Like eating Jell-O with chopsticks, finding funding for startup service providers is difficult. After a few years of being viewed as hot property by the financial community, these carriers are now seen as risky businesses. That unsavory label has left the fledglings at a loss for ways to continue funding the rollout of their networks.

Enter vendor financing. The big manufacturers of telecom equipment don't want to see part of their potential market shrivel up and die, so they're leaping into the vacuum left by the capital markets and committing billions in equipment financing to these carriers.

But what’s being done to shore up cash-strapped service providers has many wondering whether today’s big equipment vendors are walking through a forest fire on wooden stilts. Indeed, the practice of vendor financing — where vendors loan service providers money to buy their own equipment — is coming under increasing scrutiny (see SEC Cracks Down on Book Cooking).

The reasons for this are many and, remarkably, the vendors doing the most lending are the least willing to talk on record about the specifics of their practice. Cisco Systems Inc. (Nasdaq: CSCO), Nortel Networks Corp. (NYSE/Toronto: NT), Lucent Technologies Inc. (NYSE: LU), and Alcatel SA (NYSE: ALA: Paris: CGEP:PA) were all approached for this article, and only Alcatel provided a qualified representative. (Not that he could reveal much, but he was a good sport.)

To be fair, the aforementioned vendors have begun addressing vendor financing issues in their quarterly earnings calls, and each assures investors that they’re conservative lenders and that the practice is no cause for alarm. (Of course, we wouldn’t be doing our jobs if we didn’t doublecheck their claims.)

And while it’s true that each vendor’s financed contracts are but a tiny percentage of their overall revenues, it’s also true that the amount of money committed to customer loans is growing quickly.

According to SEC filings and other published research, Alcatel, Cisco, Nortel, and Lucent have committed about $1.5 billion, $2.5 billion, $2.1 billion, and $7 billion, respectively, to vendor financing. It’s important to note that a commitment is only a promise; the amount of money actually drawn down, or in use, by each service provider varies. In some cases, service providers don’t use any of the funds a vendor’s committed to them.

However, the amount of financing each vendor has committed has grown considerably in the past year or so. Lucent, for instance, only had $2.3 billion in financing commitments in 1998. Last quarter that number hit $7.7 billion and now it’s down to $7 billion. Nortel’s balance sheet, too, will continue to be a weapon in its arsenal. Analysts predict its financing commitments will grow to between $3 billion and $3.5 billion in 2001.

Also increasing is the number of troubled service provider whose misfortunes underscore the ugly side of vendor financing. Before it went bankrupt, ICG Communications Inc. (Nasdaq/Neuer Markt: ICGX) had drawn down on $99.1 million of a $180 million financing commitment it had from Cisco. Cisco may never get all its money back. (see ICG's Sinking Ship and ICG's Dark Cloud).

And while equipment vendors used to fancy themselves as arms dealers supplying weapons to all combatants in the service providers’ war, the uptick in financing shows that these vendors are choosing sides. In fact, some analysts view the aggressive financing tactics of vendors as an act of desperation to win contracts and nudge their way into new markets. An example more than one analyst pointed to was Nortel’s $1 billion commitment to Aerie Networks, a greenfield carrier that only began laying fiber in October (see Nortel's $1 Billion Pipe Dream).

That said, this report will endeavor to give readers a snapshot of the practice of vendor financing, as well as some analysis of where it will lead the industry if not managed carefully.

Read the report sequentially, or click on any of the pages hyperlinked below:

What is vendor financing?
Vendor financing fills the funding void
Why vendor financing is a "win-win"
When balance sheets attack
Before discussing vendor financing's impact on the telecommunications business, it helps to define the practice. Vendor financing occurs when an equipment vendor uses its investment-grade balance sheet to help its customers buy its equipment.

While each vendor financing case varies depending on who's being funded by whom, the service providers requiring vendor financing usually have credit profiles that are weak enough to prevent them from getting all of their funding from other lenders. Also, these service providers typically don't have enough cash to buy the equipment they need to fulfill their business plans.

Cisco, Nortel, and other big equipment vendors won't talk about what conditions their respective vendor financing arrangements include. But carriers confirm that equipment vendors, for starters, usually finance equipment at a lower rate than would a bank.

When it's clear what the service provider needs, it will usually get term sheets that will detail the amount of financing offered, the date of delivery of the equipment, and the conditions at which the vendor will be paid back.

Like a using a Visa card, service providers may have a committed amount of financing from the vendor, like a credit limit, but they don't have to use it. And depending on how the financing is structured, the service provider may have to meet certain business goals before it can draw down on more than half the committed amount.

