The market walloped Nortel Networks and much of the fiber optic equipment sector today after the company's third-quarter report last night. While earnings were slightly ahead of estimates, Nortel's optical division didn't live up to very high expectations. In addition, concerns over inventory levels and future capital expenditures by carriers may be weighing on the shares as well.
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Given those numbers, you might be surprised that Nortel actually reported 42% growth in revenues over the previous year's third quarter, to $7.3 billion, and a 64% jump in operating earnings per share (EPS), to $0.18, a penny ahead of analysts' estimates. Sales, however, were slightly below expectations. (For more info on the numbers, check out this morning's Breakfast With the Fool.)
Inventories up, sales growth down
While Nortel is a fairly diversified company, the market is focusing on its optical networking equipment division, which makes 10-Gigabit long-haul transmission systems, among other things. This division reported 90% year-over-year revenue growth, to $2.3 billion. While this is not exactly sluggish, analysts expected revenues to more than double. In addition, the division's revenues declined 17% on a sequential basis, from sales of $2.7 billion in the second quarter.
Nortel attributed this slowdown to a couple of factors, including a possible inventory buildup at a few of the company's customers. As noted in a Lehman Brothers report, lead times for some of Nortel's higher-end products jumped to six months earlier this year, thanks to capacity constraints, and several carriers may have increased their inventories in response. While Nortel has largely resolved the supply and capacity problems, reducing lead times to as low as eight weeks, customers such as Qwest (NYSE: Q) and Williams Communications (NYSE: WCG) may still be clearing out inventory.
This would also explain why Nortel's own inventories have increased. The company's days in inventory -- the length of time it takes to sell all its products on hand -- jumped to 82 days from 70 in the second quarter. And given Nortel's role as a major buyer of optical components from companies such as JDS Uniphase (it also makes plenty of its own in-house), it's no wonder the sector as a whole got whacked.
Nortel also cited delays in its systems installations as another factor restraining sales. The company plans to increase installation capacity by 20% in the fourth quarter, through productivity improvements in its field personnel and increasing training with its carrier customers, among other measures.
Demand worries
Another factor weighing on Nortel's shares is the ongoing debate among many telecom analysts over whether carriers will continue to grow their capital expenditures enough to support the expected revenue and earnings growth of companies like Nortel. Carriers such as AT&T (NYSE: T) and WorldCom (Nasdaq: WCOM) spent billions to upgrade their networks this year, while their businesses experienced wrenching transformations and their shares plummeted, leading to concerns that capital expenditure growth will slow next year.
For its part, Nortel is optimistic about the near term. CEO John Roth cited a "strong order backlog" and boosted forecasts for EPS from operations to the low-40% range, from the previous level in the high-30% range. For 2001, the company continues to expect revenue and operating EPS growth between 30% and 35%. Roth also projected overall carrier capital spending growth to be between 20% and 25% next year.
Richly valued
Regardless of how the capital spending debate plays out, Nortel's drop today is yet another example of what happens when a company priced to perfection doesn't perform perfectly. In previous quarters, Nortel has blown past estimates, while yesterday they barely beat expectations and did so in part because of a lower tax payment.
At yesterday's close, Nortel traded at 87x forward earnings, and JDS Uniphase and others were even higher. Before considering today's drops as "buying opportunities," investors should ensure they are comfortable with the price they pay. For more information, be sure to check out our most recent Motley Fool Research Internet Report on fiber optic components.
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