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More of Nortel's Slip Is Showing

By Olga Kharif When a company releases its results after the market closes on a Friday, it's generally not a good sign, as every Wall Street analyst knows only too well. So it was as telecom-equipment maker Nortel released its third-quarter results for 2004 after 9 p.m. EST on Friday, Mar. 18.

Seemingly no longer capable of disappointing the Street, the gearmaker, long going through revenue restatements, outdid itself once again. It lost $264 million on $2.2 billion in sales, which came in $121 million below Nortel's (NT) own revenue guidance back in December and well below year-ago numbers. At 36.1%, gross margins not only missed the anticipated 37% mark but they were also well off the 42.5% seen in the second quarter.

LOW PITCH. Those sales and margin trends spell trouble, since they indicate that Nortel is losing market share -- despite superattractive pricing. After falling like a rock for several years, the telecom-equipment market grew by more than 5% in 2004. Industrywide sales of wireless gear rose by double digits that year. But at Nortel, they dropped by 7%.

These market-share losses have occurred even though Nortel slashed prices to keep customers from fleeing amid all the bad publicity stemming from its accounting woes. About $159 million of Nortel's quarterly loss stemmed from a decision to offer superlow prices in order to land a wireless contract in India. That deal will result in a $200 million total loss, estimates Lehman Brothers analyst Steve Levy. Sure, the gearmaker needs to penetrate the subcontinent's fast-growing wireless market, but "it seems to be an awfully large price," notes Levy, who adds: "You are paying [the customer] to take your product."

In an effort to halt further market-share erosion, Nortel is offering bargain-bin prices elsewhere as well, which leads Bernstein & Co., analyst Paul Sagawa to expect further pressure on margins. In March, rating service Standard & Poor's cut its target price for Nortel's shares to $3 -- around 7% above the $2.85 the stock was fetching Mar. 21 -- citing concerns over a deterioration in competitive position.

ROBUST RESERVES. That position could erode further due to staff cuts and management's attention being focused on the books, says Sagawa. Nortel has increased its R&D spending in the third quarter of 2004, vs. the year before, but full-year expenditures are still unknown.

Further dampening customers' willingness to work with Nortel are the numerous shareholder lawsuits, the most recent one filed last week, alleging accounting fraud. Together with possible fines imposed by the Securities & Exchange Commission, total settlements could run to anything between $1 billion and $2 billion, analysts estimate. Because Nortel holds more than $3 billion in cash and equivalents, even these huge sums are unlikely to push it into bankruptcy. "I don't see a liquidity crisis," says Levy.

Still, those liabilities will likely dissuade suitors from pursuing this potential bride. Analysts expect the telecom-equipment industry to consolidate, now that lots of its carrier customers are getting hitched. Over the past year, wireless service provider Cingular acquired AT&T Wireless, and Quest (Q) and Verizon (VZ) are battling over MCI. Fortunately for Nortel, gearmaker consolidation could be delayed by a few more years, believes Levy. So the outfit might not miss the boat.

TALENT INFUSION. That gives Nortel the potential to change course. It's undergoing a major restructuring, commenced in October, 2004, and due to be completed by the end of June, that's expected to reduce costs. It's revamping its management team: In March, Cisco (CSCO) veteran Gary Daichendt became president and chief operating officer, and the board is about to be almost completely changed as well. This new blood could help Nortel get its house in order.

What's more, the equipment maker's financial performance should improve as its markets recover. Spending on telecom gear will likely increase by 9%, to $17.3 billion, according to Telecommunications Industry Assn. estimates. "Nortel has a strong track record in the market," says Henry Goldberg, senior analyst at market researcher In-Stat in Scottsdale, Ariz. And while Sagawa believes Nortel might not grow as fast, he thinks it might post some profits in the second half. One reason for optimism is Nortel's success in sales to corporations, which grew in the third quarter of 2004.

Once Nortel's financial performance improves, "it could be an interesting story," says Levy. Investors still remember great turnaround -- and stock-appreciation -- stories like that of copier giant Xerox (XRX), which weathered its accounting woes, returned to profitability, and saw its stock skyrocket.

WAIT AND SEE. For now, though, Nortel remains a ways from that goal. Its stock is trading at about the same price as that of rival Lucent (LU), which is profitable and controversy-free.

Particularly following on the latest earnings disappointment, the Street is adopting a wait-and-see approach to Nortel -- at least until it releases full-year 2004 results at the end of April. Indeed, until Nortel shows better results and stems its mounting liabilities, it's not likely to inspire much investor enthusiasm. Kharif in Portland, Ore.

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