Nortel vs. Cisco investment outlook

Nortel vs. Cisco Investment Outlook
Today Nortel hosted an investment community webcast to discuss expectations for its third quarter and full year 2008 financial results (Note: Nortel's stock price plunged almost 50% after today's webcast). Yesterday, Cisco hosted its Financial Analyst Conference webcast for members of the investment community with a keynote delivered by CEO John Chambers followed by Cisco executive team overviews of the company's financial roadmap and long-term strategy. Placing a Wall Street analyst perspective on this week's Nortel and Cisco webcasts, RBC Capital Markets Managing Director Mark Sue offers a comparative Nortel vs. Cisco investment outlook: Future Prospects Nortel The situation is getting worse for Nortel and the company is being forced to strengthen its balance sheet with another round of asset sales. With softening demand and increased competition, Nortel may need to once again retool and refocus as it looks to find its position in a consolidating industry. Our price target moves to $4. vs. Cisco Cisco articulated a detailed message regarding its growth prospects and highlighted key new markets and adjacent opportunities which may enable the company to meet its long term growth guidance range of 12-17%. Video, Collaboration, and Virtualization were key areas of focus and may collectively represent $62B in additional addressable markets.

Initiatives and Challenges Nortel Nortel preannounced 3Q08 earnings and revised their 2008 outlook citing the economic downturn and significant customer pressure in Carrier, Enterprise and Metro Ethernet. Additionally, Nortel is exploring divesting its Metro Ethernet-40Gig optical business which we estimate at $1.7B in 2009. MEN was one of the faster growing segments with a projected CAGR (Compound Annual Growth Rate) of 10% and a potential $2B market size. Peer groups in optical have also suffered so Nortel's timing may not be the best. Nortel is also planning additional restructuring and cost reduction initiatives. vs. Cisco Near term, metrics remain challenging, particularly in the financial verticals. But to put it in context, total financial customers represent only 3-4% of Cisco's revenues. And considering Cisco's skills of forecasting and projecting its business, we believe the extra conservatism of just 8% YoY (Year Over Year) growth for the near term may have been factored in a deteriorating enterprise environment. On the margin, Cisco may be seeing incrementally positive trends with some domestic and international carriers.

Revenue Expectations Nortel For 3Q08, Nortel sees revenues of $2.3B versus the street at $2.7B. Gross margin is expected to be ~39% due to delivery delays and product mix. Operating expense is expected to be $60M lower than 2Q08 or about $950M. For CY2008, Nortel expects sales to decline 2-4% YoY versus previous guidance of low single-digit growth. Gross margins are expected to be at 42% for the year and Management Operating Margin is expected to improve 125-175bps YoY versus prior expectations of a 300bp improvement. Deferred revenue in 4Q08 goes from $350M to $320M. vs. Cisco Cisco entered the quarter with a book to bill greater than 1.0 and backlog of $4.8B, and with geographic and segment balance offsetting weak sectors, we believe Cisco remains well placed to meet its near term financial metrics. Consensus for the current October quarter is $10.33B (just +8% YoY). Nonetheless, if the macro deteriorates further and remains broad based, Cisco will be impacted. Cisco declined to call a time frame for a recovery but we do point out that the consensus for the following January quarter calls for reasonable 8.5% YoY growth.

Strategic Considerations Nortel Cash burn during 3Q08 will be about $500M. While earnings are a significant factor, there are about $220M in "one-off" charges including a $70M payment to Flextronics, a $50M LG Electronics earnout, an $80M impact from having an additional payroll period during the quarter and some small acquisitions. End of year cash balance is expected to be between $2.6B and $2.9B. vs. Cisco Cisco's core markets of switching and routing (54%) are maturing and may grow just 8-9% over time. Yet, add to this baseline growth emerging markets, adjacent markets and services, and it might be enough to nudge the needle higher to 12-17% overall. Several new products will also help nudge the needle and Cisco emphasized the new 1000V for virtualization, mid range Telepresence systems, and web collaboration.

Investor Forecast Nortel Nortel shares are currently trading at 0.3x 2009E EV/Sales (Enterprise-Value-To-Sales). Over the last three years, Nortel shares have traded between 0.3x and 1.7x EV/Sales, with an average of 1.0x. On a P/E basis, the shares are trading at 7x our new CY09E EPS of $0.50. Visibility towards our estimates which do not factor in the planned divestiture remains low and another strategy rethink may be necessary for Nortel. Nortel Stock Chart:

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vs. Cisco Cisco's financial model remains healthy with gross margins near 65%, operating margins of 29.5% and strong cash generation. Cisco has $8B left in its share repurchase authorization. Organizational tweaks and a broader use of the development council is also helping Cisco to address market growth opportunities faster. And despite the muted environment, Cisco may be executing better than its peers. And with shares trading at 13x our CY09 earnings, we view Cisco as a strong relative defensive name. Cisco Stock Chart:

View the full CSCO chart at Wikinvest

Related stories: Nortel sees Q3 revenue down, will sell metro Ethernet unit Cisco: TelePresence will do for Cisco what iPhone did for Apple

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