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Mixed signals in telecom
Shares of telecom equipment makers are in the doldrums but their bonds have rallied. Who's right?
March 25, 2005: 11:40 AM EST
By Paul R. La Monica, CNN/Money senior writer
Equity investors have dumped shares of Corning, Nortel and Lucent even though the bond market has embraced their debt.
Equity investors have dumped shares of Corning, Nortel and Lucent even though the bond market has embraced their debt.

NEW YORK (CNN/Money) - Is the telecom equipment market primed for a comeback or set to see some more gloomy days ahead? It depends on whom you ask.

Investors in shares of Corning (Research), Nortel (Research) and Lucent (Research) don't think the outlook for these companies is too promising. Corning's stock has fallen about 8 percent this year; Lucent and Nortel are down 20 percent or more and hover near 52-week lows.

But it's been a different story in the fixed-income market. Before the Fed raised rates on Tuesday and spooked investors by saying "pricing power is more evident", the high-yield bonds for these three companies had been rallying.

That drove yields on Lucent, Nortel and Corning bonds near their lows for the year, suggesting that bondholders aren't that worried about the business outlook for these companies. (Bond yields fall as bond prices rise).

Arnie Berman, senior technology strategist with independent research firm CreditSights, thinks this is significant. He notes that bond investors are typically ahead of the curve when it comes to identifying companies in trouble, or set for a turnaround.

"The outsize rally in the publicly traded debt for companies in this sector suggests that the bond market is sending a signal that the communications equipment sub-sector is particularly attractive at present relative to other technology sub-sectors," Berman wrote in a recent report.

Worst over, mergers to follow?

What's got bondholders excited that stock investors might be missing? While the telecom market is still in a state of flux, Kim Noland, an analyst with fixed-income research firm Gimme Credit, said that bond investors are happy that the worst seems to be over for these companies.

After the tech and telecom bubble burst in 2000, losses piled up and some investors feared that telecom equipment makers would go bust. That's no longer an issue.

Lucent finished last year with $4.6 billion in cash, down just $300 million from the prior quarter, Corning's cash balance was $1.9 billion, up some $200 million, while Nortel finished last year's third quarter at about $3.6 billion, also down $300 million from the prior quarter. Nortel's delayed reporting year-end results due to accounting errors.

"Cash burn has abated, signaling that companies would likely not need debt restructuring," Noland said.

Equity investors also appear to be worrying about the wave of big mergers among telecom carriers, major customers for equipment made by Lucent, Nortel and Corning.

With Sprint buying Nextel, SBC nabbing AT&T and Verizon and Qwest battling for MCI, there have been concerns that telecom companies will slash capital spending until they finish integrating their mergers.

But bond investors might be taking the longer-term view that consolidation among carriers may spark deals among telecom equipment makers.

"Mergers of telecom carriers could cause mergers in the equipment area," said Pierre Robert, senior analyst with Advantage Data, a fixed-income research firm based in Boston. "If a Lucent or Nortel got acquired by a company with higher investment grade debt, then their bonds could shoot up."

And CreditSights' Berman said stock investors appear overly worried about lower capital spending. In fact, he thinks the recent spate of mergers is a good sign for equipment companies.

His argument? The big phone service carriers resulting from these deals will need to spend more on equipment to stay competitive against newer threats such as cable and Internet telephone providers.

"Consolidation activity is actually a signal that service providers are scared and will start spending money again. Equipment companies are long-term beneficiaries of this and frankly, I think that's what the bond market is smelling out," Berman said.

Near-term, still cloudy

Still, the near-term outlook for telecom gear makers isn't exactly rosy. And they face tough competition from firms like Cisco (Research) and Alcatel (Research).

Lucent and Nortel are expected to post single-digit percentage gains in sales this year, while profit growth has been fueled more by cost cutting than growth in demand. Corning has fared better, thanks in part to booming demand for glass sheets used in flat-screen TVs and computer monitors. But its fiber-optic business continues to struggle.

"The companies still will have to show growth in sales and growth in profits as well," said Gimme Credit's Noland.

And Robert at Advantage Data said the gear makers' bonds might be rallying simply because they're somewhat safer than the common stock. In case of severe financial trouble, bondholders have a better chance of getting back some of their investment.

"People are still skittish about telecom so it's better to get in the bonds. If worst comes to worst and companies default, you're much higher up on the food chain," Robert said. "You may get 40 cents on the dollar back instead of one penny. It's a less risky proposition."

But Berman said equity investors shouldn't ignore the signs from bondholders. If they are right about the outlook for these companies, that should eventually pan out for the stocks.

"The bond market is keenly aware that cash flows have improved and that the chances of investors getting back money they are owed is better. That's not at all irrelevant to stockholders," Berman said.

For a look at telecom equipment stocks, click here.

For more about the bond market, click here.  Top of page


Lucent Technologies Incorporated
Nortel Networks
Corning Incorporated
Company Debt
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