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Will Redback earnings open sour quarter?

The company kicks off the earnings season with solid second-quarter results, closing out a quarter that may be remembered as one of the most trying for the sector.

    Redback Networks kicked off the earnings season with solid second-quarter results Wednesday, closing out a quarter that may be remembered as one of the most trying for the once high-flying communications equipment sector.

    Since April, the manufacturer of high-speed Internet gear and fiber-optic equipment for metropolitan networks has faced the departure of its chief executive, a severe profit warning, a shareholder lawsuit and layoffs of 13 percent of its work force.

    But Redback is not alone in its misfortune. Many telecom equipment makers, several of which also went public in 1999, have taken their lumps this year, brought on by a slowdown in equipment spending by telecom carriers. Analysts expect the upcoming quarterly financial reports from many of these companies to show evidence of the malaise.

    "The overall economic slowdown and reduced carrier and (business) spending continue to put pressure on data-networking-equipment companies," Christin Armacost, an analyst at investment bank SG Cowen, wrote in a recent research report.

    Redback is one of the first companies in the communications market to report results, potentially setting the tone for investors.

    Excluding charges and other one-time items, the maker of high-speed Internet gear and fiber-optic equipment for metropolitan networks posted a loss of $37.0 million, or 26 cents per share, on net revenue of $59.4 million.

    That compares with a net loss of $5.7 million, or 5 cents per share, on revenue of $48.7 million for the same quarter a year ago, and a loss of 13 cents and revenue of $90.9 million in the preceding quarter.

    Wall Street expected Redback to post a loss of 29 cents a share, according to the consensus estimate of analysts surveyed by First Call. The company also told Wall Street that it would generate second-quarter revenue in a range between $55 million and $60 million.

    Like Redback, Juniper Networks, Foundry Networks, Extreme Networks and others exploded onto the scene with rocketing initial public offerings in 1999, but they now face similar predicaments. Most of these companies will also report their fiscal results in the coming weeks.

    Most industry analysts believe that the specific earnings numbers for the telecom equipment sector will not be pretty this quarter.

    Redback told investors recently that it will take a charge against earnings to write off stockpiled equipment that it cannot sell. Other equipment makers, like Cisco Systems, also have written off huge amounts for unsold products.

    "The environment for Redback and our competitors has weakened this quarter as we all continue to feel the full impact of an unprecedented industry slowdown," Redback Chief Financial Officer Dennis Wolf said in a conference call.

    The telecom spending slowdown has also snared much bigger fish, like Nortel Networks, which issued earnings warnings in June and March that further rattled investors' faith in the telecom sector.

    Likewise, executive changes at Redback and elsewhere have further cast a shadow over the sector and its finances. In addition to the departure of Redback CEO Vivek Ragavan, the company's CFO, Craig Gentner, left in January.

    Similarly, Lucent's board fired Chief Executive Richard McGinn in October and Chairman Henry Schacht is still holding down the fort for now. CFO Deborah Hopkins left in May after only one year on the job. Nortel's and 3Com's executives have changed places in recent months, too.

    The industry's inability to confidently forecast revenue and profit outlooks for the remainder of the year has made matters worse for the communications equipment sector. Uncertain carrier spending and other economic factors are to blame, analysts say.

    For example, Redback's earnings warning in June shrouded the company in further uncertainty, mainly because it could not provide any firm earnings guidance beyond its second quarter.

    "The company has to have some plan as to when they are going to become cash-flow positive," associate analyst Sameer Bhasin of Jefferies & Co. said.

    Redback's Wolf said the company will spend between $70 million and $80 million in cash for the second quarter, which leaves it with about $300 million in cash on its books.

    The company's primary concerns center around its two main markets, DSL (digital subscriber line) equipment and gear for metropolitan networks, or networks that transmit data within cities.

    Redback has been a dominant player in the DSL industry, but growth has stalled, and analysts are hoping for news from Redback that the worst is over. "We want to see information from the company that the DSL slowdown has passed them," Bhasin said.

    That puts more emphasis on Redback's metro product line. Carrier spending has fallen in all market segments, but many analysts believe spending will pick up in the metro area, which has not been built up as much as long-haul networks, which run between cities.

    Specifically, Redback is working toward improving its SmartEdge router for the metro market. The improvements will enable carriers to transmit different kinds of traffic faster and more efficiently. Redback expects to begin shipping the router at the end of the third quarter, so revenue from the product will show up in fourth-quarter earnings.

    Other communications hardware companies have similarly shifted gears, hoping to find success in other market niches.

    "There's no gangbuster story left in Redback for DSL," said Wells Fargo Van Kasper analyst Chet White, who adds that the DSL market will continue to grow, just at a more moderate pace.

    "If DSL just stays out of the way and does not deteriorate any further and the (router) portion comes through, that will be the real driver (for Redback)," White said.

    Another fear facing Redback--and many other communications gear suppliers--is consolidation.

    Many industry analysts also predict a wave of consolidation will hit the industry, and they view Redback as a potential takeover target. The company even went so far as to adopt a "poison pill" shareholder rights plan which makes it difficult for an outside entity to acquire a large stake in the company and take it over.

    Wall Street analysts say the possibility of a takeover will always remain, especially since the company's shares have taken a nosedive. Redback shares have traded down from $177.37 last year to about $7 a share now.

    "They are a viable candidate," White said. "They have one of the best engineering teams for data in the world."

    But exactly who could take them over remains a question because both established and new equipment companies have all seen reduced earnings expectations, layoffs and falling stock prices.

    "It's always a possibility, but in this environment, I'm not sure who is brave enough to step up to the plate and buy them," Bhasin said.