WSJE: Heard In Europe: Equipment Makers Could Hold Surprises
11 Jul 00:30
By Jesse Eisinger
Investors in European telecom-equipment makers have endured profit warnings,
write-offs, ousted executives and customer defaults. Now they should brace for
another shock: severe downgrades in credit ratings. Some of these former
darlings could even fall to junk-bond status.
If that sounds outlandish, take a look at Lucent, whose bonds were reduced by
Standard & Poor's to double B plus - below investment grade and just into junk
territory - on June 12.
Equity investors have had years to become accustomed to looking at two
numbers at the most - revenue and earnings per share. As more customers default
on contracts - as Turkey's Telsim Mobil did recently when it failed to make a
payment on a loan from Nokia - and as sales continue to slow, investors will
have to learn to assess balance sheets.
Watching assets shrink cannot be a pleasant experience, but finding out that
the cost of doing business is suddenly much more expensive is downright
frightening. If the ratings agencies take the equipment makers down many
notches, it will make it much harder to fund growth through acquisitions or
vendor financing, in which these companies lend money to their customers to
finance purchases. And that will shrink what the premium investors are willing
to pay for these high-tech stocks.
For now, few investors think that even the worst-off equipment guys will be
downgraded all the way to high-yield, or junk status. S&P downgraded Ericsson
debt in May and the company's long-term rating slipped only a notch to A- from
A. Marconi and Alcatel are on negative credit watches.
Equity investors who know little about bonds may not understand that the
credit rating agencies are fairly slow-moving and conservative organizations.
They are lagging indicators of financial performance, only downgrading after a
company has been given ample time to sort out its problems. That gives
investors room to try to anticipate such a move. "We only act when we see a
structural change" in a market, says Wolfgang Draack, a telecom-equipment
analyst for Moody's. "Usually, that's later than the first signs of a down
cycle."
The more bearish investors contend that the telecom-equipment makers aren't
in a cyclical decline, but a secular one in which demand - and therefore profit
margins - never rises back to the levels seen in the late 1990s. Mr. Draack is
familiar with these arguments: "We are watching for the stage when it turns
into structural difficulties for the industry."
For a case study in deteriorating fundamentals, take Alcatel. The company
said in late May it was taking a 3 billion euros write-off. Analysts estimate
that the company will likely have negative free cash flow after capital
expenditure this year. UBS Warburg estimates negative free cash flow of 305
million euros for the year. Estimates for earnings before interest, taxes,
depreciation and amortization, or Ebitda, for this year have been cut by more
than 50% across the board. Alcatel's inventory level stood at about 8.5 billion
euros in the first quarter, up over 1 billion euros from the end of 2000. The
company has said that the number should fall by the third quarter, but given
the current environment, an investor would do well to view that with healthy
skepticism.
But S&P still rates Alcatel's long-term debt single A; Moody's has Alcatel at
a single A1 rating. And the "spreads" on Alcatel corporate debt maturing in
2005 stand only about 100 basis points, or one percentage point, over French
government bonds. They haven't widened much since the beginning of June. The
debt due in 2009 has widened recently, to a spread of about 140 basis points,
which suggests the market is taking into account a downgrade of one notch,
investors say. That might not be enough. Marconi's spreads have blown out in
conjunction with its massive profit warning last week, trading recently at
spreadsof about 280 basis points for the 2005s and 300 for 2010s.
Granted, Marconi has what appears to be a worse debt problem, but Alcatel is
not exactly debt free. It had 4.3 billion euros in net debt at the end of 2000.
The company has said debt will fall this year, in part thanks to disposals like
its Nexans division. Exane, a French investment bank, estimates the net debt
will fall to 2.2 billion euros. Analysts will tell you that their confidence in
their estimates isn't high.
It is far from clear that Alcatel's 3 billion euros write-off will be enough.
The company said that consisted of a write-off of its investment in Canada's
360 Networks. Alcatel also said it had written off several hundred million
euros of inventories. The write-off also included restructuring costs. And it
included goodwill. The company wouldn't break the figure down further, leaving
analysts more or less to guess. Some say that the entire 1.3 billion euros in
goodwill from the Xylan acquisition was written down. But is that all there is
to be done? At the end of 2000, the company had net goodwill of 7.04 billion
euros.
Some analysts say that one-third of the write-off was for its investment in
360 Networks. But that was essentially a vendor-financing deal, raising the
question of whether Alcatel has a lot more exposure to such financing than the
market thinks.
The company has a reputation for having been stingy on vendor financing. It
said in March that it had 1.6 billion euros of financing drawn down by
customers and 1.2 billion euros committed but not yet drawn. But in its 20F
annual filing with the U.S. Securities and Exchange Commission, Alcatel says it
has 10.1 billion euros of "guarantees given on contracts and others," up from
7.1 billion euros in 1999. What is this? Alcatel officials declined to comment.
What is clear is that much of that figure represents contingent liabilities
from cash paid by customers for equipment that Alcatel has to deliver. That is
a normalbusiness item and it is unlikely that Alcatel won't deliver its
equipment.
But the company hasn't explained to analysts why the number rose 42%, more
sharply than the sales increase of 36%. The speculation is that some vendor
financing has found its way into that figure, for which Alcatel is on the hook
if the customer runs into trouble.
The problem with Alcatel is that no one knows the true status of the
company's balance sheet. When it becomes more clear, the ratings agencies'
knives will likely come out.
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Please send comments or questions to jesse.eisinger@wsj.com
(END) DOW JONES NEWS 07-11-01
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