quote), has now said it must restate its third-quarter earnings to account for shortfalls from ISP customers. The move has caused Verizon to review the terms of its $800 million deal it struck in August.

The DSL players are part of a larger group of competitive local exchange carriers, better known as CLECs. You may have heard of these outfits recently. The failure of ICG (ICGXQ Quote), among others, has given investors pause amid the thought that further defaults and bankruptcies lie in wait.

Tangled Web

Cisco, which didn't return calls seeking comment Tuesday, was also a lender to ICG, which also happens to be based in Englewood, Colo. ICG owes Cisco $32 million on vendor-financing loans the networker extended the telco, according to Chapter 11 bankruptcy protection filings with the Securities and Exchange Commission. Earlier this month Cisco extended $500 million in loans to Winstar (WCII Quote), another deeply indebted local service provider whose high-yield bonds trade between 32 cents and 74 cents on the dollar.

Cisco and the other communications equipment sellers generally disclose only a fraction of their financing deals. And for now, financing deals remain but a drop in a huge and expanding bucket at Cisco, which showed revenue of $18.9 billion for the fiscal year ended July 29.

But as the capital markets dry up and these vendors take on more of the banking, it is becoming more important to know the quality of the borrowers. Judging by Rhythms' stock and bonds, investors aren't impressed.