Nortel Networks Corp. (NYSE: NT) is the Toronto-based supplier of products and services to telecom carriers, other networking enterprises, and businesses. Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated deficit (i.e., negative retained earnings) of $40 billion (U.S.). Nortel has defied the worst-case predictions and managed to stay in business and even independent, unlike fellow fallen telecom Lucent Technologies -- now part of Alcatel-Lucent (NYSE: ALU).
Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of misdeeds. The RCMP has charged a former Nortel CEO and two other executives with fraud for errors for errors in the company's financial statements.
Nortel's financial statements confound our gauges and produce scores that are clearly too high for a struggling company. This is because some of the tried-and-true ratios that move our gauges behave perversely when applied to a firm that has contracted significantly. An increasing Revenue/Assets ratio, for most companies, is a sign that Growth is sustainable. In Nortel's case, the ratio has risen because Assets are down sharply.
We recently adjusted our scoring algorithms to overcome some of the analytical challenges we've faced with Nortel. We fixed cases where signs of weakness were misinterpreted as signs of strength. While the scores are still suspect, we hope that readers will, nevertheless, gain insights from our methods.
Three months ago, the GCFR Overall Gauge gave Nortel 41 (later revised to 36, but probably still too high) of the 100 possible points after we analyzed the company's second-quarter results. This period featured positive Operating Income, no sure thing for Nortel, but non-operating expenses pushed Net Income into the red yet again.
Nortel warned on 17 September 2008 that sales in certain markets are under "significant pressure" and that products deliveries are expected to be delayed until the fourth quarter. Guidance for the quarter and year were revised downward. The warning was accompanied by an announcement that Nortel intends "to explore a divestiture of its Metro Ethernet Networks (MEN) business," which it refers to as "a premium asset."
Now, with all available data from the September 2008 quarter, our gauges display the following scores:
- Cash Management: 12 of 25 (unchanged from 12)
- Growth: 0 of 25 (unchanged)
- Profitability: 7 of 25 (down from 9)
- Value: 10 of 25 (unchanged)
- Overall: 35 of 100 (down from 36)
As mentioned above, these scores are suspect.
Before we examine the factors that affected each gauge, we will compare the latest quarterly Income Statement to our previously communicated expectations.
Please note that the tabular format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | September 2008 (actual) | September 2008 (predicted) | September 2007 (actual) |
| Revenue (1) | | 2,319 | 2,300 | 2,705 |
| Operating expenses | | | | |
| | CGS | (1,411) | (1,403) | (1,542) |
| | R&D | (377) | (397) | (416) |
| | SG&A | (514) | (559) | (613) |
| | Other (2) | (1,211) | (60) | (68) |
| Operating Income | | (1,194) | (119) | 66 |
| Other income | | | | |
| | Investments (3) | (21) | (37) | (42) |
| Asset sales | 6 | 9 | (3) | |
| | Interest, etc. (4) | (75) | (21) | 56 |
| Pretax income | | (1,284) | (169) | 77 |
| Income tax | | (2,129) | 67 | (50) |
| Net Income | | (3,413) | (101) | 27 |
| | | ($6.85)/sh | ($0.20)/sh | $0.05/sh |
| Shares outstanding | | 498 | 500 | 500 |
2. Amortization of intangible assets + Special charges + In-process R&D
3. Minority interests + Equity in net income of associated companies. Both figures are net of tax.
4. Other income - Interest expense
The Cost of Goods Sold was 60.8 percent of Revenue, which translates into a Gross Margin of 39.2 percent. Nortel had told investors to expect the Gross Margin to be approximately 39 percent of Revenue. In the year-earlier quarter, this margin was 43 percent.
Research and Development (R&D) and Sales, General, and Administrative expenses were a combined $891 million in the quarter. If we add $50 million of "Special Charges" and $11 million for amortization of intangible assets, the result is very close to the implied $956 million guidance for operating expenses. We grouped the latter two charges into the "Other" category. Special charges are related to workforce reductions, consolidation of real estate, and other restructuring actions.
R&D expenses were 16.3 percent of Revenue, compared to 15.4 percent in the year-earlier quarter. SG&A expenses were 22.2 percent of Revenue, compared to 22.7 percent in September 2007.
While Nortel's quarterly results always include other operating expenses, a couple of which we've already mentioned, the September 2008 quarter featured an unexpected $1.1 billion charge for "Goodwill Impairment." [The company took pains to note that this is a non-cash charge. It took goodwill from $2.6 billion on 31 December 2007 to $1.4 billion.]
