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Can things get any worse for the telecom sector?

The problems include a glut of capacity, skittish investors and news that telecom-equipment suppliers extended billions in vendor financing to start-ups and wireless companies.

    The telecom sector?s recent problems have been widely discussed, but more bad news is coming to light. Some of the industry?s meteoric growth was propelled by financing that equipment providers extended to high-tech and telecom start-ups that are now having difficulty making their payments or, like Winstar Communications, have spectacularly collapsed.

    Consequently, the earnings of the equipment providers, such as Cisco Systems and Lucent Technologies, are also suffering.

    The problem is hardly confined to the telecom sector. Xerox, for example, is struggling under the burden of the $11 billion it borrowed to help customers purchase its products. Managers in all kinds of industries assumed that if the cash on hand or the future cash flows of high-tech start-up companies were not sufficient to finance their purchases of needed equipment, the capital markets and private equity firms would cooperate. But investors abandoned that faith many months ago.

    How can vendors protect themselves in the future? It probably isn?t necessary for them to drop the practice of financing their sales, but they will need to scrutinize borrowers more closely and to adopt better risk-management techniques.

    During the good times, companies like Lucent and Nortel Networks expanded their vendor financing at nearly triple-digit compound annual growth rates.

    By the end of last year, we estimate, there was at least $25.6 billion worth of loans on the books of nine global telecom giants: Alcatel, Cisco, Ericsson, Lucent, Motorola, Nokia, Nortel, Qualcomm and Siemens. Total vendor financing by the five North American companies in that group equals 123 percent of their pretax earnings in 1999. Perhaps 35 percent of this credit has gone to telecom and Internet start-ups, including competitive local-exchange carriers (CLECs), data local-exchange carriers (DLECs), competitive interexchange carriers (CIXCs), fixed-wireless providers and dot-coms, many of them now reeling. Since loan losses in excess of reserves are charged to current earnings, high rates of default will have a substantial and immediate impact on the vendors? financial performance.

    (Vendors) will need to scrutinize borrowers more closely and to adopt better risk-management techniques. The true extent of the underlying credit problem is hard to determine, since companies are not obliged to report even the total amount of credit they have extended to customers, let alone the true level of nonperforming assets; many companies incorporate their credit losses into a general-restructuring expense. But what we have gleaned from company interviews and financial analysis suggests that as much as 30 to 40 percent of the $25.6 billion outstanding is at risk.

    Lucent, for example, took a $501 million charge to earnings in its fiscal 2000 to reflect its customers? unpaid debts (equivalent to 41 percent of 2000 earnings). Although Cisco?s financial statements provide little detail on its exposure, the company has an estimated $2.4 billion in vendor loans outstanding, and in 1999 it suffered a $60 million credit loss from a single customer. At Nortel, vendor financing represented almost 7 percent of revenue last year.

    Telecom start-ups and dot-coms without earnings or credit histories managed to obtain significant credit from their equipment suppliers on terms they could never have obtained from a bank. Such loans were in effect a discount on the price of the equipment. Many of these uneconomic loans were motivated by a fear of losing relationships with the likely purchasers of the equipment vendors? next-generation offerings.

    Most companies lack loan workout specialists and are able to recover only a small portion of the original loan when debts go bad. Repossessing the unpaid-for equipment barely offsets the losses, since it has in the meantime drastically depreciated in value. Cisco, for instance, estimated that gear it sold to obligor Digital Broadband Communications would fetch only ten cents on the dollar in a bankruptcy auction. In a recent liquidation, a Cisco 7500 Series router, which sells for $150,000 new and for $11,000 after being refurbished, fetched just $1,850. Even worse, the flood of used equipment on the market depresses sales of new equipment. The combination of reduced sales and massive write-offs will batter the equipment providers? bottom lines still more.

    Finding the cause
    Much of the problem can be attributed either to the vendors? lack of awareness of best lending practices or to pressures to circumvent them. At most companies, vendor finance loans are initiated by the sales force; only then do credit underwriters assess the risk and set a price. But these underwriters often lack even basic tools, such as credit-scoring models. While it is not impossible for rigorous credit analyses to be conducted within a sales unit--provided that its credit managers receive the independence, the authority and the time they need--the soundest finance decisions are usually made by a separate treasury or finance department.

    The combination of reduced sales and massive write-offs will batter the equipment providers' bottom lines still more. Prudent risk management requires companies to maintain reserves for expected losses, just as banks do. These reserves should be based on the probability of default and the expected magnitude of the loss in the event of default. In addition, it is necessary to maintain sufficient capital to withstand the unexpected losses that will occur periodically. The expected losses and the cost of the capital set aside for unexpected losses represent the economic cost of extending credit. Regrettably, few companies have taken this cost fully into account.

    By taking advantage of new advances in credit derivatives and other hedging instruments offered by investment banks and brokers, companies can transfer at least some of their credit risk to investors. In effect, a vendor can insure against the bankruptcy of its largest customers, or it can offset its entire credit risk by purchasing a customized portfolio of so-called default swaps, if it does so before a major crisis makes the price of credit protection uneconomical--the situation of today?s telecoms.

    Investors would benefit if companies reported the amount of their vendor finance outstanding (including future credit obligations and loan guarantees to customers) as well as the quality of their credit portfolios. Banks, for example, must publicly disclose their nonperforming loans, declare their losses and hold capital to cover potential loan defaults.

    Although the total volume of vendor finance doesn?t appear separately on the balance sheets of companies, Wall Street analysts should have noted with concern the explosive growth of receivables. Rating agencies downgraded several large telecom-equipment providers only last autumn, well after they had taken on a huge exposure to risk. Spreads for telecom bonds, reflecting an assessment of increased risk, have widened by 300 basis points since April 2000, but vendor finance had already started to explode back in 1997 and 1998. We expect it will get worse in coming months, as borrowers face increasing cash constraints and their revenue is hit by an abundance of used equipment for sale.

    Specialized "vulture" investors can take advantage of the current troubles by purchasing vendor debt at steep discounts and then pursuing collections and arranging workouts. Several investment banks and financial boutiques have been looking at new ways market such debt to a bearish investment community. Vendors will be grateful for the cash and for being freed from an operational burden.

    Such steps would merely make a bad situation somewhat better, while the practice of vendor financing itself cries out for reform. It is understandable that telecom suppliers pursuing continued rapid growth would turn to vendor financing to stimulate sales and help finance the ambitious plans of their customers. Unfortunately, most lacked the risk-management tools, the organizational checks and balances, and the credit culture needed to assess and manage the risk associated with the huge bets they were placing on their customers.

    For more insight, go to the McKinsey Quarterly Web site.

    Copyright © 1992-2001 McKinsey & Company, Inc.