On the vendor's side, after it finances a sale, the vendor counts the sale as part of its revenues, and the financed equipment shows up as an asset on its balance sheet.

In his report, "The Other Side of Leverage," Lehman Brothers convertibles analyst Ravi Suria writes that vendor financing is a double-edged sword for the vendor, because it could mean a deteriorating balance sheet, and for the service provider, because it aggravates their already weak credit profile.

But vendors often resell their loans to financial institutions, though that's becoming tougher as market conditions have grown gloomy. And, increasingly, vendors arrangements with financial buyers have become more creative. Alcatel, for instance, has an arrangement with Citibank where a trust buys interest in a portfolio of Alcatel's loans to customers.

At a recent meeting with reporters, Nortel CEO John Roth remarked that Nortel has been "very adept at laying [vendor financed debt] off with little impact" on its balance sheet. What's unclear, though, is whether vendors can keep selling loans to banks that have had their fill of telecom debt.

"The clear takeaway from the vendor financing situation is that its important role probably masks the total indebtedness of the services sector when looked at from the viewpoint of primary borrowing," Suria writes.

Carriers can finance the buildout of their networks in a variety of ways. Among the most popular are stock offerings, bond offerings, obtaining venture capital, and working with corporate bankers to arrange equipment leasing or corporate loans. These means of financing are linked in that they're all subject to how much risk the bank, the VC, or the investing public is willing to take.

All other things being equal, service providers don't rank vendor financing as a critical decision point when they're evaluating a vendor, says Kevin Mitchell, an analyst at Infonetics Research Inc.. In his report, "The Service Provider Opportunity 2000," Mitchell asked service providers to rank the criteria they use to choose an equipment vendor. Small and large service providers alike ranked several factors -- including technology and support -- ahead of financing.

But in the current climate of investor uncertainty, other financing avenues aren't as open as they were a short while ago. Indeed, in the past few months, investors have been spooked by everything from components shortages to feared carrier spending slowdowns (see Market Sell-Off Clips Optics and Cisco Caught by Capex Concerns).

This helps explain why vendor financing has become more important for vendors to win business. In the throes of the late 90s bull market, investors didn't question whether service providers' revenue growth would slow; nor did they ask what service providers would do when the financial markets stopped funding a basketful of copycat CLECs (competitive local exchange carriers) in every major city.

Indeed, Suria's report notes that telecom services' share of the convertibles market increased from 5 percent in 1998 to about 20 percent in 1999. (Convertibles, by the way, are corporate securities that can be converted to shares of the issuing company at a set price, if certain conditions are met.)Telecom companies peddled a lot of debt using convertibles, and now the concern is that those companies, which have found it hard to wring revenue from their networks, won't have the cash flow to cover their interest payments.

Likewise, data from Merrill Lynch & Co. Inc. (NYSE: MER) shows that telecommunications companies have the highest share of the high-yield bond (or junk bond) market, which is chock full of companies that have unproven or shaky credit histories.

Suria writes that in 1999, "when value investing went out the window and the market was almost completely obsessed by the technology-laden Nasdaq, it was appropriate that the convertibles market -- as a premier source for financing emerging growth companies -- should post its best-ever returns."Alas, the party didn't last.

Suria's report further notes that after posting the best industry returns in the convertibles market at 121 percent last year, the telecom sector has fallen to become the market's worst performer, with year-to-date losses in 2000 of negative 31 percent.

Another factor that soured investors and the capital markets is that capital spending growth by service providers has outstripped revenue growth every year since 1996. This means that returns on invested capital are quickly eroding, and investors aren't willing to wait as long for service providers to see a return on their capital spending.

In his report, "Telecom Sea Change Creates Overcapitalization," Lehman Brothers analyst Blake Bath notes that since 1996, capital spending has grown an average of nearly 26 percent a year. Over the same period, however, total revenue for the sector has only grown 10.5 percent.

"Clearly, this 2.5:1 ratio of capital growth to revenue growth cannot continue indefinitely, although we may not yet have hit bottom," Bath writes.

Recent stock market gyrations have only amplified such concerns (see Morgan Report Socks Equipment Stocks). And though venture capital investing hasn't slowed much this year, telecom VCs are unanimous in saying that they're much more selective when funding upstart carriers (see VCs Boost Optical Investments ).

