Disconnected
Telecom equipment makers have been abandoned by investors. An opportunity on
the line?
By ANDREW BARY
The battered telecommunications-equipment sector is about the last place that most investors are
looking to put money into these days. All the major stocks in the group have plunged this year amid
a sharp contraction in industry capital spending spurred by the bankruptcy of upstart providers like
Global Crossing and more restrained expenditures by the Baby Bells and other financially solid
telecom carriers around the world.
The two main North American equipment makers, Lucent Technologies and Nortel Networks, once
had market values topping $200 billion, but both are now on the ropes. Lucent is down 76% this
year, to just 1.50, and stands way below its 1999 peak of 64. Lucent shares have lost nearly half
their value in the past few weeks, following its warning of a 10% to 15% drop in revenues during its
just-completed June quarter. Rival Nortel, once the pride of Canada, is off 80%, to 1.50, this year
and is down 98% from its 2000 high of 89.
The collapse of WorldCom has made matters even
worse because the company plans a further cutback in
its 2002 capital spending to about $2 billion, down from
a prior estimate of $3.5 billion and a peak of $11 billion
in 2000 -- a figure that admittedly may be inflated.
Before the WorldCom disaster, capital expenditures by
U.S. carriers were expected to drop about 30% this
year to $78 billion from $110 billion in 2001, according
to Tod Jacobs, a telecommunications-equipment analyst
at J.P. Morgan. The 2002 spending estimates likely will
come down in the wake of WorldCom, the financial
pressures in the wireless industry and potentially stingier spending by the Bells, which are focused
more than ever on boosting their free cash flow.
Yet some brave investors are buying the telecom-equipment stocks, arguing that spending may turn
up in 2003 or 2004 and that the washed-out sector is discounting a complete industry meltdown.
"These stocks are trading as if people aren't going to use their phones anymore," says Ross
Margolies, manager of the Salomon Brothers Capital fund. "This is an industry with high barriers to
entry. The worse it gets now, the better it may get because the upturn will come sooner. A lot of the
spending is just to maintain services the way they are."
Margolies is well aware of the argument that it's too early to invest in the group because an upturn in
equipment spending may not come until late 2003 or 2004 and that most companies now are
operating in the red. But he maintains that the stocks are too cheap to ignore.
"The way to play the group is to buy a basket of stocks. You want to try to protect yourself and
create a margin of safety," Margolies says. "That means picking clear survivors -- companies that
have large, solvent customers, good technology and the ability to finance research and development.
And finally, you want to select companies that won't have to dilute you with equity offerings if things
go bad."
Margolies is partial to Lucent, Ciena, a producer of optical networking gear, and Comverse
Technology, an Israeli outfit that is the leading producer of voicemail software for the wireless
industry. He says that all three have the potential to double -- or even triple -- by late 2003.
Cash-rich Ciena, which just bought another optical networking company, ONI Systems, could itself
become a takeover target for the likes of Cisco Systems.
As the accompanying table shows, Ciena and Comverse
trade for little more than the net cash on their balance
sheets after subtracting debt. Ciena, whose shares trade around 4, has just over $3 a share in net
cash while Comverse, at about 9, has $7 a share in net cash. Tellabs, which trades under $6 a
share, has more than $2 a share in cash, a debt-free balance sheet and is the only one of the five
companies listed in the table that remains profitable.
Lucent and Nortel are dicier because they have more debt than cash and still are losing money. But
both companies have bought time to right their businesses with significant financing actions this year
that probably will allow them to go until 2004 without needing additional money. This effectively has
turned their stocks into cheap call options on an industry upturn.
Margolies says that Lucent is "clearly a survivor because it has the best customer base, good
technology and not a lot of leverage." Lucent, the former telecom equipment arm of AT&T, clearly
has been mismanaged in recent years, but it has retained solid relationships with the Baby Bells and
its former parent. Ticking off some of its financial attributes, Margolies notes that Lucent trades for a
little over half its book value of $3 a share and that its enterprise value/sales ratio stands at just 0.6.
Lucent's enterprise value of $7.2 billion is based on a market value of $5.1 billion and net debt and
preferred stock of $2.1 billion.
Lucent also has a valuable business servicing its equipment that's expected to generate $3 billion to
$3.5 billion of sales in 2002. Lucent has the biggest service business among the major telecom
equipment vendors but still has just 10% of a fragmented market and plenty of growth opportunities,
according to Lehman Brothers analyst Steven Levy. Lucent's cash, which totaled $4.8 billion at the
end of the March quarter, may drop by around $1 billion at year-end 2002, but the cash burn could
stop in 2003.
Make no mistake; Lucent isn't a picture of health. The company's projected revenues of $13 billion
in its current fiscal year, which ends in September, will be down more than 50% from peak sales of
$28 billion in its fiscal 2000. Telecom-equipment producers continue to be plagued by liquidations
of used equipment owned by bankrupt carriers that often sell for a fraction of the original list prices.
Howard Jonas, the chairman of IDT, an upstart, cash-rich telecom that is rapidly becoming an
industry power, says used equipment, which often sells for as little as one-tenth of the list price, can
be an attractive alternative to new gear. "It's not like a car engine. There are no moving parts to
wear out," Jonas says.
Lucent, meanwhile, is expected to lose about $2.3 billion, or 67 cents a share, in its current fiscal
year and it may not break-even until early 2003. The company's sales in the June quarter are
estimated at $3 billion, below its estimated break-even quarterly rate of $4 billion. Lucent and other
telecom equipment makers have been furiously cutting costs in largely unsuccessful effort to generate
break-even results at lower revenue levels.
