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  We still see telecom in turmoil

BENJ GALLANDER and BEN STADELMANN

Friday, July 22, 2005

It's not unusual for companies in the midst of a turnaround to take a step backwards or sideways before the next hop ahead. Patient investors are not thrown off by such inconsistencies in the pace of progress; nonetheless they have to stay attuned to the possibility that the apparent recovery is fundamentally flawed.

A "double bottom" is a term used primarily by technical analysts to specify a chart where the stock price has descended to two approximately equal lows, separated by a period of time.

But it also can be used, in a more general sense, to describe a corporation, or even an entire sector, that finds its problems to be more intractable than expected.

Is this currently the case for the manufacturers of equipment for telecommunication carriers? Here are three that we don't own, but are keeping an eye on.

New Jersey-based Lucent Technologies has extensively restructured its operations, laying off tens of thousands of employees, as revenue dropped from a high of $33.8 billion (U.S.) in 2000 to $8.5 billion in 2003.

Sales moved up to $9 billion in 2004 and the company turned a profit of 42 cents a share. But forecasts indicate that net income will be less than half that this year, and operating margins are thin. Long-term debt has been pared from 2003's $5.6 billion, but it's still high at $4.8 billion.

The share price, which had worked its way back up to the $5 mark in January 2004 is currently languishing below $3.

In Europe this sector is dominated by Paris-based Alcatel. The drop in revenue over the past few years shows a very similar pattern, from 31.4 billion euros in 2000 to 8.5 billion in 2003, then moving up to 9 billion in 2004.

Performance this year has been sluggish, but the company has made substantial progress in repairing its balance sheet, hacking debt from 5.9 billion in 2001 to 3.3 billion in 2004. Currently the ADRs trade at about $12 on the NYSE.

Though home team Nortel Networks is considerably smaller than Lucent and Alcatel, its travails are proportional to its larger competitors. Revenue fell from $6.3 billion (U.S.) in 2000 to $2.3 billion in 2003, but the recovery was slight, to $2.4 billion in 2004.

The volatility in the share price has been more extreme, mostly due to the protracted struggle to release definitive financial statements. After getting close to $12 (Canadian) on the Toronto Stock Exchange in January of last year, the stock price has wilted to around $3.25. On a relative basis, Nortel's debt is by far the highest, at $3.9 billion (U.S.).

For the sector, analysts expect single-digit revenue gains for the rest of this year, and better numbers for 2006. This is expected to occur as manufacturers gradually move away from legacy product lines to the next generation of technology using "voice over IP", as well as strong growth in the global demand for mobile phone systems. We question this "gradual-recuperation" consensus.

After the crazy growth of the 1990s, these companies have essentially been in a depression as capital spending by carriers collapsed. Meanwhile the economy as a whole, despite the mild recession in 2002, has been fairly strong.

So the irony is that, despite the miserable sales environment of the past few years, these enterprises have yet to be tested by a general business recession.

If such a thing were to occur in 2006, carriers would again cut capital expenditures, as there is no shortage of capacity in the marketplace. In this scenario, these three companies would find it extremely challenging to sell enough gear to handle the interest payments on outstanding debt.

This is also an industry that has not yet weaned itself from granting generous options to management. By the emerging standard of what Standard & Poor's calls "core operating earnings," the bottom lines of this trio look much worse.

Given the muted upside and the considerable downside risk, it is unlikely we will make a stab at an investment until the danger of a double bottom has passed.


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