The result? Service providers are turning to vendors for funding. "You can't hope to play in this field if you can't offer vendor financing to your clients," says Ariane Mahler, an analyst with Dresdner Kleinwort Benson. "Carriers are all becoming more dependent on vendor financing as other avenues for financing have closed."

Vendors are definitely damned if they do and damned if they don't. If they don't offer to finance a struggling customer, the customer could default on its loans and cause the vendor to have reduced earnings or write-offs. If they do finance, it may prolong a dying business, which will create bigger problems down the road.

In a Barron's article on lending, Bob Konefal, head of the telecom, media, and technology groups at Moody's Investors Service, said that once vendors have stepped in, it's increasingly hard to step away. "In some cases, the equipment manufacturer may already have some exposure to a company that needs capital, so it's in the manufacturer's best interest to keep their customers alive."

Service providers have much to gain from vendor financing. First and foremost, they get access to gear that they desperately need to build their networks. And, rather than having to pay for all the gear they're using up front, they make monthly or quarterly payments, depending on the conditions set with the equipment vendor.

Especially lately, equipment vendors have been more willing to finance service providers -- and they work faster to make a deal happen -- than banks and financial institutions. "We could have built our network without vendor financing," says Cogent Communications Inc.'s CEO and founder Dave Schaeffer. "But it would have been more difficult, and it would have taken longer."

Schaeffer, who has a $280 million financing arrangement with Cisco, says he evaluated term sheets from six different vendors, each worth more than $200 million. "For the most part they all had fairly comparable terms," he says. "There wasn't a dramatic difference in terms of the actual amount of financing."

A "soft" benefit for carriers that take vendor financing is that the vendor, once committed financially, is often more willing to help in non-financial ways. For instance, large equipment vendors certainly don't miss many chances to publicize their customer wins, especially in this hyper-competitive market.

Depending on the level of commitment to one vendor, a service provider might ride a wave of publicity as the vendor touts its conquest in financial conference calls, in press releases, and in advertisements.

Take Cambrian Communications. Cisco reportedly financed most or all of its recent $150 million deal to buy Cisco's gear (see Cisco Plods Toward Optical Portfolio). How else would Cambrian, a company with only $11 million in funding, be able to bite off such a contract?

"We've seen Cisco step up their efforts on the vendor financing side in the last 8 to 9 months, and its difficult the tell if it's a function of them wanting to penetrate the service provider market or if they're reacting to stepped up activity from Lucent and Nortel," says Mark Edelen, an analyst with Thomas Weisel Partners.Cisco touted its deal with Cambrian in conference calls and by phoning journalists. The big news here, according to Cisco, was that Cambrian was proof that Cisco's oft-delayed ONS 15900 Wavelength Router had paying customers.

But a closer look revealed that it would be several months before Cambrian was even ready to receive the ONS 15900. "The way we're going to be deploying our network, the capabilities coming from the Monterey product aren't needed early on," said Cambrian's chief operating officer, Jose Cecin, at the time. (Cambrian would not comment for this article).

Which raises the question: Would Cambrian have agreed to have it's name linked with an unproven product had it not received a financing package?

This brings us to how vendors benefit when they decide to step into the financing void left by banks and other professional risk managers. The most obvious benefit, of course, is that the vendor gets a multiyear customer contract.

If a service provider succeeds in building a network and then making revenues off the services it offers, the equipment vendor stands to win big by making money back on its financing, but also in new equipment sales to an established customer.

In the race to gain market share in optical networking and other hot equipment sectors, vendors that provide financing also can get their service provider customers to agree to things that a cash-rich carrier would not. As alluded to earlier, vendors might urge them to take on equipment that's not ready for broad deployment.

"Some vendors are just more hype than reality," cautions Cogent's Schaeffer. "You shouldn't assume that just because you're dealing with a big company that they have a real product."

Also, the vendor might get the service provider to agree to have a certain portion of their network come from them. Or the vendor might assist an upstart carrier in designing its network, which gives the vendor ample opportunity to build in more equipment and costs than may be strictly necessary.

On the whole, though, the vendor's primary gain by financing a service provider is a customer relationship that's theirs to lose. "Vendor financing definitely leads to a clearer-cut relationship," Schaeffer says. "They need to help you and you need to help them."

It goes without saying that the recent increase in vendor financing activity is causing concern across the industry. The large equipment vendors -- including Cisco, Nortel, Lucent, and Alcatel -- have tried to quell concerns by emphasizing their conservative approaches and by saying they evaluate each financing opportunity on a case-by-case basis. Also, they point out that since only a tiny percent of their contracts are financed, the practice isn't a big deal.

