Let's say you don't buy Wall Street's recent call for the collapse of telecommunications spending. Sure, you know that many of the big spenders --

AT & T

(T) - Get Report

and

WorldCom

(WCOM)

, for example -- are finding growth hard to come by. But you still firmly believe that any analyst predicting that growth in equipment sales will drop from 30% a year to less than 10% is ... well, let's be polite and say they're off base. The CEOs who run these communications companies know that the only way to survive the cutthroat price competition in their business is to drive down costs by buying as much of the newest generation of cost-smashing equipment as they can. Cut capital spending and a telecommunications service provider will die.

So you want to use the current pessimism about the sector -- exacerbated by the fear regularly sweeping through the technology sector these days -- to increase your holdings of names like

Nortel Networks

(NT)

,

Sycamore Networks

(SCMR)

,

Juniper Networks

(JNPR) - Get Report

and

Redback Networks

(RBAK)

.

But which stock or stocks should one invest in? Should it be an expensive but proven steady grower such as Nortel? At 94 times estimated earnings per share for 2000, Nortel isn't cheap. But the company's earnings per share are projected to grow by 35% in 2001. The stock was up almost 200% in the last 12 months.

Or how about an incredibly expensive, potential rocket like Juniper? Juniper sells for 660 times estimated 2000 earnings per share -- a figure that seems slightly more reasonable if you realize that analysts are projecting 1,071% earnings growth for Juniper in 2000. The stock was up 590% in the last 12 months.

Go Back to the Basics

To decide, I think you ought to look at fundamentals.

Now, I know that it may seem odd or even quaint to suggest looking at such things as earnings growth, margins and the like for a stock like Juniper or Redback or Sycamore. I'm certainly not going to pretend that any of these stocks trade at values based on fundamentals.

Juniper, Sycamore and Redback are price-momentum stocks. That's why on Sept. 19, for example, investors in Juniper watched in delight as their stock soared almost $18 a share. Redback came close to matching that, advancing almost $16 a share.

Even Nortel trades more on momentum than on fundamentals, although in this case it's earnings momentum, rather than price momentum. An investor buying this stock is betting that the company can continue to deliver accelerating earnings growth and the kind of 25% earnings surprise that investors have seen from Nortel in each of the past three quarters.

But I think it's important to realize that momentum stocks are built on fundamental stories.

PMC-Sierra

(PMCS)

,

Applied Micro Circuits

(AMCC)

or

JDS Uniphase

(JDSU)

-- to name a few momentum stars of the past 18 months -- got their momentum from very real fundamental stories about earnings. You may think that at 213 times projected 2000 earnings, the value that momentum investors have put on a stock such as PMC-Sierra, is insane. But that momentum valuation soars from a pretty impressive fundamental foundation. Analysts project that the stock will grow earnings per share by 122% in 2000 and by 51% in 2001. I'd argue that the latter projection is probably low -- after all, the company beat estimates by 21% in the June 2000 quarter. And 2001 won't be the end of the company's growth, either -- the market for wide-area network semiconductors is projected to grow by almost 30% annually through 2003.

Just as projected fundamental stories are the fuel for momentum stocks on the way up, real fundamentals -- that is, actual numbers -- can set a momentum stock into a downward spiral. If actual earnings growth, margins and financials call the momentum story into question when the company reports numbers, the stock can plunge back toward valuations more fitting for traditional growth, or in extreme cases, value stocks. With its story discredited, investors decide to pay only for what the company has actually delivered.

A momentum stock's potential appreciation or loss depends on the balance between projected fundamentals and actual fundamentals. And one way to judge a momentum stock is to see how those two visions of a company's fundamentals balance out.

So how do those four telecommunications rate when placed in this scale?

Nortel's Comeback

Let's start with Nortel. The fundamental story here is that Nortel, after years as a slumbering giant that sold gear to the world's big phone companies, is now an aggressive competitor with cutting-edge technology -- especially in the optical area where the company is widely regarded as the market leader. You can see evidence of the new Nortel in its numbers this year: In reporting its second-quarter results, the company raised its projections for 2000 revenue growth to be between 40% and 45%, up from the earlier projection of 30% to 35% growth. Operating earnings per share for the full year will grow by 35% to 39%, the company said.

