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Nortel warning highlights telecom woes

A larger-than-expected loss and additional layoffs at Nortel Networks may usher in a new world order of slower growth for the telecommunications sector.

Nortel Networks' profit warning Friday may have just ushered in the new world order of slower growth for the telecommunications sector.

In previous profit warnings from Nortel, Lucent Technologies and Cisco Systems, executives described the sudden slowdown earlier this year as a "100-year flood" and used other such terms to indicate that inventory problems and profit missteps were freak events.

No longer. The write-downs, warnings and layoffs are adding up. The market for the telecommunications equipment that these companies sell to the big phone companies and others has been crumbling for months, with some analysts predicting continuing weakness that could stretch far into next year.

"Carrier spending continues to be anemic in North America, and the rest of the world is now showing signs of weakness," said Tom Astle, an analyst at Merrill Lynch. "The dead zone deepens."

On Friday, Nortel said it will report a much larger-than-expected loss in the second quarter and lay off an additional 10,000 workers, on top of 20,000 layoffs already in the works.

The Brampton, Ontario-based company also expects to report a loss from operations of 48 cents a share on sales of about $4.5 billion. According to First Call, Nortel was expected to report a loss of 6 cents a share on revenue of $6.22 billion.

With its warning, Nortel said it plans to take a charge of $12.3 billion to write off goodwill associated with acquisitions. That would bring the total loss on a net basis to about $19.2 billion.

The company also will suspend its dividend distribution. Discontinuing dividends is often seen by Wall Street as a sign of severe financial strain. The company did say that it obtained a $2 billion credit line from affiliates of J. P. Morgan Chase and Credit Suisse First Boston.

But those financial facts and figures hide something more subtle: Nortel's tone has changed. No longer are there assumptions that demand will reappear to save the day in the near future. Nortel isn't expecting any year-over-year revenue growth to appear until mid-2002.

On a conference call with Wall Street, executives said that Nortel could turn a profit with $5 billion in sales, but did not say the company could bring in that much revenue; analysts couldn't get them to commit to a prediction of $5 billion in sales in upcoming quarters. That's a harsh reality for a company whose lowest revenue tally in 2000 was $6.33 billion.

Nortel Networks
Stock price from June 2000 to present.  
Source: Prophet Finance
Standard & Poor's said it may cut Nortel's debt ratings based on its "expectation that the company will not be profitable in 2001 and the likelihood that its turnaround efforts will be more difficult than previously expected."

CEO John Roth suggested that his company won't be alone in the doldrums. The telecommunications sector, he said, is being hit by more than just a hiccup in demand and excess inventory and has to adjust to a lower sales plateau.

"We're experiencing a very significant reduction in sales in the industry and, in our case, optical long-haul networks," Roth said. "We are focusing on getting our cost structure in place and going forward."

The news bruised shares of Nortel and other telecommunications equipment companies by market close. Nortel's shares fell 7 percent, or 74 cents, to $9.86. Shares of Lucent dropped 44 cents to $6.31, and Cisco fell $1.09 to $16.65. JDS Uniphase, a major supplier to Nortel, lost $1.37 to $12.44, or 10 percent, after its own profit warning Thursday. The CNET Telecommunications Equipment index fell almost 5 percent.

Customers aren't shelling out the bucks to build out their networks anymore, Nortel said. Instead, they're focusing on how to get more capacity out of equipment they already own. Nortel's chief finance officer, Frank Dunn, cited a customer who initially planned to order around $350 million worth of equipment. But as engineers worked on the network, they were able to expand its capacity and ended up ordering only about a quarter of that amount.

"Carriers have shifted away from last year's gut-renovations of their networks' builds to a 'make do with what you have' approach," said Steve Kamman, a telecommunications analyst with CIBC World Markets. "We believe this shift supports our expectation that carrier capital spending will drop by at least 5 percent and more likely 10 percent this year, with the likelihood of further cuts in 2002."

Other analysts concurred with research notes reiterating "neutral" ratings. "Overall, things appear quite weak," said Merrill Lynch analyst Tom Astle.

That's why Nortel is tightening its belt again. Friday's layoffs are in addition to the 20,000 job cuts announced in April. The company said it will meet its goal of cutting those 20,000 jobs in the second quarter and will close facilities. It also said it will save $875 million from those moves and realize the savings in the third quarter.

"After several years of capital expansion exceeding the pace of business performance, the capital markets have significantly reduced the flow of funds to service providers," Roth said. As a result, Nortel has seen "a very significant reduction" in equipment purchases in the second quarter of 2001, compared with the first quarter and the year-ago quarter.

The $12.3 billion write-off involves Nortel's acquisitions of Alteon WebSystems, the 980-nanometer pump-laser chip business, and Xros and Qtera. It also means reducing the carrying amount of those purchases to reflect current market valuations. "It is the equivalent of having made these acquisitions at the current stock prices," Roth said.

As part of its restructuring, Nortel plans to shutter its access-solutions operations, including its narrowband and broadband access divisions. Those business accounted for 7.7 percent and 6.9 percent of revenue for 2000 and the first quarter of 2001, respectively.

The slowdown has taken its toll on almost every company in the sector, from Lucent and Cisco to 3Com and others, but Nortel could be particularly vulnerable because the market for one of its main product lines, high-speed optical equipment, has "collapsed," according to Sanford Bernstein analyst Paul Sagawa. In a recent research note, Sagawa pointed out that while the product line was popular among carriers, its customers have finished building out their products, leaving Nortel hanging.

Although the optical equipment slump is harsh, some analysts held out hope that consumer broadband networks can pick up the slack next year. ""We caution investors, however, that a negative 2001 to 2002 outlook does not condemn this industry to eternal damnation," said Kamman. "We fully expect to see a massive return to spending once we reach critical mass in U.S. residential broadband, which we expect to occur in the latter part of 2002."