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Putting a Spotlight on Cisco’s Lending

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Times Staff Writer

First of two parts.

A few years ago, as competition among local phone companies intensified, a Louisiana-based telecommunications provider called American Metrocomm Corp. found itself out of cash and, seemingly, out of answers.

“There was no rhyme or reason that anyone in their right mind would loan them any money,” said Michael Henry, who later joined Metrocomm as its chief executive.

Yet even though Metrocomm was in the process of interviewing bankruptcy lawyers, it did find one party perfectly willing to extend more than $62 million in credit: Cisco Systems Inc., the Silicon Valley giant that makes routers and switches to direct Internet traffic.

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In fact, Cisco proved downright eager to lend Metrocomm -- along with scores of other telecom firms with shaky financial positions -- billions of dollars in financing over the years.

The loans weren’t made out of charity, of course. Rather, the transactions helped fuel a steady rise in Cisco’s revenue.

That’s because when the company’s financing arm, Cisco Capital, lent cash, the borrower would in turn buy Cisco gear. More typically, the credit came in the form of Cisco equipment itself. In many cases, Cisco counted the transaction as a sale, even before the customer had begun paying off its debt.

By 2000, company executives said, the financing and leasing deals were responsible for about 10% of the corporation’s $20 billion in annual revenue.

Eventually, the practice of making loans to tenuous telecom firms caught up with Cisco. In late 2001, in recognition that many of them were unlikely to be repaid, the San Jose company was forced to set aside a reserve of almost $900 million for bad loans. The year before, Cisco notes, it tightened its lending practices by establishing a review committee. The goal: to ensure that its financing was going to creditworthy customers.

Today, Cisco portrays the bad loans as unavoidable fallout from the telecom industry’s collapse -- a difficult chapter, the company suggests, that it has closed. Indeed, the extent of its lending has declined sharply.

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“Cisco recognized that there were risks involved” in its earlier strategy, it said in a statement, “but the decision to proceed was made for sound business reasons and based on analysis of the facts that existed at the time.”

Yet it may not be so simple for Cisco just to move on.

Late last month, a federal judge in San Jose refused to dismiss 17 class-action lawsuits filed against Cisco, its auditor and top executives. The suits have been consolidated before U.S. District Judge James Ware, who described the insider selling of $600 million worth of Cisco shares from 1999 through early 2001 as “suspicious” in their timing.

Ware wrote that the allegations contained in the 198-page complaint, including a claim that Cisco artificially inflated its revenue through its lending operation, were “sufficient to support a strong inference” of wrongdoing. His ruling clears the way for investor attorneys, who are seeking billions of dollars in damages, to collect internal documents and conduct sworn interviews with Chief Executive John Chambers and other executives.

Even more troubling for Cisco could be the allegations made by a former company executive, who has met with federal authorities. People familiar with the matter said FBI agents have interviewed the executive in the last few weeks. Among his claims is that Cisco misled investors by hiding its customers’ credit problems.

The executive is seeking leniency in an unrelated criminal case against him, and his contentions may not lead to a formal investigation. The FBI declined to comment. Cisco spokeswoman Penny Bruce said, “We have not been contacted by the FBI on this matter, and we have no reason to believe we would be. Cisco stands by its lending practices and its conservative accounting policies.”

Bruce also said the class-action suits are without merit. “We will vigorously defend ourselves against the false allegations in the complaint.”

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Lending Practices

The story of Cisco’s aggressive lending -- little scrutinized until now -- emerges in dozens of interviews, as well as reams of court papers and regulatory filings. It highlights the lengths to which one of the darlings of Wall Street would go to keep reporting revenue increases during the height of the tech boom.

By making loans to so many distressed companies, “these guys were operating under a fallacy,” said Jerry Hausman, a Massachusetts Institute of Technology economist who has studied the telecommunications industry and reviewed various documents about Cisco’s lending practices. For a company to increase sales this way, he added, it’s like “you’re pumping yourself up on steroids.”

To be sure, not all of the recipients of Cisco financing were in bad shape. And not all of its loans led to instant revenue gains. In some cases, such as those of American Metrocomm and Digital Broadband Communications Inc., Cisco recorded sales only when the customers began repaying.

In other cases, though, Cisco booked sales at the outset -- even before a penny had been collected and even when the customers were teetering toward a bankruptcy filing.

That’s what happened with Rhythms NetConnections Inc., an Internet access provider founded in Englewood, Colo., by major Cisco shareholder Bill Stensrud.