The question for Nortel, as for any earnings-momentum stock, is how long earnings will continue to accelerate (see my Sept. 1 column on earnings momentum,

Find stocks built for speed -- and acceleration). For an earnings-momentum stock, its own success results in an increasingly tough bar to jump. Nortel has managed to step on the gas this year to drive expectations for operating earnings growth up to somewhere near 40%. What about next year?

TST Recommends

Right now, the fundamental story for next year sounds very promising. The company is saying its market will grow by about 20% to 21% in 2001. That's down from what has been closer to 30% growth in 2000. So, in order to get to the company's announced goal of 30% to 35% earnings growth for 2001, Nortel will have to continue to take market share from its competitors.

That certainly looks possible. The company has momentum across its product line. For example, its Passport switch product saw 56% year-over-year unit growth in the second quarter. According to market research firm

Dell'Oro Group

, Nortel's product line now has 26% of the global market. Acquisitions like the July deal to buy

Alteon WebSystems

(ATON)

, a company specializing in switches that can intelligently react to content on the network, give Nortel the ability to continue to add functions and value to its products. The biggest bet, though, is Nortel's announced but so far unproved gear for all-optical switching. Nortel's equipment is supposed to eliminate the need to translate the light used by optical fiber networks into electrical signals anywhere on the network. If Nortel can pull that off, the huge cost savings to customers would result in another big spike to Nortel's revenues.

In this case, I think the balance comes down pretty heavily in favor of continued appreciation for Nortel's stock, at least through the end of the year. Nortel should be able to keep growth accelerating through the next two quarters. That will keep the earnings-momentum story alive, with support from details on market-share gains and speculation about the company's optical strategy. I think the stock has a good chance to hit my $96 target by December.

The trouble will come in 2001, when comparisons with the great quarters of 2000 get tougher and when earnings growth will probably top out at 40% before starting a modest decline to 30% to 35%. Nortel, I'd say, is worth holding to the end of the year, but will certainly deserve a new evaluation on the fundamentals then.

Juniper's Well-Loved Story

Let's move to Juniper. The market values Juniper at a lofty $66 billion -- and that's for a company with just $113 million in revenue in its June 2000 quarter and pro forma net income of $29 million.

Why so dear? It's not Juniper's growth rate -- as tremendous as the company's growth is, the current stock price still discounts 100% annual growth (and a 100 price-to-earnings ratio) well into 2004. And if you assume that the stock will appreciate by 25% a year while earnings are racing to catch up, then the current stock price discounts 100% annual earnings growth into 2006. That's a lot of years at 100%.

No, what has created the stock's tremendous price is the incredible strength of the fundamental

story

-- not the fundamental

numbers

. More than any other next-generation networker, Juniper actually sounds capable of being the next

Cisco Systems

(CSCO) - Get Report

. And the market capitalization on Cisco, even with the stock's recent troubles, is a rather tidy $436 billion.

Exactly what is the Juniper story? It reads like this: New applications and the demand for increased bandwidth require a complete upgrading of the telecommunications network. Juniper's routers are designed to sit at the core of this redesigned network, and -- I think this is the killer "fact" in the story -- the company has been able to take market share from Cisco, head-to-head, in what has long been one the bigger company's core strengths. Juniper has been able to score its wins not just by undercutting Cisco's prices but also by offering increased speed and software-based network configuration. And now, Juniper is taking the advantages that helped it win business in the market for core Internet routers and moving to attack another huge networking market -- the one for routers that sit at the edge of the network. On Sept.19, the company announced that it had ported its network core hardware to new M5 and M10 edge routers.

