Three weeks ago I wrote a column about companies such as Cisco Systems (Nasdaq: CSCO), Nortel Networks (NYSE: NT), and Lucent (NYSE: LU) lending money to telecommunications service providers (SPs). Tonight, I'd like to explore why SPs have turned to equipment makers for funding. I'll also look more closely at ICG Telecommunications (Nasdaq: ICGXQ) and Pacific Gateway Exchange (Nasdaq: PGEX), two service providers for which Cisco recognized bad debt earlier this year.
As businesses mature, it's not unusual for the way they are valued and analyzed to mature as well. Initially (1996-1998), competitive local exchange carriers (CLECs) were building out their networks, a stage early in their lifecycle. The focus at this point was on things such as identifying addressable markets. No one really focused on how the money invested in fixed assets would create revenues. Stocks soared, money was easy to find, and these companies financed much of their activity with debt.
In the next stage of their lifecycle (1998-1999), investors became more concerned about the operating metrics of CLECs. Revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA) became more important. Here the focus was on getting customers. At this point there were finally some concerns about business plans.
Even though some CLECs are customers of Cisco, you still might be wondering what the relevance of this is to Rule Maker investors. While we often talk of how much more important business quality is than valuation, when we look at what company in our portfolio should receive additional funds each month, we're not totally value-blind.
In simple terms, the true value of a company is dependent upon its ability to generate future cash flows. This is one of the primary reasons that Cash King Margin was added to our Rule Maker criteria. The basic idea here is that we want to invest in companies able to generate significant amounts of cash earnings and also reinvest those earnings in ways that will lead to significant gains in the future.
Through the first two stages of the CLEC lifecycle, this basic element of value was largely ignored. People became so excited about the bandwidth boom and the opportunities that they failed to focus on whether CLECs would earn a satisfactory return on their investment in terms of positive cash flow. This factor is particularly important for those CLECs that have relied on debt to finance their growth. Companies unable to generate positive cash flow will ultimately be unable to repay their obligations and fail.
Many of the CLECs and other start up carriers have been so focused on building their networks that they failed to grow revenues or customer bases at an acceptable rate. They over-expanded their networks without realizing commensurate revenue growth. These companies were purely in build mode and operated under the assumption the capital markets would continue to provide funds even though they were losing money and failing to generate positive cash flow.
Initially, this wasn't a significant problem, but then the rules changed -- capital became scarce. Scarce capital led to heightened scrutiny. CLECs were unable to hit business targets due to such factors as increased competition, difficulty in acquiring new customers at anticipated rates, and higher-than-anticipated expenses. CLEC operations weren't generating enough cash, and when they turned to the capital markets, they weren't able to secure funding as easily as before. So the CLECs and other carriers turned for help.
This situation has put companies like Cisco, Nortel, and Lucent in a difficult position. They need to sell their products. CLECs that are building new networks are important potential customers. So, deals have been worked out whereby the equipment makers fund service providers like the CLECs. Unfortunately, not all the CLECs have well-developed business plans and some of these loans have gone bad.
Lucent has been particularly hard hit by these events. Last week it announced a $679 million reduction in revenues, much of which could be attributed to problems with CLECs.
Cisco hasn't been immune either. While it has made appropriate reserves to cover these losses, two of its customers are in serious trouble. According to Cisco, ICG Communications, which filed for bankruptcy in October, had just shy of $100 million of outstanding Cisco loans. Pacific Gateway Exchange, an international carrier, also defaulted on $2.7 million in loans from Cisco earlier this year.
In correspondence with the company, Cisco has told me that it is "extremely conservative in its decision- making process in vendor financing, as well as its accounting treatment." Let's look at the financials for ICG and Pacific and see what we find out. (Note: CFO stands for cash from operations; purchased PP&E is property, plant, and equipment; and FCF is free cash flow.)
Pacific Gateway ($ in 000s) Sep-00 1999 1998 CFO ($18,835) $30,372 $28,914 PP&E (31,646) (69,644) (49,611) Sold PP&E 49,776 0 0 FCF (705) (39,272) (20,697) Current debt 55,165 54,760 9,136 L/T debt 0 10,604 99 ICG Communications Inc. ($ in 000s) Sep-00 1999 1998 CFO $139,163 $21,083 ($100,060) PP&E (649,096) (591,518) (355,261) Sold PP&E 20 4,300 168 FCF (509,913) (566,135) (455,153) Current debt 56,557 8,886 4,892 L/T debt (*) 3,430,945 2,488,572 2,127,846 (*) L/T debt includes preferred and convertible preferred stock.While I admit I haven't carefully studied the operations of Pacific Gateway and ICG, after taking a closer look at these numbers I find it hard to imagine either would have been able to repay debt any time soon. In fact, both were adding debt and failing to generate enough cash to fund either operations or debt repayment. I also can't say I'm convinced loaning significant sums of money to a company like ICG is an example of conservative lending practices.
The lesson from all this is that when looking at investments, we should shy away from investing in the latest hot industry unless we've taken time to research and understand the company, its business model, and its vision for future success. Typically, the strongest companies thrive. The weak shouldn't receive money from capital markets or from individual investors.
Have a great afternoon. I'd also like to wish a happy, healthy, and safe New Year to all.
Phil Weiss, TMF Grape on the Discussion Boards