Rhythms’ dismal outlook was certainly no secret. The company had lost $36 million on sales of just $1 million in 1998, and the prospectus for its initial public offering the next year warned that it would continue to lose money for years to come. In June 1999, the first Standard & Poor’s credit rating on Rhythms’ debt was five notches below the agency’s best rating for junk bonds.

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Yet Rhythms evidently looked like a winner to Cisco.

It shipped $20 million worth of computers to Rhythms on credit just before the firm’s IPO in April 1999 -- technically, “financial leases” that Cisco recorded as a sale, people familiar with the transaction said.

Even after Rhythms’ stock began melting down and the company’s net worth plunged into negative territory, Cisco remained committed, extending new financing as late as November 2000. By the time Rhythms filed for bankruptcy protection in August of the next year, it owed Cisco more than $30 million.

Sources say Cisco also booked revenue from financial leases with WinStar Communications Inc. and PSINet Inc., both of which filed for bankruptcy protection in 2001, together owing Cisco more than $80 million. “At the time Cisco Capital provided financing to PSINet and Rhythms, they were considered financially viable, generally speaking, by credit rating agencies” and other outside financial professionals, Cisco said in a statement. “Not all the investments worked out the way we had hoped.”

When Cisco recorded a financed deal as a sale, and then the customer had trouble making payments, Cisco made deductions from revenue reported later, people familiar with the process said.

But all along, Cisco downplayed its exposure to such loans. In September 2000, Senior Vice President Mike Volpi was cited by TheStreet.com as saying that only 1% hadn’t worked out. Cisco says that Volpi “has no recollection” of that remark today.

Meantime, during a Nov. 6, 2000, conference call with analysts, Chief Financial Officer Larry Carter said that in two-thirds of Cisco financings -- instances in which when the company recorded revenue from a loan before it was paid back -- it was generally a transaction involving “our quality enterprise and tier one service provider accounts.”

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To analysts such as Raj Srikanth of Deutsche Bank, that sounded as if Carter was describing industry stalwarts such as the Baby Bells and AT&T; Corp. Told recently that Cisco also had instantly booked revenue from loans made to firms like Rhythms and WinStar, Srikanth said: “That would be surprising to me.” Bruce, the Cisco spokeswoman, declined to comment on the company’s criteria for describing its customers as “tier-one.”

By most any measure, Cisco Capital was hardly a conventional lender. In many instances, the company didn’t require audited financial statements from its borrowers, according to the company’s Web site in those days. Instead, it focused on the future, seeking business plans and “two to three years of financial projections.”

“More than a finance company,” it told customers, “Cisco Capital is a partner and investor in your business.”

Mike Hampton, the unit’s general manager, acknowledged that the approach had one main goal: to place Cisco equipment into the hands of more telecom firms. “We were simply a customer-oriented sales tool,” Hampton said in a newsletter published by the Center for Simplified Strategic Planning. “We helped Cisco book profits on sales that might otherwise have been lost or delayed.”

Equipment Placement

Take, for instance, the case of HarvardNet, a Boston-based provider of high-speed Internet connections and fiber-optic channels for transporting data. HarvardNet began offering digital subscriber lines to business customers in 1996. Two years down the road, it had sales of less than $5 million a year, was losing more than $1 million annually and had a negative net worth.

To survive and expand, the young firm needed new equipment. The engineering staff, led by Chief Technical Officer Roger Ach III, compared gear from Cisco with equipment from HarvardNet supplier Paradyne Networks Inc.

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“The Paradyne equipment was at least a couple of inches ahead of Cisco,” Ach recalled. “We made the technical decision to stick with Paradyne.”

But Cisco already was dealing above Ach’s head, offering as much as $120 million in credit -- surprisingly generous financing for a firm with such uncertain prospects. Although the specific terms of the HarvardNet deal couldn’t be learned, similar Cisco financing allowed customers to defer initial payments for years and to spend 25% of their loans on non-Cisco equipment.

“The next thing I knew,” Ach said, “I was getting feedback from the CEO that we should use Cisco because of the vendor financing. From that point onward, almost all the equipment purchased was Cisco.”

As HarvardNet installed the new Cisco gear, Ach and another engineer said, as much as a quarter of the DSL lines that had worked on Paradyne machines stopped functioning properly, and customers started dropping HarvardNet. Cisco said it stands by its product quality.

By the end of 2000, HarvardNet had cut more than half its 480 employees and abandoned the DSL market. It soon vanished entirely, taking much of Cisco’s money with it.

Cisco wouldn’t say how much revenue, if any, it booked from HarvardNet. But it noted that this was a so-called structured deal, not the financed leasing of the sort at Rhythms that immediately added to Cisco’s sales results.

