canoe.ca
Nortel: Everything but the analysts' blessing
Northern Telecom's share price has been on the skids, thanks to a sloppy
performance in front of New York analysts. But wait, Nortel is still a
fundamentally great company
By DAVID OLIVE
Senior Writer The Financial Post
Northern Telecom Ltd. is fundamentally sound.
Canada's high-tech flagship will probably hit its revenue and profit
targets when it reports its third-quarter financial results on Oct. 27,
and go on to produce record sales and profit for the year as a whole. As
a hedge against the possibility of a slowdown in sales growth next year,
Nortel has taken the pre-emptive step of trimming its payroll by 4.4% in
order to protect its margins. Most important, though, Nortel is a
front-line player in the World Wide Web technology that is transforming
the telecommunications equipment industry.
The race to exert mastery in "convergence," the melding of voice and
data networks, will go to those with research and development prowess,
deep pockets and audacity. Nortel boasts the industry's most extensive
R&D network, with dozens of facilities on four continents. And with its
bold move in shelling out US$7.6 billion in June for Bay Networks Inc.
of Santa Clara, Calif., Nortel has gotten a jump on larger rivals such
as Lucent Technologies Inc., Alcatel Alsthom Group, L.M. Ericsson and
Siemens AG, which have yet to buy or develop the technology that will
some day make it as easy to access the Internet as obtaining a dial
tone. So, Nortel is fundamentally sound. Nortel's volatile market ride May
20: Nortel stock soars to a record high on news of its five-year,
US$1.5-billion deal to supply equipment to Baby Bell SBC Communications
Inc.June 15: Investors pan Nortel's plan to pay US$9.1 billion in stock
for Bay Networks Inc., the U.S. No. 3 maker of data networking equipment
July 21: Big jump in third-quarter operating profit lifts Nortel shares.
Sept. 14: Nortel shares are pummelled on news it plans to cut 3,500 jobs
-- about 4% of its workforce -- in an efficiency drive.Sept. 29: After a
meeting with Nortel brass, analysts dump the stock on fears the company
will miss its earnings targets.
That assertion rings hollow, of course, for the widow in Estevan,
Sask., who holds $10,000 worth of Nortel shares that would have fetched
more than $20,000 just five months ago.
Main Street investors have a reason to feel betrayed. Nortel is not
Moose Pasture Mines Ltd., after all. It's the second-most widely held
stock in the country, an affiliate of Ma Bell, for heaven's sake. Yet
last week alone, Nortel shares plummeted by 18%, erasing $9.1 billion in
shareholder value. Whipsawed investors in Nortel and countless other
blue-chip issues such as Coca-Cola Co., American Express Co. and
Canada's Big Five banks are puzzling over the penny-stock antics of
investments their brokers were describing as rock-solid as recently as
last summer. And, naturally enough, they're looking for someone to
blame.
In this case, many Bay Street analysts have identified the culprit as
Nortel itself. They complain Nortel failed to warn them the Asian flu
and belt-tightening by key customers in the U.S. and Europe point to a
likely slowdown in sales growth, and Nortel blindsided them last month
with its plans to lay off 3,500 employees. They scorn the purchase of
Bay, which they rate an also-ran in Web technology to Cisco Systems Inc.
The last straw was an analysts' conference hosted by Nortel on Sept. 29
in New York, where chief executive John Roth and chief financial officer
Wes Scott seemed to display an inexpert grasp of the company's numbers.
Audience members fled the room to bark sell orders into their
cellphones.
In the aftermath of that disastrous session, says Toronto technology
analyst Robert MacLellan of Kearns Capital Ltd., "our investor clients
are livid. They see the confusion among Nortel executives and feel their
intelligence has been insulted." Many institutional investors, says
MacLellan, are clamoring for heads to roll at Nortel, starting with Roth
and Scott. "Nortel has lost all credibility and it'll take a long time
for the company to recover. Starting with the Bay deal, every time
investors have bought back into Nortel on weakness, they've caught a
falling knife by the blade."
The tailspin in Nortel shares has prompted a rare display of
frustration by Roth, who blames the market. "The Street," he told The
Financial Post late last week, "went into chaos ... they just absolutely
went into panic mode." He describes the share plunge as "largely an
emotional reaction rather than a logical, directed reaction."
Who to believe? The weight of evidence favors Roth, who lacks both the
arrogance and complacency typical of CEOs who are for the high jump.