How far can this story drive Juniper? A comparison with JDS Uniphase suggests there may be an important psychological barrier at $100 billion in market capitalization for a technology stock that's running on potential revenue and earnings. Juniper won't run up against any fundamental numbers that might hurt its story until 2001. Analysts are projecting that earnings-per-share growth, currently projected at 1,071% in 2000, will drop to just 43% in 2001. That kind of drop, if it materializes, would probably be enough to stall the momentum even of Juniper. So, like Nortel, I'd say Juniper is good to run through the end of 2000 before it faces any major challenges from reality as we know it.

One measure of exactly how strong Juniper's story has been is the stock's surprisingly low volatility during this year's turmoil in technology shares. Certainly the stock took a huge hit in the spring when technology shares first broke down, falling almost 50% from March 28 through May 10. But the stock held reasonably firm during the technology correction of early September. While Nortel, for example, fell 23% from Sept. 1 through Sept. 12, Juniper dropped 17% from Sept. 1 through its low on Sept. 11.

What's Holding Back Redback?

I'm not surprised that while Juniper has very easily climbed above its highs of last spring, Redback has had a much tougher time of it this year. The stock lost more than 70% of its value in the spring technology selloff (measured from March 14 through April 24), and until very recently, it seemed stuck below $150 a share.

So what's been holding back Redback? Certainly, this is one expensive stock -- although still nowhere near as expensive as Juniper. The market has valued Redback at $23 billion even though it had just $49 million in revenue during the June 2000 quarter and recorded a loss of 5 cents a share.

But I don't think that's the problem. Instead, I chalk it up to a story that's harder to understand, and to timing. It's easy to sum up Juniper. It's "the next Cisco." Redback, however, is harder to summarize. It's even harder to explain what the company does. Redback is in the business of making gear to manage broadband subscriber traffic. Its gear lets broadband service providers such as

Qwest Communications

(Q)

and

Verizon Communications

(VZ) - Get Report

manage the accounts of their broadband customers to do things like guarantee speedy and low-cost delivery. That kind of management is extremely valuable, but it sure is hard to describe. And it's hard for investors to see exactly what this business' barriers to entry might be or where the company might be headed.

I think that story will get stronger in 2001 if Redback can surge into profitability, as analysts now expect. But right now, the company is perched on the cusp between losses and profits. Wall Street estimates that it will lose 2 cents a share in the September quarter, make 2 cents a share in the December quarter, and finish the year with a loss of a penny a share overall. That's so close to break-even that it makes analysts and institutional investors nervous. A penny or two here or there can make the difference between a pattern showing smooth progress toward profitability, and a slide back into the red.

In 2001, however, that shouldn't be an issue. Analysts are projecting an earnings explosion to 46 cents a share. My guess is that as the year unfolds, earnings news from the company will quickly make the technology story much easier to understand. Redback's momentum should pick up as we get closer to 2001 and into the year -- as long as the company delivers.

Sycamore's Struggle

If you need proof that momentum stocks can't outrun the effects of fundamentals, you don't need to look any further than Sycamore. Despite Wall Street buy recommendations and target prices of $200, the stock has faltered so badly that it's now fair to say that it has lost all momentum. The source of the problem is in falling projections for earnings over the next few quarters. Just 90 days ago, Wall Street was expecting the company to report 6 cents a share in the October quarter. Now, the number is down to 2 cents. For the January quarter the new projection is 4 cents, down from 6 cents. And for the entire fiscal year ending in July 2001, the drop is to 19 cents from 27 cents.

But while Sycamore has currently lost its momentum, it's certainly still valued like a momentum stock at a market capitalization of $26 billion on that projected 19 cents in earnings for fiscal 2001. This stock certainly isn't cheap right now. The question is, will Sycamore get its story together and build new momentum, or will fundamentals continue to wear it down? The recent accumulation of shares by institutional investors suggests that Sycamore, "the optical switch company," isn't yet out of the momentum game. Watch the chart.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Ariba, Atmel, Cable and Wireless, Cisco Systems, Global Crossing, Mercury Interactive, Nortel Networks and Wind River Systems. He welcomes your feedback at

mctsc@microsoft.com.

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