Nortel is the Canadian-based supplier of products and services to telecom carriers, other networking enterprises, and businesses. Nortel has defied the worst-case predictions and managed to stay in business and even independent, unlike fellow fallen telecom Lucent Technologies. Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated earnings deficit of $35 billion (U.S.).
Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of fraud. The restatements complicate any financial analysis of Nortel.
When we analyzed Nortel after the September quarter, the Overall score was only 26 points. Recent changes to our scoring algorithms have bumped that up to a still-weak 29 points. Of the four individual gauges that fed into this composite result, Profitability was strongest at 9 points. Growth was weakest at 2 points.
Now, with the full-year data from the 10-K, our gauges display the following scores:
- Cash Management: 5 of 25
- Growth: 8 of 25
- Profitability: 8 of 25
- Value: 9 of 25
- Overall: 32 of 100
Before we examine the factors that affected each gauge, let's examine the Income Statements for the December 2007 quarter. We didn't issue a forecast for the quarterly results, so all figures are actuals. Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats. A common difference is the classification of income and expenses as Operating and Non-Operating. The standardization is simply for convenience and to facilitate cross-company comparisons.
| ($M) | | Dec 2007 (actual) | Dec 2006 (actual) |
| Revenue (1) | | 3198 | 3322 |
| Op expenses | | | |
| | CGS | (1801) | (1999) |
| | R&D | (475) | (488) |
| | SG&A | (678) | (694) |
| | Other (2) | (45) | (42) |
| Operating Income | | 199 | 99 |
| Other income | | | |
| | Investments (3) | (39) | (55) |
| Asset sales | 23 | 164 | |
| | Interest, etc. (4) | 13 | (63) |
| Pretax income | | 196 | 145 |
| Income tax | | (1040) | (9) |
| Net Income | | (844) | 154 |
| | | ($1.69)/sh | $0.35/sh |
| Extraordinary items (5) | | | (234) |
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
5. Shareholder litigation settlement expense.
Revenue was 3.7 percent less than in the year-earlier quarter. On a year-over-year basis, Revenue was down 4.1 percent. On a more positive note, Gross Margin increased as Cost of Goods Sold dropped from 60.2 to 56.3 percent of Revenue. Research and Development (R&D) expense edged up from 14.7 to 14.9 percent of Revenue. Sales, General, and Administrative (SG&A) expenses increased from 20.9 to 21.2 percent of Revenue.
The lower levels of CGS outweighed the higher R&D and SG&A costs. As a result, Operating Income essentially doubled.
Net non-operating income dropped by almost $50 million, primarily because the gain on asset sales was much greater in the December 2006 quarter.
Income taxes bizarrely turned a quarter with a modest gain into a quarter with a huge loss in Net Income. The income tax amount reflects Nortel's decision to record a non-cash charge over $1 billion to increase the valuation allowance associated with Canadian deferred tax assets.
Cash Management. This gauge decreased from 6 points in September to 5 points at the end of the year.
The following measures contributed the most to the score:
- Current Ratio =1.4; weaker than we prefer, but stable.
- Finished Goods/Inventory = 40 percent, although it is up from 36.6 percent one year ago, it has come down a lot from long-term averages
- LTD/Equity = 138.4 percent; still too high, but at least it is down from last year's 397 percent! Equity is so minimal that small reductions in debt are magnified.
- Debt/CFO = N/A (CFO has been negative)
- Inventory/CGS = 115 days, compared to 106.4 days last year.
- Cash Conversion Cycle Time (CCCT) = 138 days, up from 135 days a year ago, for this measure of efficiency
- Working Capital/Market Capitalization = 19.7 percent, almost unchanged from 19.9 percent in December 2006.
- Days of Sales Outstanding (DSO) = 89.5 days, almost unchanged from 89.7 days last year
Growth. This gauge increased from 2 points in September to 8 points now.
The following measure was the one positive contributor:
- Revenue/Assets = 64.1 percent, up from 60.2 percent last year.
- Revenue growth = -4.1 percent year-over-year, down from +8.6 percent
- Net Income growth = N/A
- CFO growth = N/A
Profitability. This gauge decreased from 9 points in September to 8 points now.
The following measures pushed the score up the most:
- Operating Expenses/Revenue = 96.3 percent, down from 100.0 percent in a year
- Accrual Ratio = -5.6 percent, down from -0.9 percent in a year
As the result of a reader comment, we're experimenting with a different way to calculate the Accrual Ratio. We'll explain the details in a subsequent post, but the new approach provides a different view of the relationship between Net Income and Cash Flow. Low Accrual Ratios, preferably below 0, indicate that more of the company's Net Income is due to Cash Flow and, therefore, less is due to changes in non-operational Balance Sheet accruals.
The following measures held the score down:
- FCF/Equity = -23 percent, down from -7 percent last year
- ROIC = 0 percent
Value. Nortel's stock price dropped over the course of the quarter from $16.98 to $15.09 (it's much less now). Based on the latter price, the Value gauge increased from 8 points in September to 9 points.
The following measures contributed the most to the score:
- Price/Revenue ratio = 0.7, down from 1.0 in December 2006
- Enterprise Value/Cash Flow = N/A
- P/E = N/A
- P/E to S&P 500 average P/E = N/A
The average P/E for the Communication Equipment industry is currently 23. The average Price/Revenue for the industry is currently 4.8.
Now at 32 out of 100 possible points, the best we can say about the Overall gauge score for Nortel is that has been worse. More than 6 years after the high-tech bubble burst, we don't yet see any firm signs that Nortel has turned the corner towards sustained profitability. Over the years, there have been a couple of encouraging moments. But, they proved evanescent. We need to see more.
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