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For a company -- not to mention a long-suffering group of shareholders -- that has seen as much disappointment as Nortel Networks, there's no question that news of a $1-billion (U.S.) wireless contract with Verizon comes as a welcome breath of fresh air. Unfortunately for anyone looking at whether to buy the stock or not, the current price already reflects all of that optimism and then some.
First, the good news.
The Verizon contract -- a three-year deal to supply equipment for the U.S. carrier's network expansion and upgrades -- was hailed by many Nortel watchers not just as a good contract to get, but also as a sign of the Canadian company's strength compared to some of its competitors, such as Lucent Technologies.
And not only did Nortel win the contract, it also won praise from Verizon that suggested the potential for future business. For example, the carrier said in its press release that Nortel had "earned this additional business by demonstrating strong performance over the last several years." Analyst Richard Winslade of Dresdner Kleinwort Wasserstein said this could be seen as "a warning to competitors that Nortel is becoming the preferred supplier."
In fact, the wireless sector over all has been stronger for Nortel in the latest quarter than many analysts were expecting. UBS said in a recent report that checking with Nortel customers showed that the business is "tracking slightly better than our [third-quarter 2003] original estimate," and that the firm believes Nortel is "in a solid position to be a top 3 supplier" in next-generation equipment.
So where's the bad news? The bad news comes in a couple of different forms -- and one is that wireless is only a part of Nortel's business. In fact, despite the higher-than-expected growth in wireless equipment, UBS barely changed its revenue and profit targets for the company. Why? Because that growth is offset by slower growth, or lack of same, in the optical, wireline and corporate sectors.
In other words, Nortel doesn't come out ahead despite the stronger growth in wireless. UBS said Nortel's performance in the optical and enterprise markets has been particularly weak, and not many industry watchers see much of a recovery in those sectors. In fact, wireless is the one semi-bright spot in a telecom equipment market that continues to suffer from over-capacity and under-demand.
And even that bright spot is only bright in comparison with the rest of the business. Nortel's own wireless division says that it expects sales of wireless equipment to be down again this year by about 10 per cent, and for sales to remain at about that level through 2004. Within the wireless market, sales of next-generation equipment such as W-CDMA are growing while sales of older products continue to shrink.
In other words, Nortel's future growth is dependent on taking a larger and larger share of a smaller and smaller market. To do that, it must not only focus on the right parts of the growing demand for next-generation equipment, but win contracts from the few carriers that are actually boosting their spending rather than cutting it or keeping it the same.
Even for a telecom specialist such as Nortel, that is not an easy task.
Several brokerage firms, such as Goldman Sachs, raised their price targets for Nortel in the wake of the Verizon win, saying gaining market share would pay off in higher revenue and higher profit margins for the company.
By the end of the week, however, Nortel had hit most of these targets, climbing to over $4 -- and some analysts warned that it was getting a bit ahead of itself.
Despite the fact that its sales and profit estimates didn't move that much, UBS still raised its target for the stock to $4.20 from $3.05. The firm said the new target was 20 times "normalized" profit for 2005 -- a figure that was calculated by assuming profit margins of 11 per cent. The previous stock target was based on a 10-per-cent profit margin. Goldman Sachs raised its target to $4.
Dresdner Kleinwort Wasserstein, however, said that the Verizon deal does not represent any additional new business for Nortel, but is a renewal of existing equipment contracts.
In fact, Mr. Winslade said that new pricing arrangements "should have a small negative effect" on Nortel's bottom line, rather than a positive one.
The analyst said some of Nortel's other wins may also be the result of "aggressive" pricing, raising questions about profitability.
In contrast to the $4 and upward stock-price targets from other firms, Dresdner has a target of $2.50 for Nortel and a "sell" rating on the stock. BMO Nesbitt Burns, meanwhile, said that while the Verizon contract win was a positive, it was also maintaining its "underperform" rating on Nortel with a price target of $2.50.
There's no question that Nortel has successfully restructured itself to the point where it is close to being profitable, and it is seeing some growth in wireless.
But wireless is just one part of the over-all telecom market, and even that growth is coming at a cost, since pricing pressure threatens to eat into margins.
Is that worth more than 20 times Nortel's theoretical profits in 2005? A good question to ask.
Mathew Ingram writes commentary and analysis for globeandmail.com
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