In recent years, the big network equipment makers captured new customers by providing them with money to buy gear to build networks. But many start-ups such as those offering digital subscriber line (DSL) services are flopping--and that's bad news for the network equipment providers that loaned them money.
While Wall Street analysts say it's too soon to tell how much loan defaults will affect Lucent, Nortel and Cisco, they predict potential big losses. More start-up telecommunications carriers are expected to die this year. And the survivors won't spend as much on networking equipment as they have in the past. Troubled WinStar Communications, for example, is stopping construction on its network to focus on profits.
"It's quite a debacle. There will be massive consolidation in the (start-up service provider) market," said financial analyst Michael Davies of Landenburg Thalmann. "Long term, the networking companies will recover and get beyond this, but in the next two or three quarters, they will see an impact."
Analysts say the faltering start-up carriers are affecting network equipment makers in three ways: Some start-ups can't repay their debts, forcing networking companies to eat the loans. These now gun-shy networking companies like Lucent, Cisco, and Nortel will see reduced sales because they are loaning less to carriers that otherwise can't afford to buy new equipment.
And bankrupt service providers will resell their networking equipment for cut-rate prices.
"Some carriers can buy used products that are just as good and significantly cheaper. That will detract from revenue growth (for the networking companies)," Davies said. "The used equipment will have a lingering affect for a couple of quarters at a minimum."
Bills pile up
Networking companies are feeling the pain brought on by their struggling customers. For example, ICG Communications, which filed for bankruptcy last fall, owes $42 million to Lucent and $18 million to Cisco. Picus Communications, which recently went out of business, owes Nortel $1.4 million. And earlier this week, Cisco said Convergent Communications defaulted on its loan.
The number of struggling emerging carriers continues to grow. Internet service provider PSINet last week said it is running out of money and may file for bankruptcy. NorthPoint Communications recently laid off more than two-thirds of its work force, shut off service to thousands of customers, and sold its remaining assets to AT&T. Covad Communications shut more than 260 central offices and announced a profit warning in February.
Cisco, Nortel and Lucent representatives say the companies have strong guidelines established to approve loans to customers.
"We're being more selective in how we use this as a resource," a Lucent spokeswoman said. "We continue to evaluate opportunities on a case-by-case basis and offer financing only when it makes good business sense."
Most analysts believe Lucent is more at risk from bad loans than Nortel and Cisco, both now and in the near future. Last October, Lucent blamed its earnings warning partially from start-up carriers that couldn't pay their bills.
"The companies with the stronger product lines, Cisco and Nortel, have the opportunity to pick the best accounts," said B. Alexander Henderson of Salomon Smith Barney. "Lucent has a much weaker portfolio, and they're more desperate for business."
Lucent loaned $1.8 billion with a total of $5.7 billion in loan commitments, while Nortel loaned $1.8 billion with a total of $4.1 billion in loan commitments, according to the companies. The term, "loan commitments," is the total amount Lucent has promised to loan to carriers if they comply with all facets of the loan agreement such as making profit numbers.
Cisco in January announced it had $475 million in loans for its last quarter. Of that amount, $340 million was loaned to established customers, while $135 million went to start-ups, according to analyst company SG Cowen.
After Lucent's warning in October, Cisco and Nortel executives were quick to maintain that Lucent's problems with bad loans are isolated. Cisco, for example, said it has taken a conservative approach by accounting for bills potentially going unpaid, nullifying the impact of such expenses on the bottom line. But in their latest filings with the Securities and Exchange Commission, Cisco and Nortel state that future loan defaults could harm their businesses.
Henderson, of Salomon Smith Barney, predicts some one-time charges this year resulting from bad loans.
"There will be some sizable write-offs," Henderson said. "But it's not that big a deal forward-looking. Are they going to take charges that impacts them from an operational perspective? Not really. It's really a one-time charge, and it goes away."
Cisco above the fray?
Another analyst, speaking on the condition of anonymity, said Cisco faces the least risk from bad loans. "They don't have as much exposure," the analyst said. "It could be a few 100 million of doubtful accounts. They can write that off and hit their bottom line a little bit. Lucent and Nortel would have a much larger scale write-off because their exposure (to loans) is larger."
Larger companies have long offered financing deals to customers to help make a sale, especially in the once highly competitive technology market. But with the capital markets drying up as venture capitalists and banks lend money less freely, networking companies may face increased pressure to offer loans to potential customers to make a sale.
Smaller networking companies like Cisco rival Juniper Networks have been unscathed because they don't offer loans. But Cisco, Lucent and Nortel say they still plan to offer financing to customers, just not at the same pace as they have before. Lucent, for example, said it is taking more of a critical eye toward loan applications, but will still finance companies in emerging areas such as wireless.
For example, Nortel executives on Thursday said it's unlikely the company will dangle loans to win contracts from European service providers that are building their wireless networks, according to a Reuters report.
"There will be a trend to reduce the level of financing offered. It makes sense in this environment," said SG Cowen analyst Michael Jung.