Roth is Mr. Proactive.
His selection as CEO can be traced to the wireless operation he built
from scratch, beginning in 1991. In just six years, it evolved into
Nortel's biggest division, accounting for 25% of sales. Within two
months of becoming CEO last October, he indicated he wasn't about to
coast on Nortel's double-digit profit increases of the past two years.
In December, he unveiled "Webtone," his one-word mantra for turning an
old-line supplier of traditional telephone equipment into a nimble
contestant in the high-risk Internet game. In pursuing that strategy
with the purchase of Bay, a firm with a weak customer list but an
impressive new product pipeline, Roth didn't let his long apprenticeship
in Nortel's R&D labs color his humble view that Nortel needs rapid
access to outside technology. With becoming candor, he acknowledged he
would have preferred to buy Cisco or Ascend Communications Inc., as many
on the Street now wish he had -- "but they weren't for sale."
Handicapping the telecom stocks Nortel is only one of many victims in a
selloff that has cut a swathe through the entire telecommunications
equipment sector Northern Telecom Ltd., Brampton, Ont. (US$29.50, down
58% from its record high). Suffers slack demand for switching products
and tough slog in integrating Bay Networks acquisition. Newbridge
Networks Corp., Kanata, Ont. (US$15.50, down 76%). Coping with price
wars and soft international markets, but benefits from alliance with
Siemens AG. Lucent Technologies Inc., Murray Hill, N.J. (US$62.75, down
42%). Expected to gain Internet and networking expertise through
takeovers. Motorola Inc., Schaumburg, Ill. (US$45.40, down 39%). Recent
profit recovery is due to cost-cutting, not a turnaround in long-term
sales slump. Cisco Systems Inc., San Jose, Calif. (US$49.90, down 29%).
Has surrendered status as darling of the sector with recent stock plunge
on suspicions of weakening demand for its networking equipment. 3Com
Corp., Santa Clara, Calif. (US$27, down 28%). No. 2 data networking
supplier is struggling with dimming growth prospects, may be takeover
prey to L.M. Ericsson or Alcatel Althsom Group. Ascend Communications
Inc., Alameda, Calif. (US$41.60, down 24%). Hot data networking firm is
a rumored takeover target for Lucent.
Roth still has his fans, even if many of the analysts who once cheered
him on have gone into hiding. "I'm more bullish on Bay than ever," says
Charles DiSanza, an analyst at Gerard Klauer Mattison of New York, who
was touting Nortel stock in May when it was at $93.30 and still has a
crush on it at $45.55. "They bought the right company in Bay. The New
York Stock Exchange runs on Bay equipment -- that's pretty good. As for
Roth, who has impressed me over the years in building Nortel's R&D
strengths and then with wireless, if they rolled his head, I'm not sure
I'd keep the stock. Roth is integral to my recommendation that this
stock is still a 'buy.' "
Roth's many doubters argue that in Bay, he has equipped himself with a
pea-shooter against giants like Lucent, which is poised to buy Cisco,
Ascend or any number of stronger Web technology firms. "Bay is a
handyman's special, and it won't provide Nortel with any decent new
products to put on the market for at least a year, yet Roth paid a small
fortune for it," says MacLellan. "Ascend would have cost a bit more,
maybe US$12 billion, but it wouldn't have been a fixer upper. With
Ascend, Roth could have had a strong line of new Nortel-labelled data
networking products on the market in 30 days."
Another skeptic is Duncan Stewart, who runs the Navigator Canadian
Technology Fund for Tera Capital Corp. in Toronto. He is bullish on the
long-term prospects of Nortel and its Bay acquisition, but says Roth is
off-base in sticking to his double-digit earnings forecasts for next
year. "All I can say to that is, if they're certain about 18% to 20%
profit growth next year, are they sure about that in the same way they
were sure about the revenue outlook that abruptly changed during that
analysts' conference?"
