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Nortel's New Lease on Life

Investors have long compared North America's largest telecom-equipment makers: Lucent Technologies (LU) and Nortel Networks (NT). In those comparisons in recent years, Lucent has often come out on top. As Nortel stumbled under the weight of an accounting scandal that led to results restatements, executive dismissals, and fraud investigations, Lucent executives were busy slashing costs and reviving growth after the telecom meltdown.

So while Nortel has been viewed as a work in progress at best -- and at times a train wreck -- Lucent was a turnaround story. But the tables slowly may be starting to turn. This year, Nortel could outdo Lucent in sales growth and other financial metrics, analysts say. Part of the optimism begins with Nortel's newly appointed chief executive, Mike Zafirovski (see BW Online, 10/18/05, "Can an Iron Man Remake Nortel?").

"TIDE IS CHANGING." Zafirovski, who previously righted Motorola's (MOT) handset unit, is expected to map out a growth strategy and announce a new round of restructuring in the coming months. Although his predecessor, William Owens, did eliminate jobs, the absence of a comprehensive growth plan for Nortel helps explain why its stock's performance has been poorer than Lucent's, says Mark Sue, an analyst with RBC Capital Markets.

At $2.52 per share, Lucent is still trading slightly higher, on a price-to-earnings and price-to-sales basis, than Nortel's stock, priced at $2.97.

Nortel's new CEO is already leaving his mark. On Jan. 19, Zafirovski appointed fellow Motorola exec Dennis Carey to streamline Nortel operations. A week earlier, he announced a new head of manufacturing services. More changes are likely to follow. Lucent Chief Executive Pat Russo has eliminated thousands of jobs since taking the helm in 2002. Though she could still wring cost savings, Lucent's deepest cuts may already have been made, investors say.

While Lucent is still the better performer of the two companies, it has "already announced a lot of restructuring, the stock had some movement," explains Peter Hofstra, senior analyst at AIC funds, which doesn't own either stock. "Maybe it's Nortel's turn to do that. The tide is changing."

REVISED FORECAST. When he assumed the CEO post in October, Zafirovski said he would focus on profitability. Nortel can easily cut more than $400 million in costs this year alone, says American Technology Research analyst Albert Lin. Nortel could see 15% to 20% sales growth in areas such as equipment used in broadband networks for telephone companies. As a result, it could come close to turning in its first annual profit, Lin says.

The outlook isn't as bright these days at Lucent, which said Jan. 24 that revenue fell 12%, to $2.05 billion, in the first fiscal quarter, which ended Dec. 31, due to a $278 million litigation charge that dragged it into the red. A week earlier, Lucent said 2006 sales would be flat or increase by a low-single-digit percentage. Previously, the company had expected growth in the mid-single digits (see BW Online, 1/17/06, "Darkness Creeps Over Lucent"). Nortel will release its quarterly earnings in February.

Lucent's earnings before depreciation and taxes may tumble to $1.5 billion this year, from $1.75 billion in calendar 2005, figures Michael Mahoney, senior managing director for EGM Capital hedge funds in San Francisco. For Nortel, the same metric may almost double, to $1.1 billion in 2006, from $600 million last year, he says. Per-share earnings also may slide. Richard Windsor, an analyst at Nomura in London, says Lucent's EPS may tumble 48% to 13 cents per share, as sales remain weak and cost reductions slow down.

SLOW PROGRESS. Another reason for concern, say analysts, is Lucent's future pension-benefits payoff to some 125,000 former employees. The burden will increase as health-care costs soar, says Lin.

"Our pension funds are well funded, so there is no pension liability," an e-mail statement from Lucent says. "We do not expect to make contributions to our qualified U.S. pension plans fiscal through 2007." Even so, funds used for retirement health-care benefits should run out in 2007 (see BW, 1/30/06, "Retiree Accounting: More Than Meets The Eye"). By contrast, much of Nortel employee-benefit costs are covered by the Canadian government.

In light of the expected growth slump, Lucent may need to revamp its strategy to stay afloat in a telecom market that's expected to remain flat this year. While the company is expanding into fast-growing areas like Internet protocol-based networks, analysts like Lin worry that this market is highly price-competitive, and customers are taking too long to try out the gear. Lucent Chief Marketing Officer John Giere says seven customers began trials of Lucent's IP equipment just in the past six months. "We started the business two years ago, and we just started signing contracts last quarter."

Even sales of wireless equipment, which accounts for about half of Lucent's sales, don't always pan out. Sales of wireless gear in the most recent quarter tanked 19.2% percent year-over-year. Wireless-infrastructure giant Ericsson (ERICY) is expected to report a 29% sequential rise in revenues in its fourth quarter. Another rival, Alcatel (ALA), currently the largest telecom-equipment maker in the world, has managed to grow its revenues steadily, thanks to its vast diversification: It's a player in everything from wireless to broadband infrastructure.

HONEYMOON'S OVER. It's no wonder then that, as Lucent's revenue growth slacks off, Wall Street is considering its competitors as the more attractive investments. Nomura has a buy rating on Alcatel. And, in North America, Nortel increasingly is getting a second look. "People are too worried about these negative surprises from Lucent," says Lin. "This implies an inability to forecast future shortfalls. Nortel is likely to be a better stock [than Lucent]." In fact, Nomura is looking at initiating coverage on Nortel. By contrast, on Jan. 25, Charter Equity Research actually downgraded Lucent to market perform.

"The honeymoon period for Lucent is over, and now it's with Nortel," says AIC's Hofstra. "But, at the end of the day, it's a tough business." And Nortel may be better poised to cope in that environment than its chief North American rival.

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