Moody's Junks Nortel Debt
A little less than a year after Lucent Technologies Inc.'s (NYSE: LU) debt was downgraded to junk status, Nortel Networks Corp. (NYSE/Toronto: NT) has achieved the same dubious distinction.
Moody's Investors Service today lowered Nortel's senior long term debt to Ba3 from Baa3, the rating on the company's preferred stock to B3 from Ba2, and the company's rating for commercial paper to Not Prime from Prime-3 (see Nortel Responds to Moody's). A Ba3 debt rating is considered junk-bond status.
Moody's blames the decline in capital spending among incumbent carriers for Nortel's weak financial performance. Moody's believes that further declines are possible as carriers increasingly focus on their own liquidity and capacity requirements.
"Nortel has done an awful lot to improve their situation," says Robert Ray, senior vice president at Moody's. "But the end market they are looking at appears to be under significant pressures, and it likely won't rebound anytime soon. Nothing specific prompted this action. We've gotten a sense that incumbent carrier spending, in North America especially, has been pared back."
Consequently, Moody's believes that spending will continue to be depressed for wireline networks and could be made worse for Nortel and other equipment providers as surviving carriers scarf up assets from those that have failed. Wireless provides some hope, but 3G networks will be slow to take hold, keeping growth in this market to a minimum.
Despite the downgrade, the firm seems positive about Nortel's long-term prospects, saying the company is well positioned with leading market share in many of its products. Additionally, the company has aggressively reduced its cost base, by an estimated $6 billion per year, and has been successful in managing its working capital, which has substantially offset the operating losses. This has helped the company cut back on its debt without having to rely on asset sales to do so.
Some bond traders say they were already expecting the downgrade. "In reality, Nortel hasn't been investment grade since at least its last earnings call," says one bond trader who didn't want to be named. "It was a foregone conculsion that the bonds would be downgraded. People were already hesitant to lend to them."
So what exactly does this all mean for Nortel? Nortel says that it will continue to be business as usual.
"We do not expect the ratings downgrade to have a significant impact on our day-to-day business operations," said CEO Frank Dunn in a prepared statement. "We see the downgrade as being primarily driven by industry conditions affecting the telecom sector following the events of 2001."
But going from investment grade to junk status will most likely affect Nortel's ability to raise new capital. Lenders are much less likely to buy bonds that are below investment grade. And even if Nortel is able to sell its bonds, it will likely pay a higher percentage on that debt than if its debt were rated investment grade. As a result, the company may be forced to rely more heavily on its cash reserves to fund its operations.
Unlike many carriers -- like McLeodUSA Inc. (Nasdaq: MCLD) and XO Communications Inc. (OTC: XOXO), which have recently seen their debt ratings fall below investment grade -- Nortel has enough cash and liquidity to keep it out of insolvency, at least for the short term (see McLeodUSA on the Brink and Carrier Bankruptcies in Full Bloom). The company is sitting on $3.5 billion in cash. Clearly, this year will be a challenge for Nortel as it will be forced to dig into that cash reserve, but it still buys the company quite a bit of time.
"They are burning through a lot of cash," says the unnamed bond trader. "But it's highly unlikely they'd go through $3.5 billion in just one year. Maybe in 12 months things will look different."
The market reacted modestly to the downgrade. At midday the stock was trading down $0.08 (1.84%) to $4.27. Part of this can be explained by the fact that many mutual funds are not allowed to hold stocks that are below investment grade.
Nortel's key rival Lucent was downgraded to junk status in June of last year and still hasn't had its debt upgraded to investment status since then. Nortel will report its next quarterly earnings on April 18th.
- Marguerite Reardon, Senior Editor, Light Reading