Nortel Spots the Tip of the Optical-Slowdown Iceberg

To some eyes, Nortel's (NT Quote - Cramer on NT - Stock Picks) oddly timed earnings and revenue warning Wednesday looks like the tip of the iceberg for a cooling optical-networking sector.

The Nortel Plunge Charting optical networker's descent

Sanford Bernstein analyst Paul Sagawa says the optical stalwart's move to trim first-quarter growth targets illustrates a much larger problem: Even the strongest companies in this pricey sector have an increasingly tenuous grasp on just how much product their customers will be able to afford in the next year. The cash crunch that the network builders are facing is fueling a spending slowdown that could affect any company -- even ones that have executed flawlessly -- soon.

The bottom line: There is a shortage of cash to buy new equipment. The optical boom has peaked. An entire industry whose plans were predicated on unstinting demand must now confront uncertainty.

That Smell

Sagawa, who was among the first on Wall Street to note the slowing spending among big network builders, says that a gap in communications with its cash-strapped buyers means Nortel is only beginning to catch a whiff of the decreasing spending at customers such as WorldCom (WCOM Quote - Cramer on WCOM - Stock Picks), AT&T (T Quote - Cramer on T - Stock Picks) and Williams Communications (WCG Quote - Cramer on WCG - Stock Picks).

Big Spenders Top five telcos in projected 2000 capital spending
Company	Projected 2000 outlay ($billions)
Verizon (VZ:NYSE)	16
AT&T (T:NYSE)	14
SBC (SBC:NYSE)	13
Qwest (Q:NYSE)	9
WorldCom (WCOM:Nasdaq)	8
Source: Companies, analyst reports.

"We had a little euphoria yesterday and a one-day rally because Alcatel (ALA Quote - Cramer on ALA - Stock Picks) put up a good number," says Sagawa. "But this [Nortel guidance] is a big chunk of bad news, and I think there is a lot more to come." Nortel stock slipped $1.75 Wednesday to close at $43.75.

The big-spending phone and Internet service providers have said one after another that they will be pulling out their checkbooks less often next year as they seek to preserve precious cash. With the IPO market all but dried up and bond payments soaking up excess cash, network builders that once were flush are finding they have no choice but to cut back on their ambitious buildout plans.

"The optical boom has been driven by the buildout of 14 North American and about 14 European optical networks, and the money is drying up for those deals," says Sagawa.

Blind Spot Blues

Word of a cash crunch has trickled slowly through the market in the past three months, catching a wider awareness only in recent weeks. In August, TheStreet.com reported that Williams had begun to liquidate its investment to help make its network expansion budget. Then in September, AT&T's network chief told TheStreet.com that spending would "level off" next year.

Then last week, WorldCom, AT&T and Williams said equipment spending would be pulled back.

How does Nortel, with its sales force talking to customers every day, miss this trend?

A Nortel spokesman said he couldn't comment on the financial affairs of the service providers, and sticks by the company's official guidance.

But Sagawa, who worked as a Lucent (LU Quote - Cramer on LU - Stock Picks) salesman when it was still a part of AT&T, says there's a classic blind spot in the buyer/seller picture.

Equipment-company executives work with projections they get from their sales teams. And the sales forces get their signals from customers, the engineers and the network planners at the phone companies. The engineers make the buying decisions, but they have to get money from the accountants.

Simon Sings: Dry Up

That is where the trouble comes, says Sagawa. In years past, the engineers picked the products and the bean counters came up with the money, which amid the Nasdaq boom and the global tech buildout, was easy to come by. But this time it's different: Now the bean counters are saying there is no money, and the engineers' wish lists aren't getting funded.

Sagawa, whose firm does no investment banking, in September was the first prominent Wall Street equipment analyst to point to the inevitable impact the falling fortunes of the equipment buyers would have on the equipment sellers. At that time, he cut Nortel and Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) to market perform.

"We did a lot of analysis of the cash flow and potential cash flow with the carriers," says Sagawa. "They need to find $100 billion to keep up the spending growth, and it's not there."

Of course, Sagawa could be wrong about this, and certainly he has caught his fair share of heat for throwing cold water on the bonfire. His sell-side peers at the major firms have largely stuck to their bullish projections. But as more network builders see their shares plummet, their access to loans diminish and their revenue fall, the evidence of a crunch gets harder to ignore.

Hitting Snooze

Nortel's press release Wednesday was intended to clarify its outlook for this year and next. And at first blush, the guidance confirmed the forecast the company gave analysts on an earnings call last week. Yet the company also forecast revenue for the first quarter of 2001 of $8.1 billion to $8.3 billion, a 28% to 31% increase over the previous year, which is significantly lower than the 30% to 35% revenue growth the company expects for the year. In addition, the company said earnings would be 16 cents a share, a penny lower than the consensus.

Getting a slow start in what looks to be a slower-than-recent-norms spending year raises the question of just how Nortel expects to stay within the growth range it has projected.

The Nortel spokesman says that although Sagawa is entitled to his opinion, surging Internet traffic will fuel demand for new, higher-capacity networks.

This buildout story has long been "a matter of faith," says Sagawa. "But look, if people don't have money, they can't spend it. That's the reality of it."