Awaiting the Kitchen Sink at Nortel

It seems like Nortel (NT Quote - Cramer on NT - Stock Picks) investors have suffered every possible indignity in recent months. Now they're about to get hit with the kitchen sink.

New Era Nortel well off its highs

When the once mighty telecom-networking giant pulls back the curtain Thursday on first-quarter results, analysts expect to see deep losses, steep charges and a continued sense that the good times are past, for now. Nortel, which has warned twice that first-quarter results wouldn't be up to snuff, is expected to lose 12 cents a share for the period, according to analysts polled by Thomson Financial/First Call.

"I don't think you're going to hear a lot of optimism near-term," says Solomon Smith Barney analyst Alex Henderson. "They cleared the decks when they preannounced the second time and threw in the towel on the outlook. They are already forecasting losses. Can it get worse than that?"

Waste Land

Many investors are probably still hoping Nortel will benefit from a second-half bounce in the economy. But regardless of whether business picks up, Nortel's list of potential worries is substantial. Money is scarce across the industry, Nortel's product lines are aging, vendor-financing deals are looking increasingly risky and inventory is building to distressing levels. Add to this the fact that Nortel's earnings and revenue numbers are likely to be flat out ugly.

"I think we need to see inventory levels continue to come down, and sequential revenue growth, before we see a sustained upturn," says Edward Jones analyst Dave Powers. "It all comes back to the services providers. We need to see them improve their operating cash flows and thus be willing to spend more capital in terms of deploying new equipment." Powers rates Nortel a buy and Edward Jones has no underwriting ties to Nortel.

Pointing up just how bleak the networking business looks right now to some observers, Henderson, who rates Nortel a buy, expects the company to ring up an 8-cent-a-share loss for the year. Analysts expect Nortel to earn an 18-cent profit for 2001, though the estimates range wildly, from a 53-cent profit to a 19-cent loss, owing to the company's lack of guidance beyond this quarter. Solomon Smith Barney has no underwriting ties to Nortel.

Albatross?

Nortel's $3.1 billion in financing commitments to ailing phone and Internet service customers appear increasingly likely to take on albatross status as more outfits go belly-up. The borrowers have tapped Nortel for an estimated $1.8 billion in loans. Solly's Henderson estimates Nortel will have to reserve as much as $500 million to cover loans held by sinking deadbeats.

Nortel is also sitting on tons of inventory. In fact, the company had $4.3 billion in inventory at the end of last year, a figure that could rise substantially considering the slowdown punishing rivals like Cisco (CSCO Quote - Cramer on CSCO - Stock Picks).

Pointedly, $2.5 billion of that inventory is finished products, gear Nortel just couldn't sell. Cisco's monstrous and controversial writedown of $2.5 billion in inventory was 80% components and parts -- a problem of a different kind. Analysts say they wouldn't be surprised to see Nortel take its own sizable writedown -- perhaps as much as $1.5 billion.

No Quarter

Probably most dismaying about Nortel's predicament is that it has provided itself little by way of a ladder to climb out. Nortel is late to the market with several key products, and the industry has begun evolving away from the products in Nortel's vast portfolio. With its stock some 80% off its 52-week high even after the last week's tech-stock rally, Nortel investors must be wondering when the winds will change.

A year ago, Nortel dominated the optical market with an exceptionally popular high-capacity transport product. The timing was great as network builders, flush with investor cash, went shopping for the latest gear to optimize their long-distance fiber-optic network routes. Rivals such as Ciena (CIEN Quote - Cramer on CIEN - Stock Picks), Marconi (MONI Quote - Cramer on MONI - Stock Picks), Lucent (LU Quote - Cramer on LU - Stock Picks) and Fujitsu have come along with their own boxes, some at cheaper prices. Nortel has sought to defend its market share mainly through pricing and financing efforts, a rather grim turn of events.

Recently, spending patterns have changed in two significant ways: More money is being concentrated on construction of local or metro fiber networks, which are increasingly the province of single-minded upstarts like ONI (ONIS Quote - Cramer on ONIS - Stock Picks). And in optical switches, the gear that is considered the brains of new networks, helping to manage the traffic running over long and short routes, Nortel has missed the current product cycle. With Cisco bowing out, Ciena has the market nearly to itself.

To make matters still worse, some of Nortel's best customers, including BCE (BCE Quote - Cramer on BCE - Stock Picks), Worldcom (WCOM Quote - Cramer on WCOM - Stock Picks) and Sprint (FON Quote - Cramer on FON - Stock Picks), are planning to trim their equipment spending.

"It's pretty clear they are going to be cleaning out the kitchen," says Henderson. "If you're Nortel, you've basically made a decision that this is a transition year and said, "The heck with it, let's clean everything up.' I think that's what you'll hear out of them, one way or another, in their comments."

Right. There is always next year.