Telecom firms have driven the ball into deep U.S. Open rough with vendor financing deals. Getting out will take strength and discipline. I'm not sure how many golf courses there are in Finland, but Nokia (NYSE: NOK) seems to be as confident about its future as Tiger Woods.
Just as most telecommunications equipment manufacturers are wishing they'd stayed out of the banking business, Nokia is diving in head first. Have the long winters finally cracked those Finns, or is it something else.
First, let's look at what Nokia could be headed for.
What is vendor financing?
Vendor financing is when equipment manufacturers extend credit to customers so that the customers can buy their equipment. I loan you $1.00 so you can afford to buy my lemonade for which you will eventually pay me $1.05 as soon as you start making money of your own. It's not unlike Henry Ford's thinking when he lowered the price of Model T's so his workers could afford them. Vendor financing is nothing new, but the brick-wall slowdown in capital spending over the last few quarters has brought the issue front and center.
The logic behind vendor financing is simple. Original equipment manufacturers (OEMs) like Nokia, Motorola (NYSE: MOT), Lucent (NYSE: LU), and Nortel (NYSE: NT) want to sell their equipment, but the great majority of their customers are cash-poor. So, the growth-hungry OEMs loan the start-ups money and equipment to build their high-tech networks. Once in motion, the cycle perpetuates itself.
It's businesses the American way -- built with credit. In a growing market, everyone is happy. The OEM is happy because growth rates are high, and the network companies are happy because they don't have to dilute the little amount of equity they have or hassle with bank credit lines or loans. (Those banks can be such sticklers when it comes to positive cash flow!) Even you and I are happy because with each new fiber cable laid and wireless base station built, we get closer to our dream of always-on, high-speed Internet connections.
Over the past few years, OEMs have been dolling out credit to these fledgling companies at an astonishing rate, fueling hypergrowth. The most famous -- excuse me, notorious -- case was Lucent and its all-too-generous $7 billion in financing commitments.
The problem is nobody anticipated the abrupt decline in capital spending even though the signs of trouble were evident in the financials of many of the big-tech names. Next comes the domino effect. As the start-ups fail, the OEMs lose revenue, and -- just like buying on margin -- things get exponentially worse. Not only do OEMs lose customers, but, unless they were very conservative in booking revenues, they get hit twice on the revenue front. First, future revenue slows because of fewer customers. Then come the write-offs for uncollectable revenue. Some big names got in deeper than others, but none of the OEMs has escaped. There goes my $1.00 and the $0.05 I thought was income.
Vendor financing does have its merits. Relationships between OEMs and network builders are strengthened by these financial ties. Network builders like Winstar (Nasdaq: WCII) are more likely to make repeat purchases from a company like Lucent that has loaned it $2.0 billion rather than shop around for a slightly better deal. But, just like buying on margin, the downside pain is more poignant than the upside jubilee.
Nokia's thinking
So why is Nokia tossing around euro like Monopoly money? Just since April 1, Nokia has announced three network infrastructure deals that include vendor financing. Perhaps even more startling is that after you add up the contract value -- the revenue to Nokia -- and the vendor financing amounts, the loans are bigger. The amounts below are in millions of euro.
Vendor Term Amt Financing
Hutchison 3yr 500 743
Orange(1) 3yr 1,500 2,000
Orange(2) 3yr 160 240
�2,160 �2,983
(1) For France, Germany, and the U.K.
(2) For SwitzerlandBased on 0.88 euro to 1.00 U.S. dollar, Nokia is in for more than $2.6 billion in financing. Adding the last two weeks' deals to year-end financing commitments (Q1 2001 is excluded because the financials are not yet available), Nokia has more than $3.8 billion in vendor financing outstanding. At the end of calendar 1999, that amount was only $528 million.
Of little consolation is Nokia's explanation in its year-end financials. "Vendor financing is often involved in the international trade of telecommunications networks. Nokia has maintained conservative financing policy in this area and aimed at close cooperation with banks and financial institutions to support clients in their financing of infrastructure investments." Excuse me, but if $3.5 billion is conservative, what is aggressive?
Possible explanations
Nokia is exerting its financial muscle. As we have pointed out repeatedly in this column, Rule Makers usually come out of rough times in a better position relative to the competition. The tough balance sheet requirements and high margins we demand are not by mistake. These are the times when fiscal fitness pays off. Nokia may be going after market share and taking advantage of the its weakened competitors. With Motorola, Nortel, and Lucent facing financing troubles, Nokia can improve its contract win rate by offering what the competition can't: financing help. With only a little more than $1.0 billion in debt, Nokia's risk tolerance is greater than Motorola and Lucent with $11.6 billion and $8.1 billion in debt, respectively, at year end. Even after Lucent's spring cleaning with Agere (NYSE: AGR.A), Lucent still has more than $2.5 billion in debt.
Another possibility is that $1 of Nokia financing is more beneficial to Nokia than $1 of financing is to Lucent or Nortel. In other words, the risk/reward ratio is different for Nokia. This is because Lucent and Nortel lack handset divisions. If Nokia supplies infrastructure gear and offers friendly financing terms to a customer, surely it will have a good shot at a handset contract. Therefore, it has more to gain. Ericsson (Nasdaq: ERICY) has been using this argument for the past year -- much to the chagrin of its investors -- when defending its decision not to discard its unprofitable handset division. Perhaps there is some truth to the argument, and Nokia is simply capitalizing on it.
Of course, the door swings both ways. If the vendor-financed customers fold, Nokia Networks and Nokia Mobile Phones will suffer.
Nokia could be attempting to jump-start the 3G build-out all by its lonesome. As ridiculous as it sounds, the idea has been batted around. Jorma Olilla, Nokia's chairman and CEO, may see a rebound on the horizon and is getting ahead of the curve. Whatever the reason, our #1 pick for the Rule Maker Top 25 has got some explaining to do. We'll be watching and asking for an explanation on Friday, April 20, when Nokia announces earnings.
On an administrative note, we will be moving to a thrice-weekly Rule Maker column schedule beginning next week. For more on the change see "Less Is More."
Todd Lebor is usually playing out of the rough. At the time of publication, he did not own shares in any of the companies mentioned above. Todd's other holdings can be found online. The Motley Fool is investors writing for investors.
