Financing Risk Looms Despite Cisco's Cautious Stance

Just as Cisco (CSCO Quote) claws away at its mismanaged mountain of inventory, Wall Street is stumbling over another heap of trouble: Loans to cash-strapped customers.

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Time and time again, Cisco has said it would be cautious in lending customers money with which to buy equipment and meet operating costs, a practice known as vendor financing. The San Jose, Calif.-based networker spoke of its caution most recently on Monday, during its earnings warning. But a recent financing deal, combined with a loan default Monday at upstart telco Winstar (WCII Quote), has several analysts and investors saying Cisco is throwing good money after bad.

Promises, Promises

Cisco recently invested $200 million in closely held network builder Velocita and promised it $285 million in financing, according to a filing with the Securities and Exchange Commission Friday. Reston, Va.-based Velocita is spending $1.17 billion to build an 18,500-mile, 50-city fiber optic network. The offshoot of energy-services giant Koch declined to specify the terms of Cisco's investment, but a spokeswoman said Velocita is happy to have a "vendor that shares this vision of the optical network of the future."

Cisco has been eager to get in on the ground floor of a nationwide network buildout, and Velocita represents a huge opportunity to put Cisco's optical gear to test in a fast-growing market.

Cisco says it also values Velocita's network building partnership with AT&T (T Quote), and Velocita's management team, headed by former AT&T executive and TCG pioneer Robert Annunziata as chairman and former MFS Communications and UUNet executive Kirby "Buddy" Pickle as CEO.

But Velocita, by some estimates, is at least the eighth company to embark on the construction of a nationwide fiber optic network. Existing competitors have run smack into a funding shortage and fierce competition, preventing them from switching on more than a smidgeon of their capacity. The bottom line: Investors don't like the capital-intensive, money-losing business plans sported by the network builders, and observers say Cisco is putting shareholders at risk in supporting one.

Crowded House

"If [Cisco CEO John] Chambers gives these folks at Velocita his shareholders' hard-earned money, then he is a fool and should be replaced," says Paul O'Neil, a money manager with Knight Bain Seath & Holbrook who sold all his Cisco last year. "In fact, I would ask Chambers to co-invest $100 million of his own money in this losing scenario so that he too will benefit from the stupidity of his executive decision."

Building massive new networks is a financially daunting task even in the most favorable markets. It becomes even more of a challenge at a time when investors apparently already have their fill of latest and greatest in Internet building projects.

"We are very suspicious of equipment companies extending credit lines or providing other forms of financial support to emerging carriers," says Tim Kristiansen, a money manager with Carnegie Asset Management in Copenhagen whose firm recently sold its entire 2.5 million-share stake in Cisco.

Velocita spent $313 million on network expansion last year and recorded $31 million in operational losses on revenue of $250,000. The company expects to spend $79.5 million on interest payments alone in the two-year period ending Dec. 31.

Trendsetting

The Velocita deal highlights a growing trend in which big equipment vendors use their ample cash hoards to serve as lenders of last resort to a telecom services industry in collapse. To date, Cisco says it has committed about $2 billion in vendor financing and that customers have taken $675 million of that. Cisco has made loans to Winstar, which is trading for pennies as it teeters on the verge of bankruptcy, and ICG, which has already filed Chapter 11.

Despite its claims to the contrary, Cisco has grown increasingly involved with lending to customers who are having difficulty finding cash elsewhere. In February, Cisco cut a $100 million financing deal with closely held Looking Glass Networks, a small Baby Bell challenger based in Oak Brook, Ill. In November, Cisco ponied up an additional $50 million in financing for digital subscriber line provider Rhythms NetConnections, bringing the total commitment to Rhythms to $125 million. Also in November, Cisco promised $500 million to the teetering local phone service Winstar.

Notably, Cisco's latest plunge into lending comes as Lucent (LU Quote), the all-time vendor-lender bad boy, washes its hands of an earlier $350 million loan commitment to Velocita, selling the loan to First Union. Lucent is also on the hook for $2 billion to Winstar.

Where the Risk Is

"In general, vendor financing will only prolong the necessary cycle of consolidation and failures in the telecom service provider industry," says UBS PaineWebber analyst Nikos Theodosopoulos, who has a buy on Cisco and whose firm has no underwriting ties with the company. "Either service provider business models make sense or they don't. If they do not make sense, then financing them won't change that."

In a note Monday to clients, Theodosopolous noted that the Velocita deal marked a significant departure for Cisco, which traditionally doesn't take ownership stakes in telecom service companies. But, as Theodosopolous points out, Velocita is one of the few customers Cisco has managed to win for its long-haul optical transport gear that it purchased when it acquired Pirelli last year.

Lending to customers isn't likely to break the bank at Cisco, which boasted $4 billion in cash at the end of last quarter. But as sales plunge and business remains unpredictable, shareholders can hardly be expected to overlook possible risk. O'Neil, the money manager, says Cisco's top brass should be accountable: "I hereby offer up a challenge to both John Chambers and [CFO] Larry Carter," O'Neil says. "If Velocita fails, they should both resign."