Nortel Eyes Growth in Optical Networking (News) October 27, 1999

Nortel Eyes Growth in Optical Networking

By Brian Graney (TMF Panic)
October 27, 1999

Northern neighbor telecommunications equipment supplier Nortel Networks (NYSE: NT) gained some ground this morning after turning in strong growth results for the third quarter. Overall, revenues rose 30% year-over-year to $5.39 billion and earnings per share (excluding charges related to the acquisition of Bay Networks) rose 33% to $0.28. A higher U.S. tax deduction related to the exercise of stock options lowered the company's effective tax rate for the period and contributed $0.02 to the EPS figure. But even without the tax-related bonus, the quarterly earnings results were in line with analysts' expectations.

Nortel is definitely on a tear, outperforming most of its expected growth rates for this year. Here's what the segment growth in the third quarter looked like:

Segment     Expected CAGR (1998 - 2001)     Q3 Growth Rate

Carriers               20%                       32%
Enterprise             15%                       27%*
Wireless               23%                    mid-teens
*Includes results from Bay Networks
Source: Nortel, Motley Fool data

The company's carrier business, which provides networking products for Internet service providers, public carriers, and cable networks, stole the show during Q3. Revenues rose 32% in the quarter, largely on the back of exploding demand for optical networking and access products. At the beginning of the year, Nortel was selling its optical products at a 50% growth clip; the annual sales rate has since accelerated to over 100%. Similarly, the company's smaller access products are also seeing triple-digit sales growth.

In fact, Nortel could have done even more optical Internet business during the period if it had not sold out many of its products. On a conference call last night, the company said it is increasing capacity to satisfy the still-rising demand and expects to be fully caught-up with optical demand by the end of the year.

Quite frankly, Nortel has the fastest optical equipment out there, and its clients just can't seem to get enough of it. According to recent comments by Optical Internet group president Anil Khatod, optical sales are on track to hit $5 billion this year, up 70% to 80% from a year ago and dwarfing the $600 million in sales booked just four years ago. Scarrier still, the company expects optical demand to march smartly ahead for several more years and sees 2000 growth in line with the rate seen this year.

With that kind of growth outlook and the company plowing back 14% of revenues into research and development efforts to maintain its strong competitive position in optical and Internet Protocol (IP) networking, its easy to overlook the less impressive results turned in by the company's other two main business units.

Without factoring in the addition of Bay, the enterprise business reported flat results during the period. Of course, Nortel picked up Bay for the very reason of jumpstarting this segment, so excluding the unit's enterprise data networking business from the equation isn't really appropriate. A better indication of how the entire enterprise business is doing will come in Q4, which will include the first set of full quarter, year-on-year comparative results for Nortel with Bay on board.

Meanwhile, the wireless segment is also growing at a slower rate than was once envisioned as the company sees business tailing off in TDM switching. For 2000, Nortel is forecasting wireless sales growth in the teens, lower than the high-teens growth expected in enterprise and the 20%-plus growth previewed in the carrier business. Carrier should drive overall 2000 sales growth of 20% to 21%, with an expected increase in gross margins allowing for an earnings per share growth rate higher than the sales rate.

With its 200% share price appreciation over the past year -- dusting the 55% price rise by its larger and more visible U.S. rival, Lucent Technologies (NYSE: LU) -- Nortel is now comparably priced to its neighbor to the south in terms of trailing and foward price-to-earnings ratios. However, the company is still priced at a slight discount to Lucent in terms of price-to-sales, with Nortel's PSR at 3.7 compared to Lucent's 5.1. This alone does not mean that Nortel is cheap by any stretch of the analytical imagination, but it reflects the fact that the days of the market treating the company as merely Lucent's lower-tier Canadian understudy have largely come and gone.

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