Lucent and Nortel: A Rough Road Back
By Ari Bensinger
Lucent (LU ) and Nortel (NT ) have been hit especially hard by the sharp downturn in telecom spending for the long-haul optical system and circuit-switching products that are their bread and butter. The two companies -- which for years were reliable profit generators -- have recently posted some of the largest operating losses in corporate history.
These companies -- which are among the world's largest communications equipment vendors and have enormous customer bases -- were depending on strong growth of optical networking equipment products to offset weakness in their legacy circuit-switch businesses. That growth did not materialize, and the impact has been devastating to Lucent's and Nortel's bottom lines.
And that isn't the extent of the bad news. Telecom carriers have overbuilt their networks, and the significant excess capacity is allowing them to defer spending on building out and upgrading their networks. A stark example of the effect: Nortel reported optical revenue of $300 million for the quarter ended September 30, 2002, compared with $1.6 billion in the first quarter of 2001.
The stock prices of both Lucent and Nortel have spiraled downward as mounting losses make investors increasingly concerned about their liquidity positions. In mid-2002, the shares of both these billion-dollar companies dipped to under a dollar. What are these fallen giants doing to restore profitability? And what are the prospects for success? Let's take a look.
In an effort to improve execution of its business plan, Lucent is focusing on the world's top 50 service providers, which account for approximately 75% of total capital spending for all U.S. telecoms. To address this market, Lucent has realigned its numerous businesses around two focused segments: integrated network solutions and mobility solutions. As the wireline market continues to contract, wireless will play a key role in sustaining the company through the industry downturn.
To improve operating profitability and cash flow, Lucent is in the midst of a massive streamlining. After numerous rounds of layoffs, it ended fiscal 2002 (which ended September 30, 2002), with 47,000 employees. It's aiming to reduce headcount to 35,000 by the end of fiscal 2003. As for its liquidity picture, Lucent had cash and short-term investments of more than $4.4 billion of September 30, 2002, a $1 billion decline from the prior quarter. Lucent canceled its $1.5 billion credit facility in October and is actively negotiating a new, smaller line.
Following a 37% sales decline in fiscal 2002, we at S&P expect sales to decline about 25% in fiscal 2003 because of the weak telecom market. As a result of aggressive cost-cutting initiatives and new-product introductions, gross margins should trend upward to around 30%, from the depressed 20% in fiscal 2002. Lucent is successfully rationalizing operations, pruning its product portfolio, and lowering its cost structure. We expect fiscal 2003 operating expenses in absolute dollars to be dramatically lower than in fiscal 2002.
Still, Lucent's journey back to the black will take some time. We don't foresee Lucent returning to operating profitability until some time in fiscal 2004. Overall, we forecast a pro forma loss of 54 cents a share (excluding special charges) in fiscal 2003, compared to the loss per share of $1.23 posted in fiscal 2002.
With projected operating losses through at least part of fiscal year 2004, Lucent cannot be valued on a price-to-earnings basis. In terms of sales, the stock is trading at an enterprise value of 2.5 times our fiscal year 2003 sales estimate, slightly above average of its industry peers. With a negative book value, the shares could see further downside.
We recognize that the company, with its large customer base and renowned Bell Labs research division, will likely be one of the first to rebound during the next spending upturn. But with no near-term catalysts in sight, we would avoid the shares.
Nortel management is aiming to reset its cost structure to support annual revenues of less than $10 billion, well below the $30 billion in sales that the company registered in 2000. Nortel is targeting a work force of approximately 35,000 -- a sharp contrast to the 94,500 it employed in December, 2000. Nortel also divested several of its noncore divisions, including its low-profit access solutions businesses, which were acquired for almost $800 million only a year ago.
As of September 30, 2002, Nortel's total cash position stood at $4.9 billion. We expect the company to burn through about $2 billion during 2002 and through roughly $1 billion in 2003, before operating losses shrink and restructuring programs wind down. Nortel doesn't expect its $1.5 billion credit facility, which matures in mid-December, 2002, to be amended or extended.
We expect sales to drop 10% in 2003, following an estimated decline of 40% in 2002, on continued weak telecom spending. Nortel will need to overcome a steady decline in its traditional circuit-based voice systems, as service providers shift to Internet protocol-based data systems. And we believe Nortel is experiencing increased pricing pressure on some of its products.
It continues to streamline operations not aligned with its core markets and business strategies, so fixed costs in 2003 will be dramatically lower in absolute dollars. Based on a lower cost structure, we expect gross margins to widen significantly from the depressed 34% level estimated for 2002. Overall, we forecast a 2003 loss of 13 cents a share (excluding special charges), narrower than our 39 cent loss estimate for 2002.
Like Lucent, Nortel cannot be valued on a p-e ratio basis because of the operating losses projected for the next two years. In terms of sales, the stock was recently trading at an enterprise value of 1.7 times our 2002 sales estimate, below its peer average. We believe this discount is warranted, due to declining sales and narrow operating margins.
We expect the difficult sales environment to make it very difficult for Nortel to leverage restructuring cost benefits and view the company's target of profitability in the second quarter of 2003 as aggressive. In light of its low enterprise value multiple, we believe that investors have priced the challenging environment into the stock and would hold existing positions.
The bottom line for both companies? Given that each has a high total debt-to-capital ratio, we'll keep a keen eye on cash flow, which is being strained by the difficult operating environment. While cash burn from operations has slowed considerably in recent quarters, we believe an operating turnaround cannot be achieved until revenue growth strengthens. And we don't see any tangible evidence pointing to a significant upturn in sequential revenue for these one-time tech industry leaders and would remain cautious until fundamentals start to improve.
Analyst Bensinger follows telecommunications equipment stocks for Standard & Poor's