Nortel Ready to Shrink Again

Nortel's (NT) accounting investigation is on track, but it turns out the company's business isn't going as well as planned.

The Brampton, Ontario, telecom gearmaker said Tuesday that it would need to make more cuts to achieve its profit targets. Investors, expecting Nortel to sound a more upbeat note in a scheduled biweekly financial update, were taken aback by the surprisingly weak margin outlook.

Nortel shares fell 61 cents, or 15%, to $3.46 Tuesday. That puts them more than 50% below the highs they reached earlier this year, when Wall Street was more optimistic about the telecom equipment market -- and before Nortel disclosed the depth of its accounting problems.

Though the company has previously sent some signals about high costs and the need to make cuts, the update Tuesday deflated any remaining hope that Nortel could emerge unscathed from a difficult period.

"The company has provided several 'hints' over the past few months ... that historical gross margins and operating expenses would be negatively impacted once its accounting restatements were finally released," wrote Lehman Brothers analyst Steve Levy in a research note Tuesday. "Nonetheless, management had never formally announced the potential shortfalls in operating profitability." Levy has a neutral rating on the stock.

New worries about the state of Nortel's current business compound an already dicey situation for the company. Earlier this year, after internal audits revealed that executive bonuses were based on false profits, the company became the center of investigations by the Securities and Exchange Commission and the Ontario Securities Commission.

The company says it is preparing an update of restatement findings for each 2003 quarter and for earlier periods, including 2002 and 2001. The company is expected to release those findings and preliminary financial reports for the first and second quarter of this year in the middle of next month.

Analysts say Nortel's need to cut costs points to potential troubles on the sales front. Some observers have suspected that in order to win business or prevent contracts from going to competitors, Nortel has been willing to cut prices steeply.

Of course, Nortel and its big networking industry peers have cut costs sharply in recent years as industrywide spending slowed to a crawl. Nortel's comments Tuesday suggest the company may have to look at further cutbacks.

Going into the year, many investors and analysts viewed Nortel's strong product lineup in areas like wireless infrastructure and voice over Internet protocol, or VoIP, as a key advantage over rivals like Lucent ( LU), Motorola ( MOT) and Cisco ( CSCO).

But those assumptions have been challenged by this year's less-than-bullish turn of events in the networking industry, where spending hasn't thawed in spite of widespread early-year forecasts. Moreover, Nortel's take on things has been muzzled by the accounting investigation, as the company hasn't been able to share its business outlook in anything but the most general of terms.

Analysts forced to draw their own conclusions offer a rather dismal assessment.

In a report to clients Tuesday, J.P. Morgan Chase analyst Ehud Gelblum reiterated his neutral rating on Nortel and offered his best guess at margins.

"We believe Nortel is producing operating margins in the low-single digit range at best, and at worst 0% or slightly negative," wrote Gelblum.

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