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Bankruptcy Filings

As the months rolled on, more and more Cisco borrowers tumbled into U.S. Bankruptcy Court. Among them: ICG Communications Inc., which filed in November 2000, owing Cisco at least $44 million; Digital Broadband, which filed in December 2000, owing Cisco $71 million; and Vectris Communications Inc., which filed in January 2001, owing Cisco $20 million.

In December 2000, as concerns mounted that Cisco would be hit by meltdowns in the Internet and telecommunications sectors, CEO Chambers reassured analysts that he had “never been more optimistic.” Sales, he said, would keep growing by 50% in the fiscal year that was then half over.

For Cisco investors, there wasn’t a hint that the company’s financing operation was in trouble. Although the bankruptcy filings by Cisco’s customers were mounting, the company reported that it had set aside just $89 million for “doubtful accounts” in the quarter ended January 2001. It didn’t give a figure for problem leases.

Yet that $89 million was less than what Cisco was owed by the already bankrupt Digital Broadband and ICG alone. An executive familiar with the accounting conceded that the problems were “almost invisible” to those outside the company. The executive said that wasn’t a legal problem for Cisco, however, because the shakiest loans were balanced by offsetting reserves.

Early 2001 marked the beginning of the end of Cisco’s big run on Wall Street. By then, the company had exceeded analysts’ earnings expectations each quarter for more than three years. This time, its profit came in below expectations. The stock plummeted 13%.

The next two quarters brought more bad news. Instead of the 50% sales growth that Chambers had predicted, revenue for the fiscal year climbed just 18%. In the third and fourth quarters, revenue actually fell.

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The biggest stunner of all came in April 2001 when Cisco announced that it was taking $1.2 billion in restructuring and other special charges and an additional $2.1 billion for obsolete inventory, one of the largest such write-downs in history. Cisco blamed a sudden, unanticipated drop in demand. “This may be the fastest deceleration any company of our size has ever experienced,” Chambers said at the time. “We never built models to anticipate something of this magnitude.”

What Cisco didn’t point out, critics say, is that it had made the hole deeper by sending its gear to companies that were now mired in bankruptcy proceedings and reselling the stuff at fire-sale prices. Many investors complained that the lack of demand by telecom firms should have been obvious before Cisco formally recognized it, and some filed suit against the company.

Even then, Cisco said little about its potential debt exposure. In its quarterly conference calls since the write-downs, the company has reiterated that the financed leases it books right away as revenue go to “quality enterprise and tier-one service provider accounts.”

An in-house analysis painted a different picture, however. In March 2001, according to internal documents reviewed by The Times, Cisco tallied up financed-lease debt exposure of about $1.3 billion to 735 customers -- including $233 million to customers identified as high credit risks and $675 million to companies identified as medium credit risks.

In operating leases, which were typically recorded as revenue over two or three years, an additional $200 million was exposed. And in structured loans, Cisco had disgorged $788 million and committed to funding $1.7 billion more, for overall potential exposure of about $4 billion.

Size of Reserve Boosted

Two months later, Cisco executives disclosed that they had set aside reserve of $800 million to cover the structured loans. But it wasn’t until the company’s annual Securities and Exchange Commission filing in September 2001 -- six months after the internal analysis was produced -- that the company said anything publicly about significant problems with its financed leases.

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That’s when the amount set aside in a type of reserves dominated by doubtful lease payments jumped to $896 million from just $195 million the year before. The $896 million represented more than half of the company’s projected lease receipts.

In the same filing, the company finally acknowledged that Internet service providers were going out of business and cautioned investors that the shut-downs were having a “material adverse effect” on Cisco’s operations.

By the time of those admissions, Cisco’s stock had plunged 84% to $12.58 from its March 2000 peak of $82, wiping out $465 billion in shareholder value. To put that figure in perspective, the world’s most valuable company, General Electric Co., is now worth less than $300 billion. Before the stock hit bottom, Cisco insiders had dumped $609 million in shares at prices ranging from $29.75 to $80.24.

Cisco closed Friday at $15.69. In its most recent quarterly filing last week, the company said it is still owed $229 million in lease payments and has committed to extend $105 million more in structured financing.

Given how long it took Cisco to make the disclosure about the bad loans, some experts say they aren’t surprised that its credit practices are attracting scrutiny from investigators as well as angry investors.

“You’re not supposed to recognize revenue selling to customers that are not creditworthy,” said Georgia Institute of Technology accounting professor Charles Mulford, who reviewed Cisco and Rhythms regulatory filings for The Times. “You can raise obvious questions about the propriety of booking revenue from what is obviously a company in decline.”

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Coming Monday: A look at Cisco’s close ties to Silicon Valley venture capitalists.

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