In his 29-year career at Nortel, Roth has seen his company doubted
before. For an entire decade in the 1960s, Nortel's profits were flat,
never exceeding $11 million, as it turned itself into a high-tech
powerhouse that eventually came to market with the world's first family
of fully digital telephone equipment. In the 1970s, Nortel's U.S.
division went through four presidents in six years and rival Rolm Corp.,
then the leader in private branch exchanges, mocked Nortel's
"incoherent" strategy for cracking the U.S. market. Rolm has since
slipped into obscurity, and Nortel is the second-largest supplier of
telecom equipment in the U.S., trailing only the mighty Lucent. In the
aftermath of layoffs, customer alienation and a staggering 1993 loss of
US$884 million --the legacy of Paul Stern's quixotic leadership of the
company -- Nortel was written off in some quarters as a company with a
bright past. Instead, Nortel used beachheads in Europe and Asia that
JCÿÿ
om Ericsson,
Siemens, Alcatel and NEC Corp. in their own backyards, culminating in
record 1997 sales of US$15.4 billion and record profit of US$812
million.
"Nortel is a well managed company with good technology and happy
customers," says independent technology analyst Ian Angus. "And,
contrary to popular wisdom, the phone companies which are Nortel's key
customers are the most ideally situated to supply the world with
Internet access. Bay should help Nortel satisfy the phone companies'
desperate hunger for Internet technology. And while it may be only a
third cousin to Cisco, Bay is very strong in the enterprise, or private
corporate, networks that now account for as much traffic as traditional
public telephone networks."
What's been missing in the Nortel meltdown story of the past two weeks
is context.
Reality check No. 1 is that the entire sector of telecom suppliers has
taken a tumble. This week, a few days after Nortel's 18% drop, it was
the turn of market darlings Lucent and Cisco to take a drubbing (See
list). A sanguine Richard McGinn, Lucent CEO, brags it's "not an unreal
picture" for his company to be growing while rivals face the prospect of
dimming growth, because "every time we make a new sale outside the U.S.,
it is market share gained at the expense of others."
Yet some doubt it is making substantial inroads on firms like Nortel,
which have a stronger overseas presence than Lucent.
"I don't believe Lucent is immune to the looming global recession,"
says fund manager Stewart, "If telecom spending is being cut, as seems
likely, everyone in that business is going to get hurt."
Reality check No. 2 is that the old rose-colored psychology of the bull
market is now working in reverse. If "new tech" stocks like Amazon.com
and Yahoo Inc. could do no wrong until recently, and enjoy market
capitalization in the billions of dollars without ever producing an
annual profit, the current bear market psychology now punishes firms for
things they do right. Until a few months ago, for instance, Nortel's
pre-emptive layoffs would have been greeted as a prudent move and likely
triggered a bounce in its stock. Analysts would have applauded its
share-swap purchase of Bay, in which the purchase price dropped US$1.4
billion after the deal was announced, because of the slide in Nortel's
shares. And a garbled message at an analysts' meeting would have been
dismissed as a non-event.
"I was at that meeting," says analyst DiSanza, "and all I heard was
something about a 'short-term problem' of sales growing by 10% to 12%
rather than an earlier forecast of 16%. I heard nothing that will affect
the long-term outlook of this company. It was a gross overreaction by
the Street to take Nortel to the woodshed."
Analyst Ross Healy of Toronto's Strategic Analysis Corp. agrees.
"Nothing has changed at Nortel," he says, "except that its stock has got
a lot cheaper." Technology analyst Angus marvels at the Street's
flip-flop on the erstwhile do-no-wrong tech sector.
Adds Stewart, "The meltdown in telecom stocks sure blows the efficient
market theory out of the water. If analysts can reverse themselves on
the basis of one presentation by Nortel management, you've got to wonder
about their credibility. If they were wrong to call Nortel a 'buy' at
$98, they're wrong to sell it now at $45."
That's little comfort to Main Street investors, of course, who must be
wondering how Nortel managed to climb to the nosebleed heights of $98.
Healy, a rare analyst who advised his clients to get out of the stock
at that price, doesn't pretend to have the explanation. "Don't look at
Nortel, which has never gone out of its way to promote its stock, and
doesn't freak out when you say negative things about it. All you can say
is that an overheated market boosted some fine, high-quality stocks like
Nortel to excessive valuations. It's like something out of Charles
Mackay's Extraordinary Popular Delusions and the Madness of Crowds --
any attempt to explain or analyse this madness is feckless."
He adds: "The only thing you can explain, because it's entirely
predictable, is that on the way up, analysts cited every reason under
the sun to justify the higher price for Nortel. And now they're citing
the damnedest reasons, like the analysts' conference, as excuses for
dumping on the stock. They should just come out with it, and say they
made mistakes in recommending it at such high prices in the first
place." |
