Job 1 for Nortel: Get Through 2002

Most analysts on Wall Street think the Canadian outfit will survive the telecom meltdown, but not before feeling a lot more pain

By Olga Kharif

Weary telecom investors have already learned the hard way that Nortel Networks is in a tough spot. In the past year, the stock of this communications-equipment maker has lost nearly three-fourth of its value. Then, in mid-February, its chief financial officer resigned after admitting he violated insider-trading rules that prevent executives from buying or selling stock ahead of key announcements. Nortel (NT ) has also hinted that first-quarter sales could be worse than previously expected. As a result, its shares have fallen an additional 13% since Feb. 11, from $6.38 to around $5.50 on Feb. 21.

That's just the tip of Nortel's iceberg of problems. Telecoms and service providers continue to cut their budgets for new networks, and the equipment market might remain depressed well into 2003, according to optical-equipment consultancy RHK. In the first quarter of 2002, Nortel will likely be the gearmaker affected most by the spending cuts, says Paul Sagawa, an analyst with Sanford Bernstein. Its quarterly sales could slide by more than 10% compared to the previous three-month period. And an expected revenue boost from a new switching product isn't coming anytime soon.

On Feb. 13, Nortel postponed the release of this new switch, used to direct voice calls and Internet traffic along communications networks, until mid-2002, nearly a year after the original planned release date. The product, anxiously awaited by Wall Street, is now in customer trials -- and analysts say there have already been some complaints about it. Several service providers say it uses too much power and is too big, says Mark Lutkowitz, an analyst at consultancy Communications Industry Researchers. At least one customer has decided against ordering it this year, adds Brian Van Steen, an analyst with RHK. Nortel declined comment.


  To be fair, at least part of the blame for the company's troubles lies in the weak market. Nortel's customers could cut their capital spending by as much as 35% this year. If so, a grim 2001 could seem like a dream by comparison. "[Customers] just aren't pulling the trigger," explains Todd Coupland, an analyst with CIBC World Markets. In fact, they're pulling back. On Feb. 14, broadband provider Qwest (Q ) chopped its 2002 capital spending by $300 million more, to $3.7 billion, half of the originally budgeted $7.5 billion. Earlier, Sprint (FON ) and WorldCom (WCOM ) announced plans to cut their spending for the year.

More bad news could be coming. Qwest, which accounts for just under 10% of Nortel's revenues, is struggling. On Feb. 14, both Standard & Poor's and Fitch Ratings downgraded Qwest's $24.9 billion in debt, although the company managed to keep an investment-grade rating. Many carriers are financially hurting, and analysts expect massive consolidation in the next 12 months (see BW Online Special Report, "Cell Phones at the Crossroads").

That would further hurt Nortel and other gearmakers. In fact, demand for their products might not pick up again until mid-2003, according to RHK. Bernstein's Sagawa, who foretold the optical industry's meltdown, disagrees. He believes orders will ramp up -- to double-digit growth -- by the fourth quarter of this year.


  Even so, Nortel will likely disappoint investors again this year. It probably won't break even in the fourth quarter as promised. Although the company has significantly cut its costs, its revenues would have to rise by $550 million a quarter to break even, says Alex Henderson, an analyst with Salomon Smith Barney.

Such sky-high growth is unlikely. In the fourth quarter of 2001, Nortel recorded $3.5 billion in pro-forma revenues and lost $720 million before taxes. In all probability, the company likely won't be profitable until the fourth quarter of 2003 -- or later, Henderson says. Nortel declined to comment.

That's a disheartening outlook, although no one is forecasting Nortel's demise. It will pull through the difficult times of slack demand and continuing outflow of high-level management talent, says David House, who served as president of Nortel until August, 1999. House, who is now the CEO of optical startup Allegro Networks, bought about seven-figures-worth of Nortel's shares in the cash market a month ago, when the stock traded near $5. He isn't sorry. "They are definitely a survivor," he says. "I put my money where my mouth is."


  He notes that, Brampton (Ontario)-based Nortel is still the largest public company in Canada. Keeping it afloat is a matter of national pride. "The Canadian government would not allow Nortel to fail," says House.

One big plus is that Nortel doesn't appear to be the next Enron, despite some speculation that it may have accounting problems. "To the best of my knowledge, everything is O.K. [with the accounting]," said former CFO Terry Hungle, three days after his Feb. 11 resignation. He left after admitting that he had bought Nortel stock just before key company announcements twice last year, in violation of insider-trading rules for executives.

The resignation did nothing to quell rumors that Nortel's accounting needs further scrutiny. But investors were relieved to learn that Hungle's departure was related to straightforward trading violations. And barring any other surprises, Nortel has the financial resources to pull through a difficult 2002. It should burn through about $3 billion in cash this year, estimates Nikos Theodosopoulos, an analyst with UBS Warburg. As of the end of December, 2001, Nortel had $3.5 billion in cash and $3.5 billion in credit lines, though one $1.75 billion credit line expires in April.


  At this time, there's no reason to think Nortel's financial conditions will deteriorate to the point of jeopardizing these lines of credit -- as has happened to some other companies in the telecom sector.

"I don't think they are in too perilous of a situation, but they are somewhat dependent on the industry improving," says Jay Ritter, an analyst at rating agency Morningstar, which has held Nortel's debt on review since October. Nortel faces a rough road ahead, but most analysts believe the company will make it. That in itself is an achievement in this challenging economic environment. Still, most of Wall Street analysts have a hold rating on the stock. And though a former president just bought a heap of Nortel shares, investors might want to hold off before following his example.

Kharif covers telecom for BusinessWeek Online from Portland, Ore.

Edited by Beth Belton

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