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Nortel's Optical Halloween

Column
Column
Column
10/25/2000

Oh, Nortel!

After the market's reaction to Nortel Networks Corp.'s (NYSE/Toronto: NT) third-quarter conference call, you would think that the company had just pulled a Lucent. Was Nortel CEO John Roth donning a Rich McGinn mask as a Halloween prank, or was this the real thing?

After the company announced solid year-over-year growth but questionable sequential quarterly growth, Wall Street's confidence in the company suddenly fell apart (see Nortel's Fright Night). Of primary concern was growth in its optical networking systems market, which fell short of forecasts, and actually declined in sequential terms.

Roth said the slowing optical growth could be attributed to a shortage of installation manpower for new optical networking equipment as well as double-booking on behalf of customers, which is now resulting in a growing customer inventory glut.

It was enough to let the imaginations of any nervous shareholder run wild -- and it drove the bean-counters mad. Had Nortel caught the Lucent flu? Were they playing with the books? Growing customer inventories? What the heck was going on here?

Nortel promptly lost 15 percent of its value in after-hours trading, only to open 20 percent in the hole in trading Wednesday morning -- and then things went from bad to worse. Trading in Nortel spiked to 80 million shares in the morning, and it took the whole optical networking market with it. This was not mom-and-pop investors selling nickel-and-dime positions in their favorite Canadian company. This was large funds dumping the stock en masse.

How confusing was the conference call? Well, Max Schuetz at Thomas Weisel described the situation as "bizarre." On Wednesday morning, the Wall Street Journal had enough trouble with the analysis: The front-page summary said, "Nortel's operating profit soared 83%, fueled by optical-networking sales." But the headline on the main story on page B2 said "Nortel Loss Widens; Stock Price Falls After Market Closes."

The markets, in their confusion, bet on the worst -- which one could attribute to the lingering paranoid effects of the Lucent debacle. After one disappointing quarter of growth in the optical networking business, the market assumed it was the beginning of a trend.

Let's calm down here for a second. Make no mistake about it, Nortel is no Lucent Technologies Inc. (NYSE: LU) , and John Roth is no Rich McGinn. There was evidence on the call that Nortel may have mismanaged growth, but this is still a company that by all measures leads the emerging optical field. And Nortel's optical braintrust, Don Smith, president of optical Internet, and Greg Mumford, president of optical networks (see The Top Ten Movers and Shakers in Optical Networking), have a coherent plan for next-generation optical technolgies such as 40-Gbit/s systems and optical switching technology, unlike Lucent's technology development experts, who have been asleep at the wheel.

There are also concerns about valuation in the larger optical market at work here, but Nortel seems less susceptible to such concerns when compared with high-multiple companies like JDS Uniphase Inc. (Nasdaq: JDSU). Surely, the optical market has gotten ahead of itself, but long-term growth is still intact. Let's do some quick back-of-the-envelope math on two telecommunications Goliaths, Lucent and Nortel.

Working backwards in quarterly revenue numbers, Nortel has reported $7.3 billion (Q3 2000), $7.821 billion (Q2), $6.32 billion (Q1), $6.99 billion (Q4 1999), $5.39 billion (Q3 1999), and $5.4 billion (Q2 1999) quarters. Thus, top-line growth has indeed been substantial, but lumpy. In fact, there were several quarters in which Nortel's sequential growth was either flat or down: from Q2 to Q3 this year, from Q4 of 1999 to Q1 of 2000, and from Q2 to Q3 of 1999. But the overall picture is of rapid annual growth -- significant for a company that will do $30 billion in business this year. And profits have steadily grown when you exclude one-time charges such as acquisitions. The market capitalization of Nortel stands at $140 billion, as of Wednesday midday.

Now, let's look at Lucent. Recent quarterly revenues: $9.4 billion (Q3 2000), $8.71 billion (Q2), $10.25 (Q1), $9.9 billion (Q4 1999), $10.57 billion (Q3 1999). (It should be noted that Avaya's revenues were removed following Q1.) Growth has been flat -- in decline, even. But more importantly, profits have declined, and Lucent's technology initiatives have no sway in the industry. The company is doing a little under $40 billion in business, but that busines is eroding. The market capitalization, as of Wednesday, was $69 billion, reflecting the recent collapse of the stock.

This is always a tricky time of year in the telecommunications industry. You are dealing with the end-of-the year bookkeeping and next year's planning. Large mutual funds are tidying up their returns. But you have to survey the entire market landscape and wonder if Nortel's business is as bad as the ticker tape indicated on Wednesday.

This was probably large fund managers slicing off large chunks of long-term profits on Nortel, a stock that's had a phenomenal run over the last year. But is the company on the edge of collapse? Most evidence says no.

-- R. Scott Raynovich, executive editor, Light Reading http://www.lightreading.com

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