Downgrade Darkens Nortel's Doorstep

Observers expect the company to sell convertible bonds to raise cash.

Author:: Scott Moritz
Publish date:: Apr 4, 2002 6:26 PM EST

Spring is here but the grass still looks brown on

Nortel's

side of the fence.

The big phone gear maker has been struggling with massive debt and deteriorating finances for going on two years now. But even for investors long accustomed to bad news, Thursday's

Moody's downgrade added a new twist: In addition to making debt more expensive, it also gave creditors the right to claim Nortel assets in the event of a default.

Nortel insisted it was "business as usual" after the downgrade. But the company, which was expected to burn through $2.5 billion this year even before Moody's effectively jacked up its borrowing costs, continues to bleed red ink as cash-strapped customers cut back on orders. Now some observers expect the company to come to market with a convertible bond issue to raise cash, even at the higher prices tacked on by the Moody's move. The company wouldn't comment on any cash-raising plans.

For Nortel, whose shares dropped 11 cents to $4.24, the downgrade was hardly surprising. But it's hardly the kind of news investors want to hear.

"We've had some value buyers up here starting to kick the tires, but I don't know any of the value players that hasn't had their hands bloodied by

Nortel in the past several months," says a Canadian money manager based in Victoria who holds no Nortel positions.

Cash on Hand

Of course, default is hardly at hand. Nortel entered the year with some $3.5 billion in cash and an untapped $1.5 billion credit line; any bond sale would simply keep the company from having to tap its emergency reserve. Moreover, Nortel is hardly a stranger to financial challenges: The Canadian networking gearmaker has slashed its staff by some 50% as customers such as

Qwest

(Q)

and

WorldCom

(WCOM)

juggle their own cash worries. Investors are already expecting a

dismal first-quarter financial report in two weeks.

But if Nortel investors didn't face enough red flags already, the company is now back on the sauce, as some observers call it -- providing customers loans to buy networking gear.

Just last month, Nortel plunged into a deal with Spanish wireless operator Telefonica Moviles, offering $230 million worth of financing in exchange for $250 million in equipment sales. Some investors question whether a company like Nortel, which clearly needs to conserve its cash and probably borrow more, should be in the business of lending to other companies. Observers have long criticized the vendor financing game as providing lenders with low-quality revenue while saddling them with high-risk debt.

Nortel has always defended its practice of lending to creditworthy customers as a small part of its business.

Wide Open

Fortunately for the company and its investors, the bond market appears to have an almost bottomless appetite for converts nowadays: Sputtering rival

Lucent

(LU)

, itself a recent downgrade victim, raised $1.7 billion last month with its second convertible offering in eight months.

But climbing out of its hole will be no small feat. Nortel has $4.5 billion in debt and is facing $550 million in interest and debt payments this year. The company has promised its banks it will have a negative cash flow of no more than $500 million in the first quarter. The guidelines limit Nortel to a negative cash flow of $650 million total for the first six months of the year.

Getting tagged with junk status violated one loan stipulation. Slipping below cash-flow promises would blow another covenant. If this were baseball or the California criminal system, Nortel might soon be facing the third strike.