What's more telling, though, is what the vendors won't talk about. While each vendor constantly promotes multimillion-dollar deals by issuing press releases and calling reporters, they clam up when asked for details.

Also, while insisting that they're taking conservative risks on good companies, vendors hardly disclose any details of their financing deals in the documentation they file with the SEC, and only recently have they even addressed such topics on conference calls with investors.

What's clear, analysts say, is that there are too many service providers paddling about in the same business pool. And with the capital markets being more selective, the concern is that vendors will go overboard in their financing activities, mistakenly using financing to delay the inevitable shakeout. And while a weak service provider is kept afloat with financing, they say, it continues to add to the price competition in the industry, which is increasingly cutthroat.

"The equipment vendors won't be able to finance everybody," says Dresdner Kleinwort's Mahler. "You can't finance the 3G [wireless network] equipment contracts, and fiber buildouts in Europe, China, and the U.S. Some carriers just are not going to make it."

Even as a carrier shakeout hits, however, equipment vendors with blue-chip customers won't be irreparably harmed. A recent report by SG Cowen noted that last year's combined capital spending of 10 troubled service providers -- Choice One Communications, GST Telecommunications, ICG Communications Inc. (Nasdaq/Neuer Markt: ICGX), McLeodUSA (Nasdaq: MCLD), Mpower Communications, Network Access Solutions, PSInet Inc. (Nasdaq: PSIX), RCN Corp., Savvis Communications (Nasdaq: SVVS), and Teligent (Nasdaq: TGNT) -- accounted for less than five percent of the total capital spending of North American service providers.

At the same time, analysts are concerned that if vendor financing is not managed more carefully, it will slowly erode an equipment vendor's financial health. One specific concern analysts have is when a vendor's cash flow from operations grows at a slower rate than its revenues.

Generally speaking, if a company has rapid revenue growth, it should have an increase in cash. If it doesn't, there's a problem. Perhaps its customers owe it too much money.

And, if there's more cash going out of a company than coming in, Wall Street will eventually notice, and even the high-growth networking champs will be stung if their financing practices are perceived as too generous.

"We think there's a natural boundary between banks and networking equipment companies," says Scott Kriens, CEO of Juniper Networks Inc. (Nasdaq: JNPR). "Operating in both spaces doesn't give sustainable leverage as a business model. We do help in certain situations where we think the service providers are bringing powerful new business models to market. But in general, buying routers from banks is a bad idea and buying money from networking companies is a bad idea."

Of course, vendor financing concerns aren't limited to the equipment giants. Service provider Iaxis Ltd. recently stuck Ciena Corp. (Nasdaq: CIEN) with $28 million in uncollectible bills (see Ciena Spooks the Market). Also, Sycamore Networks Inc. (Nasdaq: SCMR), whose CEO once said it wouldn't get into the vendor financing game, recently offered two customers a $200 million vendor financing commitment (see Why Sycamore Changed Its Mind).

On the one hand, such smaller equipment vendors can't offer financing perks as complete as those a Cisco or Nortel can offer. On the other, service providers are pressed to succeed, and if they choose a point solution over a whole product line, some bit of vendor financing helps sweeten the deal.

What's exacerbated the funding situation is that the deregulated telecommunications markets have allowed for more competitors. These companies use more equipment to compete and need more capital to fund their operations, says Scott Ashby, legal director for Alcatel's project finance group.

Often the buildout of high-speed networks has been compared to other infrastructure overhauls, such as the construction of railroads (see Optical Train Wreck?). Interestingly, railroad buildouts happened over a much longer period and occurred in either a monopolistic or regulated environment, writes Lehman's Suria. Rather than having built-in customers, service providers are realizing that once their networks are complete, they still have to compete tooth-and-nail for customers by offering cut-rate prices for services.

Rather than risk their long-term financial health by continuing to step up their vendor financing activities, analysts say vendors should become more selective and fund only the most promising service providers.

"It's a case of handling 'winner's curse,' " says one analyst. "You don't win every contract, all the time. You give up a little market share and manage yourself carefully through the process, knowing that it's better to be fiscally healthy in the long run. Hopefully, you'll be able to make up market share by buying competitors when they start to have financial difficulties."

Such a thought might be laughable to vendors who've come from the speed-driven Internet culture, where metrics such as share price and double-digit revenue growth are valued more than sustainable business practices and overall financial health. But so long as vendors tread carefully when they're done laughing, they'll manage their financing cautiously and back service providers that won't burn them later on.