Telecom-Gear Makers: Poorer, but Happy to Be Here

The likes of Lucent and Nortel are battling back toward profitability

Six months ago, telecom-equipment makers seemed to be dinosaurs on the verge of extinction. Lucent Technologies Inc. (LU ) and Nortel Networks Ltd. (NT ) were whacking jobs, but not quickly enough, it appeared, to keep ahead of the cratering communications market. As losses mounted, shares of the two companies fell below $1 and were in danger of being delisted. French rival Alcatel's (ALA ) credit rating was well below junk, reflecting fear of "a crise de cashflow."

Today, it appears that those so-called telecom dinosaurs were more like rhinos--ungainly, perhaps, but on track to survive. To their credit, the big equipment suppliers were not merely hacking out costs as rumors of their demise made the rounds. They also were fashioning smaller and more focused companies that could ride out the telecom storm. And now, they're in the process of stabilizing and returning to profitability by yearend.

Don't expect much fun or fireworks from the survivors, though. Companies emerging from the telecom depression will not only be smaller and leaner but also poorer. Revenue growth isn't likely to come close to the 20% level of the late 1990s. Analysts project a further 10% revenue slippage this year, followed by a flat year in 2004 and single-digit growth thereafter. The outlook for Europe is especially grim. Still, thanks to deep cost cuts, equipment suppliers can begin to produce operating profit margins in the 8%-to-10% range by yearend, says telecom-gear analyst Nikos Theodosopoulos, adding: "We expect to see the telecom-equipment market stabilize this year."

That tepid outlook raises questions about how much steam remains in the miniboom in telecom stocks. Lucent, Nortel, and Alcatel shares have tripled since October. But are investors getting ahead of themselves? "We were wrong. Lucent will survive. But how much is it worth?" asks Robert Gensler, manager of the $500 million T. Rowe Price Media & Telecommunications Fund.

The key to the turnaround is that the three-year plunge in telecom-equipment spending is finally lessening. In 2002, outlays were expected to fall a modest 5%--but they plummeted as much as 50%. "It was unprecedented," says Lucent CEO Patricia F. Russo. This year, Theodosopoulos expects a more modest 10% decline in spending. Why? U.S. traditional carriers have lowered capital spending, as a percentage of revenue, to historic norms. Capital expenses are down to 16% of sales, from a high of 27% in 2001 and 2000. That means they are less likely to reduce their budgets as the year progresses. And Lucent, Alcatel, and Nortel, with costs under control, can likely avoid a cash crunch well into 2004. By then, the market should start growing again.

To survive, the telecom giants have had to carry out cost-cutting that has been nothing short of brutal. Over the past 12 to 18 months, Lucent has outsourced 90% of its manufacturing. By the end of the year, it expects to have cut its staff 71%, to 35,000, down from a high of 123,000 in 2000. By yearend, Nortel will have cut its staff by 62%, to 36,000, and Alcatel by 54%, to 60,000. "I can't even think of another industry that has lost half its revenue in a two-year period. But we adjusted, and we will survive," Russo says. Nortel CEO Frank Dunn agrees. "The industry's starting to stabilize, starting to get its feet on the ground," he said on a Jan. 23 conference call.

Competition is easing, too. Smaller rivals have gone out of business, and larger ones are more interested in partnerships than all-out war. Cisco Systems Inc. (CSCO ), for example, long viewed as a fleet dinosaur hunter, has in the past two months struck resale agreements with Lucent and with SBC Communications Inc. (SBC ), the local-phone carrier. The Internet-equipment giant, which gets 20% of revenue from telecom carriers, announced on Feb. 4 a 50% rise in quarterly earnings on a 2% drop in revenue.

Executives at the slimmed-down giants have been busily positioning their companies for better days ahead, albeit in different ways. Lucent's Russo is driving the company along a path blazed by IBM (IBM ), where she spent part of her career, in sales. Her cost cuts are reminiscent of those at Big Blue, where former Chairman and CEO Louis V. Gerstner Jr. eliminated 100,000 jobs. And like Gerstner, Russo is steering Lucent away from manufacturing and toward services. The idea is to help telecom companies design, construct, and manage networks, regardless of whether they use Lucent gear. The gross margins on these consulting services, say analysts, should be well above Lucent's breakeven point in the mid-30% range.

Nortel is placing bigger bets on technology. The centerpiece is next-generation local-phone equipment. This will push optical fiber closer to homes and offices, making superfast Internet connections possible, especially for big corporate customers. Nortel is also focusing on telecom equipment for corporate offices, a market that Lucent abandoned. The risk for Nortel: These new markets could crash just as optical gear did. And like Lucent, Nortel also is pushing to extend its reach outside North America. Both companies get more than half of their revenue from the U.S., unlike the well-diversified Alcatel, which gets 18% of its $17 billion revenue from the U.S.

Alcatel has cut down less dramatically than the North Americans. CEO Serge Tchuruk is weathering analysts' criticism by remaining in a host of businesses, from fiber optics to wireless phones. What's more, he gets 25% of revenues from areas outside of telecom, such as satellites and electronic components. Analysts complain that Alcatel lacks clear focus. But even as Tchuruk announced on Feb. 4 fourth-quarter losses of $1.2 billion, he stressed that diversification had cushioned the downturn. Alcatel's strength is in the DSL high-speed Internet technology, where it holds 50% of the global market.

Even with their recovery in the markets, these telecom companies' slimmed-down market caps could make them easy takeover targets. Lucent, with its $12.3 billion in 2002 sales and blue-chip customer roster, is worth only $6.6 billion. Nortel, with $10.5 billion in revenue, and Alcatel have market capitalizations in the $9 billion range. But antitrust regulation is likely to keep the North Americans from teaming up. Alcatel felt burned on an aborted takeover of Lucent two years ago, and powerhouse Cisco has little appetite for traditional telecom companies, says analyst Paul Sagawa of Sanford C. Bernstein & Co. Any great consolidators lurking out there are probably from outside the industry. In fact, Gensler says, it might make sense for an industrial conglomerate such as General Electric (GE ) or General Dynamics (GD ) to buy Lucent or Nortel.

Barring an unforeseen economic decline, prospects for a turnaround are good. If only the dinosaurs had adapted so well, you might still see one or two strolling around the Bronx Zoo.

By Steve Rosenbush in New York, with Andy Reinhardt in Paris

— With assistance by Andy Reinhardt

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