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."