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Lucent support of start-ups could point to problems

Amid its latest earnings warning, the company may have let slip two unspoken words that could hint at a larger issue the networking industry will face in the coming months: bad loans.

Amid its latest earnings warning this week, Lucent Technologies may have let slip two words that could hint at a larger issue the networking industry will face in the coming months: bad loans.

The communications market is expanding rapidly as more people use the Internet and new network operators sprout up each day to meet demand. As a result, some network equipment providers are loaning network operator start-ups the money they need to build their networks.

Gartner analyst Bob Hafner says Lucent Technologies' earnings warning shows that its troubles in adjusting to next-generation, optical and packet networks will continue to erode its market position unless it takes decisive steps soon.

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But a flurry of woes affecting start-up carriers--as well as persistent claims that telecommunications concerns such as AT&T and WorldCom can't continue to invest as much in network equipment given their current faltering stock prices and slow-growth businesses--has raised the question of whether providing such loans is a good idea.

Lucent on Tuesday pegged bad loans to emerging service providers as one reason for a downturn in its financial fortunes. Though competitors say the issue is isolated to Lucent, the announcement only adds fuel to the fire.

"Lucent has been one of the more aggressive vendors in financing (emerging service providers), while Cisco Systems and Nortel Networks have been more conservative," said SG Cowen Securities analyst Christin Armacost. "Lucent used it for so long as a growth engine and has never been caught in a bad situation because capital was so plentiful" for the company.

"Now that they're not, they find themselves in a situation where they have to continue to provide financing to the riskier service providers they have relationships with or see their revenue impacted as a result," she said.

Lucent believed the emerging service providers were a good risk because they had strong stock prices and could go to banks for financing. But service providers' stocks are now nearing 52-week lows, forcing them to rely on companies like Lucent, Armacost said.

One small rival that battles Lucent in the high-speed Net access market noted recently that Lucent seemed to be pulling out all the stops to win customer contracts.

"I think Lucent could be left with some pretty ugly paper," Rick Gilbert, chief executive at Copper Mountain Networks, said in an interview.

To spur the creation of new networks, network equipment providers such as Cisco and Nortel, among others, have started internal capital arms that can provide these new telecommunications operators--sometimes called "green fields"--with funding for purchases of gear so those companies can get up and running. As a result, these networking companies can cultivate new customers that can add significantly to their bottom lines.

Without a network, the theory goes, a green field network operator can't make any money to repay an equipment provider or reinvest dollars in new gear as they expand.

Lucent announced a profit warning Tuesday for its current fourth quarter, citing slower sales of both traditional voice products and optical networking equipment. Lucent executives also said the company needs to increase its reserves to cover potential bad loans to emerging service providers.

While Lucent hasn't created a separate capital arm, the equipment maker does provide loans to start-up carriers, a Lucent spokesman said. In its last reported quarter in July, the company had about $1.5 billion in outstanding loans, he said.

"We have a rigorous process to evaluate financing opportunities, but in light of what we announced yesterday, we feel there are credit concerns with emerging service providers and felt we have to take steps to increase reserves for bad debts," said Lucent spokesman Bill Price.

Competitors say Lucent's bad loans are an isolated issue.

"We have heard the comments made by Lucent today, specifically those indicating that this is a Lucent-specific issue and not an industry-wide phenomenon," a Nortel spokesman said in response to Lucent's warning. "We agree with Lucent that the growth prospects remain robust."

Cisco Capital--the company's financial arm for customers--accounted for 7 percent of that company's revenues for its most recent quarter. Of that amount, less than 10 percent came from start-up telecommunications carriers, sometimes known as competitive local exchange carriers (CLEC).

Cisco was recently given a clean bill of health from a Morgan Stanley Dean Witter financial analyst who studied the company's loan practices. Analyst Chris Stix, after discussions on the issue with Cisco, said he came away "impressed with how conservative Cisco has been," noting that the company carried about $500 million of the $2.5 billion in financing it has doled out on its books at the end of its most recent fiscal year.

Some analysts said Battling Goliath weakness among start-up network operators is to be expected, but how equipment companies account for these sometimes high-wire financing plans will help determine their fiscal health.

"The start-ups are weak financially. They're going against large entrenched players, and their up-front needs are significant because they have capital spending and marketing needs," said Standard & Poor's analyst Rich Siderman. "We do not give a high probability that they will fully pay off their debts."

But the networking companies want to loan the money so they can record the sales. "It's like financing a car. A company can record sales, but if they're not paid, they have to reverse those sales," Siderman said.