Those Oldies May Not Be Such Goodies for Nortel

Analysts say it's too dependent on sales of previous-generation gear that doesn't command top dollar anymore

It has been a rough winter for Nortel Networks (NT ). On Feb. 15, the Canadian telecommunications equipment maker announced that its revenue growth would slow dramatically in 2001. CEO John Roth blamed the U.S. economic downturn and said the company would cut 10,000 jobs to slash costs. That news sent the company's stock down nearly 30%, from around $30 per share to $20 per share.

But Roth didn't mention some other bad news on the horizon. Nortel relies heavily on sales of gear based on optical technologies that are rapidly approaching obsolescence. Last year, the market for older equipment accounted for 90% of Nortel's optical sales, according to Ken Leon, analyst with ABN Amro. With cash-strapped telecoms increasingly opting to spend their scarce dollars on cutting-edge technologies, they've been demanding -- and getting -- discounts as deep as 50% on Nortel's older gear, says Voltaire Cacal, senior analyst at telecom consultancy RHK. These are huge breaks in an industry where year-to-year discounts have long averaged around 10% to 15%.

Nortel isn't alone. Lucent, Alcatel, and Fujitsu -- all sellers of so-called legacy optical equipment -- are suffering similar price pressures. But Nortel is the class of this field, and the development is likely to take a chunk out of its bottom line this quarter and possibly for the rest of the year. It's also the major reason why some analysts are taking a grim view of the company's short-term prospects for strong growth. Nortel denies any price cuts or discounts, and a company spokesperson says any claims that Nortel focuses too much on older equipment are "ludicrous."


  Unless Nortel refocuses its product lines quickly, it could face significantly slower revenue growth and lose some market share to more nimble startups, says Nancee Ruzicka, analyst with the technology consultancy the Yankee Group. She and other analysts say Nortel should put more emphasis on developing products that offer "high-channel-count dense wavelength division multiplexing" (DWDM). Devices using this technology can pipe more wavelengths of light through a single strand of fiber, allowing for significantly improved voice- and data-transmission rates. These systems can be configured remotely in real time to respond quickly to customer needs. No surprise that they're the fastest growing part of the optical market.

DWDM gear is in stark contrast to so-called synchronous optical network (SONET) equipment, which accounts for a huge chunk of Nortel's optical revenues, according to analysts. This is the dominant protocol in networks today. SONET systems must be reconfigured manually if a customer requests more bandwidth, an adjustment that can take weeks and even months to complete. High-channel-count DWDM also is light years ahead of low-channel-count DWDM, a hunk of Nortel's DWDM product offering today. High-channel-count DWDM allows for the transmission of more data, and carriers increasingly have been choosing that technology over SONET and low-channel-count DWDM.

Locked in a price war over offering bandwidth at the lowest price possible to customers, voice and data carriers are turning rapidly to high-channel-count DWDM as they look for ways to differentiate themselves through the services they offer. Carriers want networks that are more flexible and capable of providing advanced services -- such as bandwidth-on-demand. "The equipment has to be able to get big in a hurry," explains Charles Fleckenstein, spokesperson for Sprint. High-channel-count DWDM-based systems also save money, about 30% on overhead, Ruzicka estimates.


  DWDM gear has several drawbacks, however. No two companies make DWDM equipment that's interoperable, says Jim Slaby, analyst with technology consultants Giga Information Group. Furthermore, no gearmaker has emerged as dominant in DWDM technology, he says. So that means carriers buying DWDM equipment risk building optical Towers of Babel that cannot be reconciled with other technologies in the future.

But telecoms increasingly think the benefits of the cutting-edge DWDM will wash over the market, at least for the next few years. According to technology think tank Allied Business Intelligence, the $3 billion DWDM market of 2000 will grow to a minimum $25 billion market by 2006, mostly due to the explosive gains of the high-channel-count DWDM market. Last year alone, it grew 126%, according to RHK. Meanwhile, the market for older gear like SONET, estimated by some analysts to comprise two-thirds of Nortel's optical revenues, is still growing, now at about 7% a year, but it should start falling after 2003, according to RHK.

This trend puts younger companies such as Ciena (CIEN ), Sycamore (SCMR ), and Corvis (CORV ) in the sweet spot. They're are not saddled with legacy production lines and are focused exclusively on the new, next-generation technology. Linthicum (Md.)-based Ciena, which recorded $352 million in revenues in the fourth quarter of fiscal 2000 ended Jan. 31, 2001, upped its revenue guidance for 2001 from 75% to 85% growth to 95% to 105%. In fact, Ciena has a hot switching product and will likely take some of Nortel's market share this year, says Gus Papageorgiou, analyst with Scotia Capital.


  Nortel had hoped to meet the challenge through an aggressive acquisition stratety. It purchased Qtera and Xros last year for a total of $6.5 billion. Qtera was supposed to give Nortel a long-haul optical networking systems to compete with Corvis, and Xros was expected to deliver an all-optical switch to compete with Ciena. But these touted acquisitions have failed to produce successful products on time, says Slaby. In fact, the Xros acquisition has yet to produce a marketable product.

Greg Mumford, Nortel's president of optical networks, says both products are "exactly where we thought they would be." Analysts agree that Nortel still has the strongest product line overall. And it's not that the company doesn't offer DWDM -- in fact, Nortel has 57% of that market. It's just that it needs to focus on the newer versions of this technology.

Still, the giant of optical makers is putting a lot of effort into producing older technology that's rapidly losing its value. If the company doesn't refine its product line, and fast, analysts say, the market will do it for Nortel.

By Olga Kharif in New York

Edited by Alex Salkever

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