Analyst reports: Volatile Nortel OK for risk-takers

Analysts scratch their heads over whether Nortel Networks' surprisingly poor third-quarter financial performance is a sign of a gloomy future or a lucrative buying opportunity.

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Analysts scratched their heads Wednesday over whether Nortel Networks' surprisingly poor third-quarter financial performance was a sign of a gloomy future or a lucrative buying opportunity.

The only thing they seemed to figure out: The highly volatile stock is only suitable for high-risk investors.

Nortel stock traded Wednesday morning at $46.38, down 26.75 percent from Tuesday's closing price. The Canadian company's stock has traded in a range of $24.78 to $86 per share in the past year.

Nortel, which makes fiber-optic equipment to beam information from the Internet and telephone through light instead of traditional electric signals, announced Tuesday that third-quarter sales were $7.31 billion. That was a supreme disappointment to bullish analysts polled by First Call/Thomson Financial, who were expecting nearly $300 million more.

Nortel chief executive John Roth blamed the failure on a shortage of workers. The Brampton, Ont.-based company simply couldn't install all the equipment customers had ordered, he said in a conference call Tuesday night.

Revenues from optical products were roughly $2.3 billion, below many analysts' expectations of $2.8 billion. In the second quarter, the company reported revenue from optical products of $2.8 billion.

Executives said optical revenues for the year would exceed $10 billion, requiring the company to earn at least $3 billion in the segment in the fourth quarter--a feat that many analysts said was nearly impossible.

"There will likely be confusion over Nortel's' forecast for total top-line revenue in optical systems," Merrill Lynch analysts Thomas Astle and Michael Ching wrote in a research report issued Wednesday morning. The note, titled "Optical revenue hits a bump--Ouch!" was full of red flags for risk-averse investors.

"What do we do now?" the Merrill Lynch analysts asked. "Clearly this event has shaken our confidence in the company's visibility and we are not completely sure if we should buy into the explanation provided. However...we believe Nortel remains the premier optical systems player with very little competition in the long-haul market."

Nortel is notorious for having relatively weak third quarters--a hardship that many analysts say presents a buying opportunity for investors. Several other analysts said Nortel's difficulties stem from a slackening demand for optical products.

For the past several quarters, optical buyers were ordering two or three times as much equipment as necessary to ensure at least partial shipment of the hot products. They are now ordering more realistic quantities, causing demand for Nortel's order backlog to shrink.

But debate rages on Wall Street whether this shrinkage will hurt Nortel's bottom line or whether it could help the company more accurately predict and fill future orders.

Chase Hambrecht & Quist analyst Michael Neiberg downgraded his rating to "buy" from "strong buy" in a research note Tuesday, but he reiterated his long-term confidence in Nortel and fiber-optics demand.

"While this issue affected the quarter, we believe end-user demand from well-funded customers is unchanged," Neiberg wrote. "The ability to obtain funding has dictated spending plans for smaller phone companies, but we believe the majority of Nortel's customers are well-financed and should continue to drive strong demand. We believe the workdown of inventories is a finite issue, and once it is resolved, demand for optics remains strong."

Salomon Smith Barney analysts B. Alexander Henderson and Timothy Anderson agreed, calling the optics issue a "minor inventory correction" that should be dismissed as a "quasi one-time event." They reiterated their "buy" rating but noted that the volatile stock belongs only in the portfolios of high-risk investors.

No analyst upgraded Nortel in the wake of its third-quarter report. Lehman Brothers downgraded it to "outperform" from "buy."

Dresdner Kleinwort Benson reiterated its "buy" rating, while Merrill Lynch reiterated a "near-term buy." RBC Dominion maintained its "strong buy" rating.

Canadian financial institutions were also cautious. Canaccord Capital maintained its tepid "underweight" rating, while National Bank maintained a "focus buy" rating until volatility abates somewhat.

Analyst Mark V. Lucey at TD Securities maintained his "buy" rating but lowered his 12-month target price to $75 from $105 per share. Analyst Nikos Theodosopoulos at UBS Warburg also maintained a "buy" rating but slashed his 12-month price target $60 from $115 per share.