Alkesh Shah, who covers telecom equipment for Morgan Stanley, recently wrote that Lucent, which
has undergone massive layoffs, may announce yet another cost-reduction program soon. The charge
associated with the potential "Phase 3" restructuring plan could total $1 billion, Shah said in a client
note.
One of the key issues with the equipment producers is their potential earnings power in a business
recovery. Some investors will estimate 2004 or 2005 profits and then apply a price-earnings
multiple to those earnings to arrive at price targets. Merrill Lynch analysts recently did such an
exercise with Lucent and Nortel in which they put Lucent's earnings power at 19 cents and a
potential share price of nearly $3 a share.
Margolies is more optimistic, believing Lucent can earn more than 30 cents a share, or a 5.5% net
margin, on $20 billion in sales. Put a P/E of 10 on 30 cents and Lucent's stock could trade up to 3,
and apply a P/E of 20 and the share could rise to 6.
Tellabs is favored by Rich Pzena, head of Pzena Investment Management, a New York investment
firm. "Tellabs has over $2 a share in cash, no debt and it's actually generating earnings and positive
cash flow," he says. "There's no bankruptcy risk like you have at some of the other companies."
Tellabs' main product, the Titan 5500, enables business users to connect to high-speed Internet
lines. There's some technology risk with Tellabs because of the threat posed by optical switches to
the Titan product, but Pzena believes Tellabs is safe from that threat.
Tellabs' revenues this year are expected to total around $1.5 billion, less than half of its sales in
2000, but the company eked out a tiny profit in the first quarter and is expected to earn about a
dime per share this year. Noting that Tellabs earned over $1.67 a share in 2000, Pzena says the
company is capable of producing $1 a share in profits, which would support a stock price of more
than $10 a share.
Nortel's plight was apparent in a $1.4 billion financing last month that largely consisted of the sale of
632 million shares of stock sold at just $1.41 a share. That deal shored up Nortel's balance sheet
and bought time for the company, but it was enormously dilutive, boosting the company's
outstanding shares to nearly 4 billion.
IDT's Jonas, whose company is a user of Nortel switches and optical gear, is a fan of the company.
"Nortel equipment has the best reputation in the industry," he says.
With its recent equity financing, Nortel's cash rose to an estimated $4.5 billion from $3 billion at the
end of the March quarter. But the company is expected to lose $1.3 billion, or 33 cents a share, this
year and burn through more than $1.5 billion in cash before year-end. But Nortel probably has
ample cash to go through all of 2003 without needing any new financing.
Jonas says Nortel could become more involved in servicing
its equipment, a business that's now handled primarily by
independent distributors that sell Nortel gear. Jonas says
IDT would be interested in making an equity investment in
Nortel in return for the right to handle some of its service
business when existing Nortel relationships end. "It's a
gold-mine business," Jonas observes.
The bull case for Nortel is that the company is capable of
earning 15 to 20 cents a share a year. Put a P/E of 15 on
those earnings and Nortel could trade up toward $3 a
share.
Ciena's sales and stock price have collapsed, but as noted above, its stock changes hands for little
more than the $3 a share in cash on its balance sheet. Revenues in the current fiscal year ending in
October are expected to total $400 million, down 75% from the prior year's total. Ciena is
expected to post a loss of $244 million, or 74 cents a share this year, compared with profits of
$195 million, or 60 cents a share in fiscal 2001. The bear case on Ciena is that it probably doesn't
have much more than a dime in annual earnings power until at least 2006
But Margolies says Ciena has strong technology, potential takeover appeal and the financial
wherewithal to make it until an industry upturn. He notes that the company continues to spend
heavily on research and development in order to maintain its competitiveness. Ciena's net cash per
share was little changed following its recent deal to buy ONI for $400 million in stock.
Comverse also has a strong balance sheet with net cash of $7 a share, nearly equal to its current
stock price. This means investors are paying little for its voice-mail software and other products,
which generate about $800 million in annual revenues.
Margolies' view is that wireless companies have a particular need to maintain capital expenditures
because of continued subscriber and usage growth. Comverse is losing money, but its current cash
burn is modest given a projected loss of around $65 million, or 36 cents a share this year.
Comverse traded at 120 in 2000 and 28 as recently as January. Merrill Lynch analyst Tal Liani said
in a recent client note that value investors "may find Comverse's risk profile among the best in the
sector."
A less risky alternative to telecom- equipment stocks is their depressed debt. Nortel's junk-rated
convertible debt, the 4.25% bonds due in 2008, trades for about 46 cents on the dollar and yields
around 20%.
Lucent's $1.8 billion convertible preferred stock issue sold last year also trades under 50 cents on
the dollar and yields 17%. It carries junk ratings as well. The Lucent issue is convertible into stock
at around $6 a share, a big premium above Lucent's current share price. But the preferred likely will
rally if the stock rises.
Ciena's convertible debt, the 3.75% bonds due in 2008, appeals to Margolies because it now
trades for under 60 cents on the dollar and yields around 15%. He's betting the bonds are money
good because the company has considerably more cash than debt and considerable franchise value.
Comverse also has convertible bonds outstanding that yield around 9%.
The convertibles are less dangerous, but the stocks offer the most appreciation potential for intrepid
buyers willing to play in one of the most distressed areas of the stock market.
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