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Networking leaders wear two hats in hot IPOs

Some recent IPOs have taken the relationships between communications companies and the equipment makers that supply them with hardware to a new level.

    When optical equipment maker Corvis goes public later this month, some of the company?s loudest supporters on Wall Street just might be its own customers.

    Communications companies and the equipment makers that supply them with networking hardware have long maintained cozy relationships. But some recent initial public stock offerings have taken these relationships to a new level.

    Incredible growth in the networking and fiber-optic markets has led to an explosion of start-ups that make the gear to deliver Internet traffic at high speeds. Increasingly, these infrastructure companies are filing for IPOs with precious few customers--in some cases just one--and with little or no revenue.

    What's more, many of these same customers have signed equipment purchase contracts with the new companies in exchange for shares or warrants to purchase stock in what are likely to be dynamic public offerings.

    The situation has caused consternation among some analysts who warn the lofty valuations of some of these networking newbies might not be built on the most solid foundations.

    "The prospects of this narrow list of clients is of tremendous concern to the viability of any company," said David Menlow, president of the IPO Financial Network, a New Jersey-based firm that analyzes new offerings. "If you have just a couple of customers, it doesn't mean you have to go public. I, for one, would like to see less of it."

    Corvis' pre-IPO regulatory filing with the Securities and Exchange Commission offered a fairly typical assessment of the modus operandi for many communications equipment upstarts.

    "To date, we have not recognized any revenue. We currently have only three customers. Broadwing Communications Services and Williams Communications have each agreed to purchase $200 million of our products and services over a two-year period, subject to its successful completion of field trials," the Corvis prospectus reads.

    At the same time, both Williams and Broadwing will have the opportunity to buy up to $5 million of Corvis common stock at the company's initial price, an arrangement that could net the companies substantial short-term profits. Williams and Broadwing already have purchased $40 million in convertible preferred stock. Qwest Communications International also holds warrants to purchase Corvis common stock.

    Companies as VCs
    The trend highlights the changing nature of IPOs: Though going public once represented the validation of a solid business built over time, today it is frequently used to raise the capital needed to develop a new business or to acquire talent or technology.

    "Investors are playing a venture capitalist's role, funding companies before they're mature enough to go public," said George Nichols, an analyst at Morningstar, an Internet equity analysis firm. "Rather than taking an ownership stake in a strong business, investors are increasingly financing rapid expansion and infrastructure deployment."

    Nowhere is the trend more apparent than in the communications industry, where dozens of equipment makers are rushing to develop gear ahead of the expected growth in network construction. Most industry pundits believe the communications industry is in the early stages of a 20-year equipment replacement cycle. Proceeds from IPOs are being used to design and manufacture new fiber-optic gear or to build advanced networks.

    But the breakneck pace of innovation and the need for cash has led to a handful of new public companies that some analysts doubt could have hit the Street successfully just a few years ago.

    "It used to be that companies didn't go public until they'd established themselves," said Deborah Bortner, Washington state's top securities regulator and president-elect of the North American Securities Administrators Association (NASAA), an investor protection group.

    "Now, with the quote-unquote 'New Economy,' people aren't really buying a piece of a company anymore," Bortner said. "They aren't saying, 'I really want to be an owner.' They think: 'I can turn it over quickly.'"

    Corvis isn?t the first company to file for an IPO with a short customer list. Williams was the only customer of Sycamore Networks when the equipment maker went public last October. Yet Williams had access to 200,000 Sycamore common shares that after the company's first day of trading were valued at about $37 million.

    Sycamore has since broadened its customer base and recently signed a new contract with 360networks.

    Avici Systems, a high-end router maker set to go public later this year, is another example. Enron Broadband Services and Williams have agreed to buy Avici hardware in the future, and AT&T is testing its products. Avici in turn has reserved a certain number of IPO shares for Williams.

    Similarly, CoSine Communications, which makes Internet gear such as virtual private network (VPN) switches, has supplier contracts with Qwest, Broadband Office and other communications service providers, all of which already are investors or have warrants to buy CoSine stock.

    Avici, CoSine, Corvis and the others are largely forbidden from addressing the topic because of a federally mandated "quiet period" surrounding an IPO.

    Ethical issues?
    Some larger networking companies have questioned the validity of exchanging shares with a potential customer as part of a public offering, but the SEC is not actively investigating the practice, according to industry sources in Washington, D.C.

    Analysts say nothing prevents companies from going public with even just one customer and no revenue, or from investing in their suppliers.

    "If it's disclosed, it's legal," IPO Financial's Menlow said. "I think the companies for the most part are doing an excellent job of disclosure."

    Some experts say the changing nature of IPOs has been an ongoing, decades-long process and should not alarm investors who have also changed the way they evaluate potential investments.

    "You need less of a so-called traditional business model (to go public) than you did in the past," said UCLA finance professor Mark Grinblatt. "You don't need to have earnings to have value. People are valuing these companies based on growth potential."

    Grinblatt also said suppliers and their customers have always maintained tight relationships--something that should not be cause for concern.

    Regardless, as more companies go public with fewer customers--and customers that are intimately connected via rich equity positions--analysts say investors should be careful to read company disclosures.

    "It is creating a caveat emptor situation for investors," Menlow said.