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Rhythms' Plight May Trouble Cisco

Another specter of vendor financing dangers may be coming to haunt the market. Consider Cisco’s recent $50 million financing commitment to Rhythms Netconnections (Nasdaq: RTHM).

On the same day Rhythms announced equipment financing from Cisco, it also said it had put off a $5.1 million quarterly payment on its Series F Cumulative Convertible Preferred Stock. Though coincidental, the move raises the question: Why would Cisco lend to a firm that can’t pay its bills?

Networking equipment vendors repeat a familiar refrain when asked about their practice of financing customers. Each big vendor -- including Cisco Systems Inc. (Nasdaq: CSCO), Nortel Networks Corp. (NYSE/Toronto: NT), Lucent Technologies Inc. (NYSE: LU), and Alcatel SA (NYSE: ALA: Paris: CGEP:PA) -- maintains that it's a more conservative lender than its rivals.

But the amounts each vendor has committed to financing have increased dramatically in the past few quarters, partly because of a downturn in the financial markets (see Report: Vendor Financing).

In this case, Rhythms says it has the money to make its payment on the note -- $748 million in cash and investments as of September 30, to be exact. Rhythms didn’t pay, though, because the terms of the Series F Preferred Stock agreement require it to issue more shares of stock to raise the money with which to make the payment.

Such an arrangement would have forced Rhythms to float more than 4 million shares, which would not have pleased stockholders, to say the least. Therefore, Rhythms said it would put off payment until market conditions improve, then it would make its payment plus interest.

Unfortunately for Cisco, that's only one thing about Rhythms that raises a red flag.

Rhythms is plodding along in a treacherous sector, the DSL (digital subscriber line) service provider market. Its fellow plodders have been mired in a swamp of bad news lately. NorthPoint Communications (Nasdaq: NPNT), where the CEO seems to have lost her charm with Wall Street analysts, is still reeling after Verizon Communications (NYSE: VZ) said it no longer wanted to buy the struggling firm (see Carriers Hit Back at Wall Street). XO Communications Inc. (Nasdaq:XOXO) has had to curb its European buildout due to tougher market conditions. Analysts estimate XO will now need some $4.5 billion in financing to improve its cash flow situation.

Meanwhile, Rhythms burned through $210 million in its September quarter, and its managers say it will need $1 billion to $1.5 billion in additional capital for it to break even by the year 2004. Its stock closed at $0.74 Wednesday, way off it’s 52-week high of $50.

But Cisco keeps on lending. To be fair, only Cisco knows how much risk it can afford to take. Though its representatives ignored requests for comment, research from Morgan Stanley Dean Witter says that Cisco has adequate reserves for bad debt.

The company's motivation probably comes from two areas. First, Cisco wants to improve its share of the DSL Access Concentrator market, where it trails Alcatel and Lucent, according to a report from The Dell'Oro Group. At a time when equipment such as DSLAMs (DSL access multiplexers) are selling at higher prices, vendor financing helps Cisco move some gear, as it helps Rhythms grow.

Second, and most significant, is the fact that Cisco’s already closely tied to Rhythms. At one point, about 30 percent of the total Rhythms DSL lines in service were bought by Cisco for the use of its employees, according to a June 2000 filing with the SEC. Also, Cisco committed at least $75 million in equipment lease financing to Rhythms between April 1999 and February 2000.

All told, Cisco’s willingness to lend in a sector that’s as rickety as DSL pure-plays speaks volumes about the state of vendor financing in general. Vendors such as Cisco won’t turn down a bad risk, because their stock valuations and reputations hang on the ability to deliver revenue growth to shareholders -- no matter what it takes to move equipment.

Investors can’t help but worry when vendors lend millions to companies that seem to be struggling.

“I think that in a market in which quantities are scarce, everyone's going to use their capabilities to suit their own purposes,” says Scott Ashby, legal director for Alcatel's project finance group. One has to wonder, though, how cautious equipment makers will be, as vendor financing is used more as a weapon than a tool.

-- Phil Harvey, senior editor, Light Reading http://www.lightreading.com

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