With such a huge charge, Operating Income was obviously well short of last year's value and our estimate.
Non-Operating expenses were somewhat more than expected, but the difference was not material. The non-operating factors include Interest Expenses and Minority Interests.
Negative pre-tax income didn't preclude a jaw-dropping $2.2 billion provision for Income Taxes, which pushed the Net Loss to $3.4 billion. The tax situation is extremely complicated, but the gist is that Nortel determined that "it will not be able to use all of its net deferred tax assets within a reasonable timeframe."
In the last five years, Nortel's cumulative pre-tax income has been a loss of $1.37 billion. During this same period, Nortel's Provision for Income Taxes has totaled $3.2 billion. Cash Flow from Operations was minus $530 million.
| Cash Management | September 2008 | 3 mos. ago | 12 mos. ago |
| Current Ratio | 1.5 | 1.5 | 1.4 |
| LTD/Equity | N/A | 179% | 131% |
| Debt/CFO | N/A | N/A | N/A |
| Inventory/CGS | 110 days | 112 days | 118 days |
| Finished Goods/Inventory | 50.1% | 45.2% | 36.3% |
| Days of Sales Outstanding (DSO) | 75.2 days | 73.7 days | 87.9 days |
| Working Capital/Market Capitalization | 41.2% | 33.2% | 18.6% |
| Cash Conversion Cycle Time (CCCT) | 120 days | 122 days | 149 days |
| Gauge Score (0 to 25) | 12 | 12 | 6 |
Equity is now negative, rendering the LTD/Equity meaningless. Debt/CFO is also irrelevant because Cash Flow is negative and not available for debt payments.
While the Inventory level has decreased a little, it is still to high in an industry where frequent innovation necessitates short product cycle times. The rising proportion of Finished Goods in the Inventory can be a sign of weaker sales to come.
The increase in Working Capital/Market Capitalization is the result of a much diminished market value.
The 10-Q indicates Nortel had $362 million invested in a money-market fund that suspended redemptions.
| Growth | September 2008 | 3 mos. ago | 12 mos. ago |
| Revenue growth | -1.6% | -0.1% | -0.5% |
| Revenue/Assets | 74% | 65% | 61% |
| CFO growth | N/A | N/A | N/A |
| Net Income growth | N/A | N/A | N/A |
| Gauge Score (0 to 25) | 0 | 0 | 0 |
The Cash Flow and Net Income growth rates are incalculable since the values were negative in the current and previous periods.
Revenue is declining, but Assets have fallen even more.
| Profitability | September 2008 | 3 mos. ago | 12 mos. ago |
| Operating Expenses/Revenue | 95.4% | 94.5% | 97.3% |
| ROIC | N/A | 5.0% | 0.7% |
| FCF/Equity | -31.0% | -10.1% | -23.6% |
| Accrual Ratio | -33.1% | -5.1% | -2.4% |
| Gauge Score (0 to 25) | 7 | 9 | 7 |
In the Operating Expense ratio, we exclude the special and non-recurring expenses discussed above.
| Value | September 2008 | 3 mos. ago | 12 mos. ago |
| P/E | N/A | N/A | N/A |
| P/E to S&P 500 average P/E | N/A | N/A | N/A |
| Price/Revenue | 0.1 | 0.4 | 0.8 |
| Enterprise Value/Cash Flow (EV/CFO) | N/A | N/A | N/A |
| Gauge Score (0 to 25) | 10 | 10 | 8 |
Nortel's stock price decreased during the September quarter from $8.22 to $2.24, and the shares trade for about a buck now. (It was only two years ago that Nortel implemented a 1-for-10 reverse stock split.) The Value gauge is based on the quarter-end closing price.
On a Price/Revenue basis, Nortel shares appear dirt cheap. This one factor is responsible for the Value gauge score. However, with negative earnings and negative cash flow, we don't consider the Revenue ratio to be compelling.
Nortel's valuation ratios can be compared with other companies in the Technology Processing Systems & Products industry. (It's not pretty.)
| Overall | September 2008 | 3 mos. ago | 12 mos. ago |
| Gauge Score (0 to 100) | 35 | 36 | 25 |
Nortel has implemented a long series of restructuring plans over the course of the current decade. The 2009 plan, which includes workforce reductions of about 1,300 positions and shifting the locations of 200 additional positions, has already been announced. Yet, Revenue is down, Cash Flow from Operations is negative, losses are accumulating, and shareholders' equity is less than zero.
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